Behavioral Finance

Question 1

Characteristics of Adventurer, Celebrity, Guardian, Individualist, Straight Arrow

Answer 1

Adventurer

• May hold highly undiversified portfolios
• Make their own decisions, reluctant to take advice

Celebrity

• Recognize their limitations to a certain extent
• Willing to seek & take advice

Guardian

• Concerned about protecting their assets
• May seek advice (as people age, tend to become Guardians) from those they perceive as being more knowledgeable than themselves

Individualist

• Independent and confident investor who like to make their own decisions
• Will listen & process information rationally
• Unlikely to easily take advice without doing their own analysis

Straight Arrow

• Sensible & secure
• Willing to take on some risk

Question 2

Psychographic Modeling

Answer 2

Because risk analysis is a cognitive process, the risk tolerance questionnaire may fail investors with an emotional bias, and will likely work better for investors with a cognitive bias

Question 3

Utility Theory

Answer 3

• Utility theory is associated with the Tradition Finance Perspective, which assumes that individuals are Rational Economic Men, who are perfectly rational, self-interested, and have access to perfect information.
• Individuals will seek to maximize the present value of utility subject to a present value budget constraint, and will make decisions based on their ongoing process of calculating probabilities of expected utility for option A vs. option B.
• The basic axioms of utility theory are completeness, transitivity, independence, and continuity.
• As new information becomes available, we update our calculations of expected utility using Bayes formula

Question 4

Prospect Theory

Answer 4

• Prospect Theory is associated with the Behavioural Finance perspective, which assumes that individuals don’t focus so much on the probable expected outcomes, but rather the impact (or weight) of a given deviation from their current level of wealth
• Rather than calculating probabilities of expected utility, people apply weights to the possible outcomes of the decision being considered. This is called Reference Dependence and is unique to Prospect theory.
• Most people reject a gamble with even chances to win and lose unless the possible win is at least twice the size of the possible loss
• People are risk-seeking when there is a low probability of gains or a high probability of losses
• Deviations in decision making result in overweighting low-probability outcomes

Question 5

Bounded rationality

Answer 5

Bounded rationality describes the phenomenon whereby people gather some (but not all) available information. It assumes that individuals’ choices are rational but are subject to limitations of knowledge and cognitive capacity.

Question 6

Anchoring Bias

Answer 6

Anchoring is an information-processing bias which influences the way people estimate probabilities. When required to estimate a value with unknown magnitude, people generally begin by envisioning some initial default number—an “anchor”—which they then adjust up or down to reflect subsequent information and analysis.

Question 7

Representativeness Bias

Answer 7

Representativeness bias is a cognitive bias in which people tend to classify new information based on past experiences and classifications.

Question 8

Self-Control Bias

Answer 8

Self-control bias occurs when individuals deviate from their long-term goals

Question 9

Gambler’s Fallacy

Answer 9

The gambler’s fallacy is a cognitive behavioral bias in which an analyst wrongly projects a reversal to a long-term trend. This reflects a faulty understanding about the behavior of random events.