Behavioral Finance Flashcards
definition of behavioral finance
explain observed investor and market behavior;
investors are not rational; markets are not efficient
definition of traditional finance
theory about how investors and markets behave
Investors are rational and markets are efficient
explain Raiffa Decision Analysis
3 types:
Normative
Descriptive
Prescriptive
explain Normative Analysis
rational solution is the “ideal “ that actual decision makers should strive for (assumption of traditional finance: Expected Utility & Decision Theory)
explain Descriptive Analysis
describes the way real people actually make decisions (i.e., behavioral finance: Prospect Theory; Bounded Rationality)
explain Prescriptive Analysis
practical advice and tools that help achieve results of normative analysis (use of behavioral finance in practice)
describe a rational investor
risk-avers, self-interested, utility maximizer
describe an efficient market
all information is priced into market prices and changes
describe behavioral finance micro (BFMI)
focuses on differences between actual investor and the rational investor
describe behavioral finance macro (BFMA)
focuses on differences between actual markets and efficient markets
what kinds of behavioral biases does BFMI suggest impact the financial decisions of individual investors?
cognitive errors; emotional biases
Utility Theory is…
people maximize the present value of utility, subject to a present value budget constraint, such that utility is the level of relative satisfaction received from consumption of goods and services
What are the axioms of Utility Theory?
completeness
transitivity
independence
continuity
What is Bayes’ formula
P(A given B) = P(A) * P(B given A)/P(B)
explains how existing probability beliefs should be changed given new information
Rational Decision Making
- Adhere to axioms of utility theory
- Assign a probability measure to possible events
- incorporate new information according to Bayes’ formula
- Choose action that maximizes utility function subject to budget constraints with respect to conditional probability measure
Explain Rational Economic Man (REM)
REM will try to obtain highest possible economic well-being or utility given budget constraints and available info. will base choices on consideration of own personal utility, not that of others except if it impacts his own
Utility function of risk-neutral individuals
risk-neutral individuals have linear utility functions
utility function of risk-averse individuals
risk-averse individuals have concave utility functions (arch) - diminishing marginal utility of wealth [rational investor]
utility function of risk-seeking individuals
risk-seeking individuals have convex utility functions (bowl) - increasing marginal utility of wealth)
Describe Bounded Rationality
Bounded rationality assumes that individuals’ choices are rational but subject to limitations of knowledge and cognitive capacity
- decision maker may violate a commonly accepted precept of rational behavior but acts in a manner consistent with pursuit of set of goals
Describe Prospect Theory
Prospect Theory assigns values to gains and losses rather than to final wealth, and probabilities are replaced by decision weights. Shape of decision maker’s value function is assumed to differ between the domain of gains and the domain of losses: (reference dependent). Loss-Averse investor
Stage 1: Framing/Editing
Stage 2: Evaluate
Describe Decision Theory
assumes decision maker is fully information, is able to make quantitative calculations with accuracy and is perfectly rational
Describe Mental Accounting
people classify wealth into different accounts to accommodate the competing goals of short-term gratification and long-term benefits
describe Behavioral Stochastic Discount Factor Model (SDF)
market sentiment causes asset prices to deviate from values determined using traditional finance
describe 5 factors of Behavioral Portfolio Theory (BPT)
- Layers of risk are assigned allocations depending on goals
- allocation of funds within each layer will depend on goal of layer
- number of assets depends on utility function (risk-averse investors will have more securities)
- concentration may occur from belief in information advantages
- loss-aversion causes investors to hold cash or other certain securities
describe Adaptive Markets Hypothesis (AMH)
markets are influences by competition for scarce resources and adaptability of participants:
- risk premiums change over time
- active mgmt adds value
- particular strategies will not always do well
- ability to adapt and innovate is key to survival
- survival is essential objective
What are the guidelines for determining a behaviorally modified portfolio?
- Moderate the less wealthy and adapt to the more wealthy.
2. Moderate cognitive biases and adapt to emotional biases.
What is Standard of Living Risk (SLR)?
the risk that a current or a specified acceptable lifestyle may not be sustainable.
