Behavioral Finance Flashcards
What is Traditional and Behavioral Finance
Traditional finance
- How people should behave
- Assumes rational, risk-adverse, and selfish
Behavioral finance
- How people actually behave
- Can result in biases and markets may not be efficient
- Could be risk-adverse, neutral, or seeking
Investor Risk Types
Risk-Averse - Concave
Risk-Neutral - straight
Risk-Seeking - Convex
Friedman-Savage (Forms an S)
Concave at low/high wealth
Convex at medium wealth
Challenges to Rational Economic Men (REM)
Traditional finance
- Decision making can be flawed by lack of information
- Can have conflicts that prioritize short-term (spending) goals over long-term (saving) goals
- Lack of perfect knowledge (most crucial)
Utility Theory (TF)
- Satisfaction based on level of wealth
- Diminishing marginal return: satisfaction increases at a slower rate
- Convexed indifference curve: slower rate of substitution
Decision Theory (TF)
Making the ideal decision when the decision maker is fully informed, mathematically able, and rational.
Bounded Rationality
Have a capiticty on knowledge and nothing is perfect
Accept things that satisfy but are not perfect
Example
I have excess funds. I want the funds to be backed by the government so I went to the bank. The rate seems acceptable, so I move forward. I didn’t do any other research.
Prospect Theory (BF)
Definition: Perceived gain/loss drives satisfaction (NOT level)
- Depends on starting point
- Decisions are made in stages
- Decision weights are subjective (NOT rational)
Consequences:
Takes gains quickly, hold onto losses
Low probability events are over-weighted
Prospect Theory Stages (BF)
Phase 1: Editing
Proposals are made and ranked
Could lead to isolation effect (presentation and complexity affect decisions)
Phase 2: Evaluation
Focus on loss aversion
Investors place more weight for a loss than a gain (fear)
Prospect Theory Behavior
- People overreact to small probabilities and underreact to large ones
- Results in the S shape
- Gains = risk-adverse, losses = risk-seekers
a. explains why people over-concentrate positions
Traditional Finance and Prospect Theory Assumptions
Knowledge
Utility
Decision Making
Risk
Portfolio Construction
Traditional Finance Prospect Theory
Knowledge Perfect Capacity limitations
Utility Maximization Satisfice
Decision Making Full rational Congnitive limits
Risk Risk-adverse Depends on gain/loss
Portfolio Constr. Markets are efficient Alternative theories
Focus on asset allocation
Efficient Market Hypthosesis (EMH)
Follows traditional finance
3 types of efficiency
- weak-form: prices reflect all past data
- cannot use technical analysis
- semi-strong: prices reflect all past data and public info
- cannot use technical or fundamental analysis
- strong-form: prices reflect all past data, public, and non-public
- cannot use technical or fundamental analysis or insider trading
EMH Support and Challenges
Support
Events can trigger abnormalities. (e.g. stock split) which allows for people to make predictions.
Large cap stocks may be more efficient than others
Challenges
Small and value effects
Anomalies (Fundamental & Calendar)
Behavioral Finance Portfolio Construction Types
- Consumption & savings - can people have self control and save?
- Behavioral asset pricing - adds a sentiment premium (dispersion of analysts forecasts) to CAPM. Wider dispersion = higher discount rate
- Behavioral Portfolio Theory (BPT) - Build a portfolio of layers with different types of risks (all built separately and correlation is ignored)
- Adaptive Markets Hypothesis (AMH) - Adapt your process or die (satisfice driven). Active managagement works
Cognitive Errors vs Emotional Baises
Cognitive Errors (Thinking)
Faulty reasoning
Can be corrected
Emotional Biases
Based on impulses or intuition
Must be accomodated
(Someone can have both)
Cognitive Errors Types
Belief Perseverance
- Representativeness
- Illusion of control
- Conservatism
- Confirmation bias
- Hindsight bias
Conservatism
Type: Cognitive
Definition: rationally form an initial view but won’t change it
Consequences
Hold investments too long
slow to update view
Confirmation Bias
Type: Cognitive
Definition: look for or distort information to support current view
Consequences
Under-diversified
Concentration in employer stock
Representativeness Bias
Type: Cognitive
Definition: past classification will persist and new information is based on past experience
Consequences
- Hold on to or buy recent winners
- Sell or avoid recent losers
- Excessive turnover
Illusion of Control Bias
Type: Cognitive
Definition: think you can control the outcome (a junior analyst)
Consequences (Not as important)
Fail to diversify
Trade frequently
Hindsight Bias
Type: Cognitive
Definition: selectively remember what was done in the past
Consequences
Overestimates ability
Takes on too much risky
Cognitive Errors Types
Information-Processing Biases
- Framing bias
- Availability bias
- Anchoring and adjustment bias
- Mental accounting bias
Achoring and Adjustment Bias
Type: Cognitive
Definition: Starting from an old reference point and adjusting
New data should be reviewed objectively and could be completely different
Mental Accounting Bias
Type: Cognitive
Definition: Money is treated based on category.
