Behavioral Finance

Question 1

Analyses of “real” person’s thought process (by Raiffa)

Answer 1

• Normative analysis is concerned with the rational solution to the problem at hand. (traditional finance)
• Descriptive analysis is concerned with the nanner in which real people actually make decisions. (behavioral finance explanations)
• Prescriptive analysis is concerned with practical advice and tools that might help people achieve normative results. (efforts to use behavioral finance in practice)

Question 2

Behavioral biases

Answer 2

– cognitive errors stem from basic statistical, information–processing, or memory errors.
– Emotional biases stem from impulse or intuition; emotional biases may be considered to result from reasoning influenced by feelings.

Question 3

Traditional finance assumptions

Answer 3

Investors

• are rational;
• make decisions consistent with utility theory and revise expectations consistent with Bayes’ formula.
• are risk-averse;
• are self interested;
• have access to perfect information;
• are unbiased when processing all available information

Question 4

Utility theory

Answer 4

People maximize the present value of utility (level of relative satisfaction received from the consumption of goods and services) subject to a present value budget constraint.

Decision-makers choose between risky or uncertain prospects by comparing their expected utility values. They maximize their expected utility – the weighted sum of the utility values of outcomes multiplied by their respective probabilities – subject to their budget constraints.

Question 5

Axioms of Utility Theory

Answer 5

The basic axioms of utility theory:
– Completeness (Individual has well-defined preferences. Individual can clearly choose btwn A and B or be indif btwn the two choices.)
– Transitivity (individual is consistent in his decisions. If A is preferred to C, and B lays btwn A and C, then B is preferred to C)
– Independence (If A is preferred to B and some amount, x, of C is added to A and B, then A+ xC is preferred to B+ xC)
– Continuity (continuous indifference curves says that an individual is indifferent btwn all points representing combinations of choices on a single indifference curve)

Question 6

Bayes’ formula

Answer 6

Is a mathematical rule explaining how existing probability beliefs should be changed given new information. This formula is an application of conditional probabilities. All possible events must be mutually exclusive and exhaustive events with known probabilities.
P(A|B) = [P(B|A)/P(B)] P(A)
where:
P(A|B) - updated prob of A given the new info B
P(B|A) - updated prob of new info B, given event A
P(B) - prior (unconditional) prob of info B
P(A) - prior prob of event A, wo new info B. base prob/rate of event A.

Question 7

Bayes’ Formula example:
You have two identical urns, U1 and U2. U1 has 2 red balls (R) and 3 white balls (W). U2 has 4 red balls and 1 white ball. You randomly choose one of the urns to pick out a ball. A Red ball is pulled out first. What is the probability that you picked U1, based on the fact that a red ball was pulled out first, P(U1|R)?

Answer 7

P(U1|R) = [P(R|U1)/P(R)] P(U1)
P(R|U1) = 2 red/ 5 total = 40%
P(R) = 6 red / 10 total = 60%
P(U1) = 1/2

P(U1|R) = (.4/.6) * .5 = 33.3%

Question 8

Certainty equivalent

Answer 8

Given an opportunity to participate or to forgo to participate in an event for which the outcome is uncertain, it is the max sum of money a person would pay to participate or a min sum of money a person would accept to not participate in the opportunity.

The difference between the certainty equivalent and the expected value is called the risk premium.

Question 9

Bounded rationality

Answer 9

Is proposed as an alternative to the assumptions of perfect information and perfect rationality. It relaxes the assumptions of expected utility theory and perfect information to more realistically represent human economic decision making. Bounded rationality assumes that individuals’ choices are rational but are subject to limitations of knowledge and cognitive capacity. Bounded rationality is concerned with ways in which final decisions are shaped by the decision-making process itself.

Question 10

Double inflection utility function

Answer 10

a utility function that changes based on levels of wealth. It is concave up to inflection point B, then becomes convex until inflection point C, after which it becomes concave again.

