Behavioral Finance Flashcards
The basic axioms of utility theory
- Completeness
- Transitivity
- Independence
- Continuity
Bayes’ formula
Bounded rationality
People will satisfice rather than optimize when making decisions
Heuristic
Any approach to problem-solving, learning, or discovery that employs a practical method not guaranteed to be optimal or perfect, but sufficient for the immediate goals
Rational Economic Man (REM)
Will try to obtain the highest possible economic well-being or utility given a budget constraint
Utility theory
People will maximize the present value of utility subject to a present value budget constraint
Prospect theory
- People assign value to gains and losses (changes in wealth) rather than to final wealth
- Decision weights replace probabilities
- Loss-aversion replaces risk-aversion
Behavioral Portfolio Theory (BPT)
- Investors construct their portfolios in layers
- Expectations of returns and risk vary between the layers
- Uses a probability weighting function rather than the real probability distribution used in Markowitz’s portfolio theory
The 2 phases of decision-making in Prospect theory
- Editing (framing) phase
- Evaluation phase
Friedman-Savage double-inflection utility function
- At low and high income levels, agents exhibit risk-averse behavior
- At moderate income levels, between the inflection points, agents exhibit risk-seeking behavior
Grossman–Stiglitz paradox
Argues that prices must offer a return to information acquisition, otherwise information will not be gathered and processed. If information is not gathered and processed, the market cannot be efficient
Fama three forms of market efficiency
- Weak: All past market price and volume data are fully reflected in securities’ prices
- Semi-strong: All publicly available information, past and present, is fully reflected in securities’ prices
- Strong: All information, public and private, is fully reflected in securities’ prices
- Value companies
- Growth companies
- Value companies typically have, on a per share basis, lower than average price-to-earnings, price-to-book value, and price-to-sales ratios and higher than average dividend yields
- Growth companies typically have, on a per share basis, higher than average price-to-earnings, price-to-book value, and price-to-sales ratios and lower than average dividend yields
Turn of the month anomaly
Hensel and Ziemba (1996) examined returns of the S&P 500 over a 65-year period and found that US large-cap stocks consistently generate higher returns at the turn of the month
Adaptive Market Hypothesis (AMH)
Applies principles of evolution to financial markets in an attempt to reconcile efficient market theories with behavioral alternatives
The five implications of the AMH
- The relationship between risk and reward varies over time
- Active management can add value by exploiting arbitrage opportunities
- Any particular investment strategy will have periods of superior and inferior performance
- The ability to adapt and innovate is critical for survival
- Survival is the essential objective
Updating beliefs
Done by using the Bayes’ formula or heuristics
Emotional biases
- Loss aversion bias
- Myopic loss aversion
- Overconfidence bias
- Prediction overconfidence
- Certainty overconfidence
- Self-enhancing and self-protecting biases
- Self-control bias
- Status quo bias
- Endowment bias
- Regret-aversion bias
- Error of commission or omission
Belief Perseverance Biases (cognitive biases)
- Cognitive dissonance
- Conservatism bias
- Confirmation bias
- Representativeness bias
- Base-rate neglect
- Sample size neglect
- Illusion of control bias
- Hindsight bias
Information-Processing Biases (cognitive biases)
- Anchoring and adjustment bias
- Mental accounting bias
- Framing bias
- Availability bias
- Retrievability
- Categorization
- Narrow range of experience
- Resonance
Probability estimation with anchoring
Starts with some initial default number—an anchor—which is then adjusted up or down according to new information
Value function of loss aversion
Disposition effect
Holding losers and selling winners
Goals-based investing
A portfolio is evaluated in terms of attaining financial goals and is built in layers
Goals-based portfolio construction chart
Behaviorally Modified Asset Allocation
An asset allocation that takes into account the bias of the investor in order to build an allocation that he is comfortable with
Standard of living risk (SLR)
The risk that the current or a specified acceptable lifestyle may not be sustainable
Adapt versus moderate visual depiction chart
Equity market neutral strategy
Long/short with a beta of zero
Representativeness bias
A cognitive bias in which people tend to classify new information based on past experiences and classifications
Base-rate neglect
- Is a type of representativeness bias
- In base-rate neglect, the base rate or probability of the categorization is not adequately considered
- The categorization is based on a stereotype and ignores the base probability of the stereotype actually occurring
Sample-size neglect
- Is a type of representativeness bias
- In sample-size neglect, someone incorrectly assumes that small sample sizes are representative of populations (or “real” data)
Barnewall two-way model
- Passive investors: Became wealthy passively. Have a greater need for security than they have tolerance for risk
- Active investors: Became wealthy by being actively involved in wealth creation through investment. Have a higher tolerance for risk than they have need for security
Bailard, Biehl and Kaiser five-way model chart (BBK)
Behavioral Investor Types (BITs)
Behavioral factors
- Inertia and Default
- Naïve Diversification
- Investing in the Familiar
- Excessive Trading
- Home Bias
- Behavioral Portfolio Theory
The gamblers’ fallacy
A misunderstanding of probabilities in which people wrongly project reversal to a long-term mean
The conjunction fallacy
The probability of two independent events occurring in conjunction is never greater than the probability of either event occurring alone
Social proof
A bias in which individuals are biased to follow the beliefs of a group
Halo effect
An emotional bias that extends a favorable evaluation of some characteristics to other characteristics
Home bias
An anomaly by which portfolios exhibit a strong bias in favor of domestic securities in the context of global portfolios
Passive Preservers
Are investors who place a great deal of emphasis on financial security and preserving wealth rather than taking risks to grow wealth. Many have gained wealth through inheritance or by receiving high compensation at work
Friendly Followers
Are passive investors with a low to medium risk tolerance who tend to follow leads from their friends, colleagues, or advisers when making investment decisions
Independent Individualists
Are active investors with medium to high-risk tolerance who are strong-willed and independent thinkers
Active Accumulators
Are entrepreneurial and often the first generation to create wealth; and they are even more strong-willed and confident than Independent Individualists. At high wealth levels, AAs often have controlled the outcomes of non-investment activities and believe they can do the same with investing
Cognitive biases versus emotional biases plan of action
Cognitive errors should be moderated whereas emotional biases should be adapted to