(wages are different than bonuses or client wants to only focus on income)
Consequences
Leads to porfolio layers
not looking at correlation
Framing Bias
Type: Cognitive
Decisions are affected by the presentation of the data and the reference point
Consequences
Select suboptimal assets
Excess short-term trading
Availability Bias
AKA - Recency bias
Type: Cognitive
Definition: focus on the current information thats easy to get
Type: Narrow range of experience (You live in the US so assume US laws apply)
Consequences (Not as important)
Decision based on what’s familiar (advertising)
Under diversification
Emotional Biases: Name the 6
- Loss-aversion bias
- Overconfidence bias
- Self-control bias
- Status quo bias
- Endowment bias
- Regret-aversion bias
Loss-aversion bias
Type: Emotional
- Loss-aversion bias - feel more pain from a loss
Consequences
- Loss not “real” until realized - hold a stock too long
- Sell winners too soon
- Incur too much risk waiting for stock to come back
Myopic bias
Type: Emotional loss aversion
- Wide spread aversion leads to under ownership of stocks.
- Fear of short-run potential of losses
- Keeps prices low and risk premium high
Overconfidence Bias
Type: Emotional
- Overconfidence bias - overestimate own ability
Consequences
- Trade a lot and incur high transaction costs
- Under-diversified portfolios
Self-Control Bias
Type: Emotional
- Self-control bias - lack self-discipline. Favor short-term gratification
Consequences
Excessive risk
save too little
Status Quo Bias
Type: Emotional
- Status quo bias - too comfortable to make a change
Consequences
- Leaves alone even when age, wealth, and risk tolerance changes
Endowment Bias
Type: Emotional
-
Endowment bias - special because you already own it
- Example: assets that I inherited
Regret-aversion Bias
Type: Emotional
- Regret-aversion bias - Do nothing due to fear of being wrong
Consequences
Too conservative or risky
Herding
Goals-Based Investing (GBI)
**Starts with importance of each goal**
First: Essential needs and obligations (living expenses)
Second: Desired outcomes (gift giving, charity, etc)
Third: Low priority aspiration (Want to leave $1M to my kids)
More important goals have less risky assets
Behaviorally Modified Asset Allocation (BMAA)
- Incorporates behavioral biases
- Chooses to modify or adapt to the client’s baises
- Cognitive easier to modify than emotional
- Emotional must be accomodated which means a less efficient portfolio
- Set up ranges for allowed deviation
- based on wealth and standard of living (low SLR can take higher risk)
Barnewall two-way behavioral model
Passive: didn’t risk their own wealth (inheritance, employment)
Result: more risk-adverse and want more security
Active: Risk their own capital for gain
Result: more risky and like control
Bailard, Biehl, and Kaiser (BB&K) Model
- Adventurer: willing to take chances
- Celebrity: seeks attention, has opinions
- Individualist: seeks info to make decisions
- Guardian: concered with protecting the portfolio
- Straight Arrow: balanced, willing to take appropriate risk for return
Important: people change over time
Pompian Behavioral Model
4 Step Process
- Interview to see if passive or active
- Plot on risk tolerance scale
- Test for behavioral biases
- Classify investor
- *4 Types**
1. Passive Preserver
2. Friendly Follower
3. Independent Individualist
4. Active Accumulator
Risk Tolerance Questionnaire
- Only doing a risk-tolerance questionnaire isn’t enough
- Should be done annualy
- Better at identifying cognitive issues (institutional investors) than emotional biases (individuals)
Uses and Limitations of Classfying Investors into Behavioral Types
Uses
- More efficient portfolios
- More trusting and satisifed cients
- Clients who will stick to long-term goals
- Better overall relationship with advisor/client
Limitations
- Clients may have both emotional and cogitive biases
- Advisor shouldn’t classify into just one type
- Behaviors change over time
- Each investor is unique
- Can’t predict behavior
How does behavioral factors influence portfolio construction
THINK 401(K)
- Status quo bias (they accept whatever the default it)
- Naive diversification (they will put money into any asset class offered
- Concentration in employer stock
- Home country bias
- Excessive trading (brokerage)
Analyst Forecast Biases
- Overconfidence
- illusion of knowledge &control
- self-attribution
- Representativess
- Hindsight
- Influence from management
- Be careful of framing, excessive optimisn
- Biased research
- Collecting too much info
- Can suffer from confirmation and gamblers fallacy
Mitigating Forecast Biases
- Be aware of biases
- Consider counter arguements
- Seek feedback
- Review accuracy of past decisions
Investment Committee Recommendation/Challenges
Recommendations;
- Establish and stick to an agenda
- Document decisions
- Members who are not afraid to express their opinions
- A committee chair who encourages members to speak out
- A mutual respect for all members of the group
Challenges:
- members go along with the group
- member turnover inhibits feedback and reviewing past
Traditional Finance Characteristics that Cannot be Explained
-
Value vs Growth
- Stock beaten down tend to outperform
- Growth stocks look good but may have
- overconfidence, halo effect, home bias
-
Momentum - things going up continue to go up
- herding - trading with the group
- Trend chasing
-
Financial Bubbles and Crashes
- Herding and trend chasing
- Achoring/adjustment, availability, and hindsight biases
- Bubble: 2 STD from mean, Crash: 30% drop
Utility Theory vs Loss Aversion
Utility Loss Aversion
Satisfaction Level of wealth perceived gain/loss
Risk Risk adverse risk aversion for gains
risk seeking for lossing
Focus Total value Each individual position
gain/loss
Client/Advisor Relationship
How Behavioral Finance Helps
- Long-term goals - Advisor understands
- BF helps understand reasons
- Invests as client expects
- Consistenct approach
- BF adds structure and professionalism
- Both client and advisor benefit from relationship
- BF creates a closer bond
