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CFA Level 3 > Behavioral Finance > Flashcards

Behavioral Finance Flashcards

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CFA flashcards
1
Q

The basic axioms of utility theory

A
  • Completeness
  • Transitivity
  • Independence
  • Continuity
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2
Q

Bayes’ formula

A
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3
Q

Bounded rationality

A

People will satisfice rather than optimize when making decisions

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4
Q

Heuristic

A

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

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5
Q

Rational Economic Man (REM)

A

Will try to obtain the highest possible economic well-being or utility given a budget constraint

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6
Q

Utility theory

A

People will maximize the present value of utility subject to a present value budget constraint

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7
Q

Prospect theory

A
  • People assign value to gains and losses (changes in wealth) rather than to final wealth
  • Decision weights replace probabilities
  • Loss-aversion replaces risk-aversion
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8
Q

Behavioral Portfolio Theory (BPT)

A
  • 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
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9
Q

The 2 phases of decision-making in Prospect theory

A
  • Editing (framing) phase
  • Evaluation phase
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10
Q

Friedman-Savage double-inflection utility function

A
  • At low and high income levels, agents exhibit risk-averse behavior
  • At moderate income levels, between the inflection points, agents exhibit risk-seeking behavior
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11
Q

Grossman–Stiglitz paradox

A

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

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12
Q

Fama three forms of market efficiency

A
  • 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
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13
Q
  • Value companies
  • Growth companies
A
  • 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
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14
Q

Turn of the month anomaly

A

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

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15
Q

Adaptive Market Hypothesis (AMH)

A

Applies principles of evolution to financial markets in an attempt to reconcile efficient market theories with behavioral alternatives

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16
Q

The five implications of the AMH

A
  1. The relationship between risk and reward varies over time
  2. Active management can add value by exploiting arbitrage opportunities
  3. Any particular investment strategy will have periods of superior and inferior performance
  4. The ability to adapt and innovate is critical for survival
  5. Survival is the essential objective
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17
Q

Updating beliefs

A

Done by using the Bayes’ formula or heuristics

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18
Q

Emotional biases

A
  • 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
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19
Q

Belief Perseverance Biases (cognitive biases)

A
  • Cognitive dissonance
  • Conservatism bias
  • Confirmation bias
  • Representativeness bias
    • Base-rate neglect
    • Sample size neglect
  • Illusion of control bias
  • Hindsight bias
20
Q

Information-Processing Biases (cognitive biases)

A
  • Anchoring and adjustment bias
  • Mental accounting bias
  • Framing bias
  • Availability bias
    • Retrievability
    • Categorization
    • Narrow range of experience
    • Resonance
21
Q

Probability estimation with anchoring

A

Starts with some initial default number—an anchor—which is then adjusted up or down according to new information

22
Q

Value function of loss aversion

A
23
Q

Disposition effect

A

Holding losers and selling winners

24
Q

Goals-based investing

A

A portfolio is evaluated in terms of attaining financial goals and is built in layers

25
Q

Goals-based portfolio construction chart

A
26
Q

Behaviorally Modified Asset Allocation

A

An asset allocation that takes into account the bias of the investor in order to build an allocation that he is comfortable with

27
Q

Standard of living risk (SLR)

A

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

28
Q

Adapt versus moderate visual depiction chart

A
29
Q

Equity market neutral strategy

A

Long/short with a beta of zero

30
Q

Representativeness bias

A

A cognitive bias in which people tend to classify new information based on past experiences and classifications

31
Q

Base-rate neglect

A
  • 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
32
Q

Sample-size neglect

A
  • Is a type of representativeness bias
  • In sample-size neglect, someone incorrectly assumes that small sample sizes are representative of populations (or “real” data)
33
Q

Barnewall two-way model

A
  • 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
34
Q

Bailard, Biehl and Kaiser five-way model chart (BBK)

A
35
Q

Behavioral Investor Types (BITs)

A
36
Q

Behavioral factors

A
  • Inertia and Default
  • Naïve Diversification
  • Investing in the Familiar
  • Excessive Trading
  • Home Bias
  • Behavioral Portfolio Theory
37
Q

The gamblers’ fallacy

A

A misunderstanding of probabilities in which people wrongly project reversal to a long-term mean

38
Q

The conjunction fallacy

A

The probability of two independent events occurring in conjunction is never greater than the probability of either event occurring alone

39
Q

Social proof

A

A bias in which individuals are biased to follow the beliefs of a group

40
Q

Halo effect

A

An emotional bias that extends a favorable evaluation of some characteristics to other characteristics

41
Q

Home bias

A

An anomaly by which portfolios exhibit a strong bias in favor of domestic securities in the context of global portfolios

42
Q

Passive Preservers

A

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

43
Q

Friendly Followers

A

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

44
Q

Independent Individualists

A

Are active investors with medium to high-risk tolerance who are strong-willed and independent thinkers

45
Q

Active Accumulators

A

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

46
Q

Cognitive biases versus emotional biases plan of action

A

Cognitive errors should be moderated whereas emotional biases should be adapted to

CFA Level 3 (19 decks)

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