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CFA Level III > Behavioral Finance > Flashcards

Behavioral Finance Flashcards

1
Q

Traditional Finance

A

how individuals should behave; efficient markets; utility theory with diminishing marginal returns (convex indiff curves)

REM - risk averse, rational expectations, asset integration

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2
Q

Behavioral Finance

A

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
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3
Q

Bayes’ Formula

A

Traditional Finance

incorporate new info into previous forecasts, helps the investment decision making process

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4
Q

P(A|B)

A

Conditional probablity of A

Probability of A given B

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5
Q

Bounded Reality

A

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)

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6
Q

Prospect Theory

A

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

  1. Editing phase
  2. Evaluation phase
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7
Q

Evaluation Phase

A

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

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8
Q

Weak-Form Efficient Market

A

current prices incorporate all past price and volume data

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9
Q

Semi-Strong Form Efficient Market

A

prices reflect all public info, including past price and volume data

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10
Q

Strong-Form Efficient Market

A

prices reflect all inside info, public info, and past price and volume data

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11
Q

EMH Challenges

A

anomolies = inefficiencies in market

  1. Fundamental: returns to stock fundamentals
  2. Technical: past stock price and volume
  3. Calendar: January effect
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12
Q

Consumption and Savings Model

A

mentally categorize wealth as income, assets, and present value of future income

end up spending more than saving

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13
Q

Conservatism Bias

A

Cognitive Error - Belief

rationally form initial view, fail to include new info; too little/ much turnover

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14
Q

Confirmation Bias

A

Cognative Error - Belief

look for into/ distort new info to support existing view

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15
Q

Representative Bias

A

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)
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16
Q

Illusion of Control Bias

A

Cognitive Error - Belief

think they can control or affect outcomes when they cannot

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17
Q

Hindsight Bias

A

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

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18
Q

Anchoring and Adjustment Bias

A

Cognitive Error - Info Processing

changes are made in relation to initial view

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19
Q

Mental Accounting Bias

A

Cognitive Error - Info Processing

money treated differently based on categorization

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20
Q

Framing Bias

A

Cognitive Error - Info Processing

decisions impacted by how data is “framed”

21
Q

Availability Bias

A

Cognitive Error - Info Processing

over emphasis on readily available info

22
Q

Loss-Aversion Bias

A

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)

23
Q

Overconfidence Bias

A

Emotional Bias

overestimate ability or reasoning; ego defense mechanisms (self-attribution bias)

24
Q

Self-Control Bias

A

Emotional Bias

lack self-discipline and favor immediate gratification over long-term goals (disposition effect)

25
Status Quo Bias
Emotional Bias content with existing situation, unwilling to make changes to investments
26
Endowment Bias
Emotional Bias asset believed to be worth more because it's already owned
27
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
28
GBI
Goals Based Investing investment tiers based on goals and appropriate levels of risk (obligations, low risk; desires, medium risk; aspirations, high risk)
29
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)
30
Codification
Editing Phase assigns prob to outcomes
31
Combination
Editing Phase similify outcomes, combine identical for same option
32
Segregation
Editing Phase seperate risk free and risky returns
33
Cancellation
Editing Phase remove outcomes common to diff options
34
Simplicifaction
Editing Phase remove unlikely scenarios (1%)
35
Detection of Dominance
Editing Phase remove inherently inferior options
36
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)
37
Behavioral Portfolio Theory
Alternative Behavior Model layered portfolio; goals based investing
38
Adaptive Markets Hypothesis
Alternative Behavior Model adapt models, survival of the fittest
39
Transitivity
Rational Decision Making Assumptions consistently apply completeness rankings
40
Completeness
Rational Decision Making Assumptions know preferences and use them to chose between mutually exclusive choice
41
Independence
Rational Decision Making Assumptions rankings are additive and proportional
42
Continuity
Rational Decision Making Assumptions indifference curves are continuous
43
Barnewall Two-Way Behavioral Model
investors are either 1. Passive: did not risk own capital to gain wealth 2. Active: risk own capital to gain wealth
44
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
45
Pompian Behavioral Model
behavioral investor types (BITs) based on active vs passive risk, risk tolerance, and biases 1. Passive Preserver: passive, low risk, emotional bias 2. Friendly Follower: passive, moderate risk, cognitive bias 3. Independent Individualist: active, moderate risk, cognitive bias 4. Active Accumulator: active, high risk, emotional bias
46
Limitations to Classifying Investors into BITs
1. people have both emotional and cognative biases 2. hard to put in one category 3. behaviors change as time passes 4. people with same type should not always be treated the same 5. people are do not always act rationally
47
Benefits to Classifying Investors into BITs
1. portfolios closer to the efficient frontier; resemble ones based on traditional finance theory 2. more trusting and satisfied clients 3. clients better able to stay on track w/ long-term plans 4. better relationships between client and manager
48
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

CFA Level III (12 decks)

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