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CFA Level 3 > Behavioral Finance > Flashcards

Behavioral Finance Flashcards

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CFA flashcards
1
Q

definition of behavioral finance

A

explain observed investor and market behavior;

investors are not rational; markets are not efficient

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2
Q

definition of traditional finance

A

theory about how investors and markets behave

Investors are rational and markets are efficient

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3
Q

explain Raiffa Decision Analysis

A

3 types:
Normative
Descriptive
Prescriptive

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4
Q

explain Normative Analysis

A

rational solution is the “ideal “ that actual decision makers should strive for (assumption of traditional finance: Expected Utility & Decision Theory)

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5
Q

explain Descriptive Analysis

A

describes the way real people actually make decisions (i.e., behavioral finance: Prospect Theory; Bounded Rationality)

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6
Q

explain Prescriptive Analysis

A

practical advice and tools that help achieve results of normative analysis (use of behavioral finance in practice)

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7
Q

describe a rational investor

A

risk-avers, self-interested, utility maximizer

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8
Q

describe an efficient market

A

all information is priced into market prices and changes

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9
Q

describe behavioral finance micro (BFMI)

A

focuses on differences between actual investor and the rational investor

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10
Q

describe behavioral finance macro (BFMA)

A

focuses on differences between actual markets and efficient markets

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11
Q

what kinds of behavioral biases does BFMI suggest impact the financial decisions of individual investors?

A

cognitive errors; emotional biases

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12
Q

Utility Theory is…

A

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

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13
Q

What are the axioms of Utility Theory?

A

completeness
transitivity
independence
continuity

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14
Q

What is Bayes’ formula

A

P(A given B) = P(A) * P(B given A)/P(B)

explains how existing probability beliefs should be changed given new information

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15
Q

Rational Decision Making

A
  1. Adhere to axioms of utility theory
  2. Assign a probability measure to possible events
  3. incorporate new information according to Bayes’ formula
  4. Choose action that maximizes utility function subject to budget constraints with respect to conditional probability measure
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16
Q

Explain Rational Economic Man (REM)

A

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

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17
Q

Utility function of risk-neutral individuals

A

risk-neutral individuals have linear utility functions

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18
Q

utility function of risk-averse individuals

A

risk-averse individuals have concave utility functions (arch) - diminishing marginal utility of wealth [rational investor]

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19
Q

utility function of risk-seeking individuals

A

risk-seeking individuals have convex utility functions (bowl) - increasing marginal utility of wealth)

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20
Q

Describe Bounded Rationality

A

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

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21
Q

Describe Prospect Theory

A

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

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22
Q

Describe Decision Theory

A

assumes decision maker is fully information, is able to make quantitative calculations with accuracy and is perfectly rational

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23
Q

Describe Mental Accounting

A

people classify wealth into different accounts to accommodate the competing goals of short-term gratification and long-term benefits

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24
Q

describe Behavioral Stochastic Discount Factor Model (SDF)

A

market sentiment causes asset prices to deviate from values determined using traditional finance

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25
Q

describe 5 factors of Behavioral Portfolio Theory (BPT)

A
  1. Layers of risk are assigned allocations depending on goals
  2. allocation of funds within each layer will depend on goal of layer
  3. number of assets depends on utility function (risk-averse investors will have more securities)
  4. concentration may occur from belief in information advantages
  5. loss-aversion causes investors to hold cash or other certain securities
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26
Q

describe Adaptive Markets Hypothesis (AMH)

A

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
27
Q

What are the guidelines for determining a behaviorally modified portfolio?

A
  1. Moderate the less wealthy and adapt to the more wealthy.

2. Moderate cognitive biases and adapt to emotional biases.

28
Q

What is Standard of Living Risk (SLR)?

A

the risk that a current or a specified acceptable lifestyle may not be sustainable.

