Behavioral Finance

Question 1

Prospect Theory

Answer 1

more risk averse vs pleasure seeking by ratio of 2:1
• make decisions based on probabilities than potential outcomes
• loss aversion ties into this theory; attendance to feel impact of losses more than the pleasure of gains (asymmetrical S-shape)
• people make financial and investment decisions using mental shortcuts and biases (called heuristics)

Question 2

Paradox of Choice

Answer 2

giving people more choice does not increase performance/satisfaction
• people easily overwhelmed with information
• often do nothing when conflicted
• optimal decisions are note made

Question 3

Adaptive Market Hypothesis (AMH)

Answer 3

reconciles EMH with behavioral economics
• markets evolve over time as individuals use numerous heuristics/biases to make decisions
• opportunities for arbitrage; value in fundamental/technical/quantitative strategies
• survival is primary objective, profit and utility are secondary; innovation is key to survival and growth

Question 4

Cognitive Dissonance

Answer 4

confusion/frustration when new info does not conform beliefs; hold losers, herd behavior, “different this time”

Question 5

Conservatism Bias

Answer 5

cling to prior views at expense of new info, slow to change, under-react, ignore complex/conflicting information

Question 6

Confirmation Bias

Answer 6

actively seek out information that confirms prior views, ignore conflicting info, under-diversified, pre-determined screen

Question 7

Representative Bias

Answer 7

process new info using pre-existing beliefs, similarities to past events, flawed perception; gambler’s fallacy

Question 8

Illusion of Control

Answer 8

think you can control investment outcomes, leads to overconfidence, excess trading, under diversification, limit orders

Question 9

Hindsight Bias

Answer 9

perceive outcomes as if predictable, criticizing managers in out of favor asset classes

Question 10

Mental Accounting

Answer 10

treat various sums of money differently, mental categorize, house money effect, sell at gain after draw down

Question 11

Anchoring/Adjustment Bias

Answer 11

influenced by purchase price, cling to numbers when forecasting estimated returns

Question 12

Framing Bias

Answer 12

respond to similar situations differently based on context which presented, risk tolerance questions, excessive risk aversion

Question 13

Availability Bias

Answer 13

easily recalled/recent outcomes perceived as more likely to occur; retrievability, resonance, categorization, narrow range of experience

Question 14

Self-Attribution Bias

Answer 14

ascribe successes to talent/failures to outside influences; under diversification, excessive risk-taking

Question 15

Outcome Bias

Answer 15

make decisions based on past outcomes rather than process through which outcome occurred, focus solely on track record

Question 16

Recency Bias

Answer 16

more easily recall recent events, extrapolate recent patterns that don’t exist, enter asset classes at wrong time, “different this time”

Question 17

Loss Aversion

Answer 17

pain of loss 2x worse than pleasure of gain, keep losers, sell winners too quickly, stay in cash too long, unbalanced portfolio

Question 18

Overconfidence Bias

Answer 18

unwarranted faith in one’s own abilities, under diversified, excessive risk, excess trading

Question 19

Self-Control Bias

Answer 19

focus on instant gratification, failing to act in best interest of LT goals, spend more today at expense of tomorrow

Question 20

Status Quo Bias

Answer 20

when forced with array of options, pick choice to keep same; emotionally attracted to stocks

Question 21

Endowment Bias

Answer 21

place more value on object when you won it, less when you don’t own it, decision paralysis, hold to avoid taxes

Question 22

Regret-Aversion Bias

Answer 22

avoid making decisions/taking action to avoid chance of making a mistake, too conservative, may lead to herd behavior

Question 23

Affinity Bias

Answer 23

irrational choice from new company/product that reflects value of investor, ESG only focus w/o regards for fundamentals

Question 24

Disposition Effect

Answer 24

hold losers too long, sell winners to quickly

Question 25

Ambiguity Bias

Answer 25

investors may not want to stake claims on ambiguous investments; want to take the less favorable choice if outcome is known

Question 26

Preservers

Answer 26

passive
low risk-tolerance
emotional
looking for financial security/preservation of wealth.

Need “big-picture” advice, don’t need to get lost in the details but need to be shown how their portfolio will deliver desired results for future generations and meet their LT goals.

• loss aversion
• status-quo bias
• endowment bias
• anchoring bias
• mental accounting

Question 27

Followers

Answer 27

passive
low/medium risk-tolerance cognitive
no own ideas
follow crowds
most popular investments
no regard for LT goals.

Handle with care – they often say yes to anything. Should challenge them to back up their own recommendations with data-backed substantiation.

• recency bias
• framing bias
• cognitive dissonance
• regret aversion bias

Question 28

Independents

Answer 28

active
medium/high risk-tolerance
cognitive
strong willed
independent thinker
self-assured
trust instincts

Difficult clients to advise, need to educate to change behavior, have regular unambiguous educational discussions, stress diversification and a long-term plan.

• conservatism bias
• availability bias
• representativeness
• self-attribution bias
• confirmation bias

Question 29

Accumulators

Answer 29

active
high risk-tolerance
emotional
actively involved with wealth creation
risked own capital

Take control of situation, demonstrate the impact of financial decisions.

• overconfidence bias
• self-control bias
• affinity bias
• illusions of control
• outcome bias