Behavioral Finance Flashcards
Traditional Finance
how individuals should behave; efficient markets; utility theory with diminishing marginal returns (convex indiff curves)
REM - risk averse, rational expectations, asset integration
Behavioral Finance
how individuals actually behave and make decisions to realize lifestyle-based objectives - need to consider loss aversion, biased expectations, asset segregation
- micro = decisions of individuals
- macro = why markets deviate from TF expectations
Bayes’ Formula
Traditional Finance
incorporate new info into previous forecasts, helps the investment decision making process
P(A|B)
Conditional probablity of A
Probability of A given B
Bounded Reality
assumes knowledge capactiy limits and doesn’t assume perfect info/ rational decision making/ consistent utility maximization
SATISFICE - invest based on sufficient info to make a satisfactory investment (not necessarily optimal)
Prospect Theory
framing decisions as either gains or loses and weighting uncertain outcomes
loss aversion: more willing to take uncertain risk of big loss, than more certain risk of small loss
- Editing phase
- Evaluation phase
Evaluation Phase
value proposals in terms of weighted and probability-weighted outcomes to find exp utility
risk averse when presented with gains - tendency of indiv to overreact to small prob and underreact to large prob
Weak-Form Efficient Market
current prices incorporate all past price and volume data
Semi-Strong Form Efficient Market
prices reflect all public info, including past price and volume data
Strong-Form Efficient Market
prices reflect all inside info, public info, and past price and volume data
EMH Challenges
anomolies = inefficiencies in market
- Fundamental: returns to stock fundamentals
- Technical: past stock price and volume
- Calendar: January effect
Consumption and Savings Model
mentally categorize wealth as income, assets, and present value of future income
end up spending more than saving
Conservatism Bias
Cognitive Error - Belief
rationally form initial view, fail to include new info; too little/ much turnover
Confirmation Bias
Cognative Error - Belief
look for into/ distort new info to support existing view
Representative Bias
Cognitive Error - Belief
attach more importance to recent data than old data
- base rate neglect (incorrect initial classification)
- sample-size neglect (sample size too small)
Illusion of Control Bias
Cognitive Error - Belief
think they can control or affect outcomes when they cannot
Hindsight Bias
Cognitive Error - Belief
selective memory of when past events were known; only remember being right
self attribution bias: takes credit for successes and blames external events for failures
Anchoring and Adjustment Bias
Cognitive Error - Info Processing
changes are made in relation to initial view
Mental Accounting Bias
Cognitive Error - Info Processing
money treated differently based on categorization
Framing Bias
Cognitive Error - Info Processing
decisions impacted by how data is “framed”
Availability Bias
Cognitive Error - Info Processing
over emphasis on readily available info
Loss-Aversion Bias
Emotional Bias
more pain from loss than joy form an equal gain; longer holding periods, less frequent trading
myopic loss aversion: widespread aversion causing marketwide underownership, holding down prices and increasing risk premiums (stocks)
Overconfidence Bias
Emotional Bias
overestimate ability or reasoning; ego defense mechanisms (self-attribution bias)
Self-Control Bias
Emotional Bias
lack self-discipline and favor immediate gratification over long-term goals (disposition effect)
Status Quo Bias
Emotional Bias
content with existing situation, unwilling to make changes to investments
Endowment Bias
Emotional Bias
asset believed to be worth more because it’s already owned
Regret-Aversion Bias
Emotional Bias
- do nothing b/c fear actions could be wrong
- risk seeking behavior to reverse losses
- disposition effect: winners are sold too soon and losing stocks are held too long
- herding
GBI
Goals Based Investing
investment tiers based on goals and appropriate levels of risk (obligations, low risk; desires, medium risk; aspirations, high risk)
BMAA
Behaviorally Modified Asset Allocation
incorporate behavior biases in asset allocation; whether or not to moderate or adapt to biases (easier to moderate cognative biases than emotional biases and easier to moderate for clients with greater wealth)
Codification
Editing Phase
assigns prob to outcomes
Combination
Editing Phase
similify outcomes, combine identical for same option
Segregation
Editing Phase
seperate risk free and risky returns
Cancellation
Editing Phase
remove outcomes common to diff options
Simplicifaction
Editing Phase
remove unlikely scenarios (1%)
Detection of Dominance
Editing Phase
remove inherently inferior options
Behavioral Asset Pricing Model
add sentiment premium to discount rate
- how widely disputed opinions are for an asset
- greater disparity = higher sentiment premium = higher interest rate = lower price)
Behavioral Portfolio Theory
Alternative Behavior Model
layered portfolio; goals based investing
Adaptive Markets Hypothesis
Alternative Behavior Model
adapt models, survival of the fittest
Transitivity
Rational Decision Making Assumptions
consistently apply completeness rankings
Completeness
Rational Decision Making Assumptions
know preferences and use them to chose between mutually exclusive choice
Independence
Rational Decision Making Assumptions
rankings are additive and proportional
Continuity
Rational Decision Making Assumptions
indifference curves are continuous
Barnewall Two-Way Behavioral Model
investors are either
- Passive: did not risk own capital to gain wealth
- Active: risk own capital to gain wealth
BB&K Five-Way Model
Bailard Biehl, and Kaiser five-way model
- Guardian - careful, not confident
- Individualist - careful, confident
- Straight Arrow
- Adventurer - not careful, confident
- Celebrity - not careful, not confident
Pompian Behavioral Model
behavioral investor types (BITs) based on active vs passive risk, risk tolerance, and biases
- Passive Preserver: passive, low risk, emotional bias
- Friendly Follower: passive, moderate risk, cognitive bias
- Independent Individualist: active, moderate risk, cognitive bias
- Active Accumulator: active, high risk, emotional bias
Limitations to Classifying Investors into BITs
- people have both emotional and cognative biases
- hard to put in one category
- behaviors change as time passes
- people with same type should not always be treated the same
- people are do not always act rationally
Benefits to Classifying Investors into BITs
- portfolios closer to the efficient frontier; resemble ones based on traditional finance theory
- more trusting and satisfied clients
- clients better able to stay on track w/ long-term plans
- better relationships between client and manager
Bubbles and Crashes
unusual returns b/c panic buying and selling not based on economic fundamentals
Bubbly: prices for an asset class two SD from mean
Crash: fall in prices of 30% or more over months