29
Q

Standard asset allocation program with a client involves

A
  1. Advisers administer a risk tolerance questionnaire
  2. Discuss the client’s financial goals and constraints
  3. Recommend the output of a mean-variance optimization
30
Q

List some cognitive errors that are belief perserverence

A 
conservatism bias
confirmation bias
representativeness bias
control bias
hindsight bias
31
Q

list some cognitive errors that are information processing related

A

anchoring and adjustment
mental accounting bias
framing bias
availability bias

32
Q

list some emotional biases

A 
loss aversion bias
overconfidence bias
self-control bias
status quo bias
endowment bias
regret-aversion bias
33
Q

conservatism bias

A

maintain prior views or forecasts by inadequately incorporating new information - overweight of initial beliefs

34
Q

confirmation bias

A

look for and notice what confirms beliefs and ignore or undervalue what contradicts beliefs

35
Q

representativeness bias

A

classify new information based on past experiences and classifications

36
Q

illusion of control bias

A

believe they can control or influence outcomes when they can’t

37
Q

hindsight bias

A

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

38
Q

anchoring and adjustment bias

A

use of a psychological heuristic influences the way people estimate probabilities. tend to adjust anchors insufficiently and produce end approximations that are consequently biased

39
Q

mental accounting bias

A

treat one sum of money differently from another equal-sized sum based on which mental account the money is assigned to

40
Q

framing bias

A

person answer question differently based on way in which it is asked

41
Q

availability bias

A

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.

42
Q

loss-aversion bias

A

strongly prefer avoiding losses as opposed to achieving gains

43
Q

overconfidence bias

A

demonstrate unwarranted faith in intuitive reasoning, judgments, and/or cognitive abilities

44
Q

self-control bias

A

fail to act in pursuit of long-term overarching goals because of a lack of self-discipline

45
Q

status quo bias

A

people do nothing instead of making a change

46
Q

endowment bias

A

people value an asset more when they hold rights to it than when they do not

47
Q

regret-aversion bias

A

avoid making decisions that will result in action out of fear that the decision will turn out poorly

48
Q

goals-based investing

A

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

49
Q

For a client with high wealth and low SLR with emotional biases…

A

accommodate the biases, deviating 10-15%

50
Q

For a client with high wealth and low SLR with cognitive biases…

A

moderate and accommodate the biases, deviating 5-10%

51
Q

For a client with low wealth and high SLR with emotional biases…

A

moderate and accommodate the biases, deviating 5-10%

52
Q

For a client with low wealth and high SLR with cognitive biases…

A

modify the biases, deviating 0-3%

53
Q

Barnewall two way behavioral model

A

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

54
Q

Bailard, Biehl, and Kaiser (BB&K) 5-way model

A 
two dimension of classification:
careful to impetuous
anxious to confident
- Individualist
- Guardian
- Adventurer
- Celebrity
- Straight Arrow
55
Q

Individualist (BBK)

A

Careful & Confident
makes own decisions after careful analysis
listens and processes info rationally

56
Q

Gaurdian (BBK)

A

careful & anxious
concerned with future and asset protection
may seek advice

57
Q

Adventurer (BBK)

A

confident & impetuous

may hold concentrated portfolios and willing to take chances; likes to make own decisions

58
Q

Celebrity (BBK)

A

impetuous & anxious
may have opinions but recognizes own limitations
seeks and takes advice about investing

59
Q

Straight Arrow (BBK)

A

cross of BBK extremes

average investor who will take increased risk for increased expected return

60
Q

Pompian four behavioral investor types process

A
  1. interview to determine active v passive
  2. plot on risk tolerance scale
  3. test for behavioral biases
  4. classify into one of the BITs
61
Q

Passive Preserver (Pompian)

A

emotional bias; passive; low risk tolerance; not financially sophisticated

62
Q

Friendly Follower (Pompian)

A

cognitive bias; passive; overestimates risk tolerance; likes popular investments

63
Q

Active Accumulator (Pompian)

A

emotional bias; active; high risk tolerance

entrepreneurial and strong-willed; likes to be involved

64
Q

Independent Individualist (Pompian)

A

cognitive bias; active; higher risk tolerance; will risk capital to gain wealth; strong willed; does own research and tends to be contrarian

CFA Level 3 (4 decks)

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