Question 11

Prospect theory

Answer 11

Prospect theory describes how individuals make choices in situations in which they have to decide between alternatives that involve risk (e.g, financial decisions) and how individuals evaluate potential losses and gains. Prospect theory considers how prospects (alternatives) are perceived based on their framing, how gains and losses are evaluated, and how uncertain outcomes are weighted.

Question 12

Satisfice (bounded rationality)

Answer 12

Combines “satisfy” and “suffice” and describes decisions, actions, and outcomes that may not be optimal, but they are adequate. To satisfice is to find a solution in a decision-making situation that meets the needs of the situation and achieves the goals of the decision-maker.
Satisficing is finding an acceptable solution as opposed to optimizing, which is finding the best (optimal) solution.

Question 13

Heuristics (bounded rationality): means-ends analysis

Answer 13

Rather than taking a holistic approach, heuristics may use more of an incremental approach.
Examples:
1. means-ends analysis - The problem solver is at a current state and decides on the goal state. Rather than looking for alternatives to achieve the goal, the decision-maker moves towards the goals in stages. Decisions are made progressively until the goal is achieved: The first decision is made to get one step closer to the goal state, the next decision results in getting still closer to the goal, and decisions continue to be made until the goal state is met.

Question 14

Heuristics (bounded rationality): divide–and-conquer procedure

Answer 14

a problem or issue is divided into components. In this case, rather than attempt to find alternatives to solve the issue of problem, the decision-makers attempt to find satisfactory solutions for each sub-problem

Question 15

Prospect theory: editing stage – codification

Answer 15

People perceive outcomes as gains and losses rather than final states of wealth and welfare. A gain or loss is, of course, defined with respect to some reference point. The location of the reference point affects whether that outcomes are coded as gains and losses. Prospects are coded as such that the probability is initially at 100%

Question 16

Prospect theory: editing stage – combination

Answer 16

Prospects are simplified by combining the probabilities associated with identical gains or losses. For example, a prospect initially coded as (250, 20%; 200, 25%; 200, 15%; 150, 40%) will be simplified (250, 20%; 200, 40%; 150, 40%)

Question 17

Prospect theory; editing stage – segregation

Answer 17

Then riskless component of any prospect is separated from its risky component. For example, a prospect initially coded as (300, 80%; 200, 20%) is decomposed into a sure gain of (200, 100%) and a risky prospect of (100, 80%; 0, 20%)

Question 18

Prospect theory: editing stage – cancellation

Answer 18

Cancellation involves discarding common outcome probability pairs between choices. For example, the pairs (200, 20%; 100, 50%; 20, 30%) and (200, 20%; 300, 40%; -50, 40%) are reduced to (100, 50%; 20, 30%) and (300, 40%; -50, 40%)

Question 19

Prospect theory: editing stage – simplification

Answer 19

Prospects are likely to be rounded off. A prospect of (51, 49%) is likely to be seen as an even chance to win 50. Also, extremely unlikely outcomes are likely to be discarded or assigned a probability of zero.

Question 20

Prospect theory: editing stage – detection of dominance

Answer 20

Outcomes that are strictly dominated are scanned and rejected without further evaluation.

Question 21

Preference anomalies

Answer 21

Preference anomalies may arise from the act of editing. An example of a preference anomaly is the isolation perfect. This results from the tendency of people to disregard or discard outcome probability pairs that the alternatives share (cancellation) and to focus on those which distinguish them. Because different choice problems can be decomposed in different ways, this can lead to inconsistent preferences.

Question 22

Example of the isolation effect

Answer 22

1. Gamble A: a 25% chance of receiving $3000 and a 75% chance of receiving nothing.
2. Gamble B: a 20% chance of receiving $4000 and an 80% chance of receiving nothing.

65% of the experimental subjects chose Gamble B. The expected value of Gamble B is $800 compared to an expected value $750 for gamble A, so it is not surprising that the majority of subjects chose Gamble B.

Next, the experimental subjects were given a two-stage gamble. The first stage involves a 70% probability of ending the game without winning or losing anything and a 25% probability of moving to the second stage. The second stage involves a choice between gambles C and D. The choice of Gamble C or D had to be made prior to the fair stage.

