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