Standard asset allocation program with a client involves
- Advisers administer a risk tolerance questionnaire
- Discuss the client’s financial goals and constraints
- Recommend the output of a mean-variance optimization
List some cognitive errors that are belief perserverence
conservatism bias confirmation bias representativeness bias control bias hindsight bias
list some cognitive errors that are information processing related
anchoring and adjustment
mental accounting bias
framing bias
availability bias
list some emotional biases
loss aversion bias overconfidence bias self-control bias status quo bias endowment bias regret-aversion bias
conservatism bias
maintain prior views or forecasts by inadequately incorporating new information - overweight of initial beliefs
confirmation bias
look for and notice what confirms beliefs and ignore or undervalue what contradicts beliefs
representativeness bias
classify new information based on past experiences and classifications
illusion of control bias
believe they can control or influence outcomes when they can’t
hindsight bias
selective perception and retention. remember own predictions of the future as more accurate than they actually were because they are biased by the knowledge of what has actually happened
anchoring and adjustment bias
use of a psychological heuristic influences the way people estimate probabilities. tend to adjust anchors insufficiently and produce end approximations that are consequently biased
mental accounting bias
treat one sum of money differently from another equal-sized sum based on which mental account the money is assigned to
framing bias
person answer question differently based on way in which it is asked
availability bias
heuristic approach to estimating the probability of an outcome based on how easily the outcome comes to mind. easily recalled outcomes are perceived as being more likely than those that are harder to recall or understand.
loss-aversion bias
strongly prefer avoiding losses as opposed to achieving gains
overconfidence bias
demonstrate unwarranted faith in intuitive reasoning, judgments, and/or cognitive abilities
self-control bias
fail to act in pursuit of long-term overarching goals because of a lack of self-discipline
status quo bias
people do nothing instead of making a change
endowment bias
people value an asset more when they hold rights to it than when they do not
regret-aversion bias
avoid making decisions that will result in action out of fear that the decision will turn out poorly
goals-based investing
ID an investor’s specific goals and the risk tolerance associated with each goal;
investments are chosen considering each goal individually;
portfolio is contructed in layers;
investors are assumed to be loss-averse, not risk-averse
For a client with high wealth and low SLR with emotional biases…
accommodate the biases, deviating 10-15%
For a client with high wealth and low SLR with cognitive biases…
moderate and accommodate the biases, deviating 5-10%
For a client with low wealth and high SLR with emotional biases…
moderate and accommodate the biases, deviating 5-10%
For a client with low wealth and high SLR with cognitive biases…
modify the biases, deviating 0-3%
Barnewall two way behavioral model
passive investors have not had to risk their own capital to gain wealth
active investors risked own capital to gain wealth and take active role in investing own money
Bailard, Biehl, and Kaiser (BB&K) 5-way model
two dimension of classification: careful to impetuous anxious to confident - Individualist - Guardian - Adventurer - Celebrity - Straight Arrow
Individualist (BBK)
Careful & Confident
makes own decisions after careful analysis
listens and processes info rationally
Gaurdian (BBK)
careful & anxious
concerned with future and asset protection
may seek advice
Adventurer (BBK)
confident & impetuous
may hold concentrated portfolios and willing to take chances; likes to make own decisions
Celebrity (BBK)
impetuous & anxious
may have opinions but recognizes own limitations
seeks and takes advice about investing
Straight Arrow (BBK)
cross of BBK extremes
average investor who will take increased risk for increased expected return
Pompian four behavioral investor types process
- interview to determine active v passive
- plot on risk tolerance scale
- test for behavioral biases
- classify into one of the BITs
Passive Preserver (Pompian)
emotional bias; passive; low risk tolerance; not financially sophisticated
Friendly Follower (Pompian)
cognitive bias; passive; overestimates risk tolerance; likes popular investments
Active Accumulator (Pompian)
emotional bias; active; high risk tolerance
entrepreneurial and strong-willed; likes to be involved
Independent Individualist (Pompian)
cognitive bias; active; higher risk tolerance; will risk capital to gain wealth; strong willed; does own research and tends to be contrarian