3. Gamble C: 100% chance of receiving $3000.
4. Gamble D: an 80% chance of receiving $4000 and a 20% chance of receiving nothing.

78% of the experimental subjects chose C. It is surprising because choices three and four are the same is choices one and two.

Clearly, how the prospects are framed had an effect on the choice.

Question 23

Self-control bias

Answer 23

Recognizes that people may focus on short-term satisfaction to the detriment of long-term goals.

Question 24

Mental accounting

Answer 24

Mental accounting is the phenomenon whereby people treat one some of money differently from another sum of money even though money is fungible (interchangeable).

People classify their sources of wealth into three basic accounts: current income, currently owned assets, and the present value of future income. By classifying some wealth so that it is considered less available, it is less likely to be consumed in the short-term. People are assumed to be most likely to spend from current income and least likely to spend based on expectations of future income. In other words, people lack self-control when it comes to current income. If an investor sees pension fund as current assets rather than future income, he will be more likely to spend it now.

Question 25

Framing bias

Answer 25

Framing bias results in different responses based on how questions are asked (framed).

Question 26

Behavioral portfolio theory (BPT)

Answer 26

It suggests that investors have varied aims and create an investment portfolio that meets a broad range of goals. It does not follow the same principles as the CAPM, Modern Portfolio Theory and the Arbitrage Pricing Theory. A behavioral portfolio bears a strong resemblance to a pyramid with distinct layers. Each layer has well defined goals. The base layer is devised in a way that it is meant to prevent financial disaster, whereas, the upper layer is devised to attempt to maximize returns, an attempt to provide a shot at becoming rich.

Question 27

Adaptive market hypothesis (AMH)

Answer 27

is an attempt to reconcile economic theories based on the efficient market hypothesis (which implies that markets are efficient) with behavioral economics, by applying the principles of evolution to financial interactions: competition, adaptation and natural selection.

Under this approach, the traditional models of modern financial economics can coexist with behavioral models. Lo argues that much of what behaviorists cite as counterexamples to economic rationality—loss aversion, overconfidence, overreaction, and other behavioral biases—are, in fact, consistent with an evolutionary model of individuals adapting to a changing environment using simple heuristics.

Question 28

Cognitive errors

Answer 28

1. Belief perseverance biases
   - Conservatism bias
   - Confirmation bias
   - Representativeness bias
   - Illusion of control bias
   - Hindsight bias
2. Information-processing biases
   - Anchoring and adjustment bias
   - Mental accounting bias
   - Framing bias
   - Availability bias

Question 29

Cognitive dissonance

Answer 29

Cognitive dissonance is the mental discomfort that occurs when new information conflicts with previously held beliefs or cognitions. To resolve this dissonance, people may notice only information of interest (selective exposure), ignore or modify information that conflicts with existing cognitions (selective perception), or remember and consider only information that confirms existing cognitions (selective retention).

Question 30

Conservatism bias

Answer 30

Is a belief perseverance bias in which people maintain their prior views or forecasts by inadequately incorporating new information.
In Bayesian terms, they tend to overweight the base rates and underweight the new information.
Consequence: hold on to a security for too long

Question 31

Confirmation bias

Answer 31

Is a belief perseverance bias in which people tend to look for and notice what confirms their beliefs, and to ignore or undervalue what contradicts their beliefs. May be thought of as a selection bias.
Consequences: Under diversified portfolios, disproportionate amount of investment assets in their employing companie’s stock

Question 32

Representativeness bias

Answer 32

Is a belief perseverance bias in which people tend to classify a new information based on past experiences and classifications.
In Bayesian terms, FMPs tend to underweight the base rate and overweight the new information.
1. Base rate neglect: Some FMP’s rely on stereotypes when making investment decisions without adequately incorporating the base probability of the stereotype occurring.
2. Simple size neglect:

Question 33

Hindsight bias

Answer 33

Is a bias with selective perception and retention. People may see past events as having been predictable and reasonable to expect. People don’t have perfect memory; they tend to “fill the gaps” with what they prefer to believe.