Behavioral Finance Perspective

Question 1

What is behavioral finance ?

Answer 1

Behavioral finance is the understanding how people make decisions both individually and collectively.
It can be:

• Normative: Strive to achieve the ideal of factual decision
• Descriptive: How real people actually make decision
• Prescriptive: Practical tools to help achieve optimal results

Question 2

Elaborate on behavioral finance biases categories

Answer 2

Cognitive errors

Emotional errors

Question 3

Elaborate on the perspective of traditional finance

Answer 3

The value of a good idea is not based on its price but on the utility it yields.

Completeness: Assumes defined preference A>B
Transitivity: if A>B and B>C then A>C
Independence
Continuity

If the decision satisfy all 4 axiom, the individual is said to be rational.

Question 4

Elaborate on Bayes formula

Answer 4

Baye’s formula explains how probability evolves given new information. (Bayesian update)

P(U1/R) = [P(R/U1)/P(R)] * P(U1)

Question 5

How is the risk premium defined ?

Answer 5

The difference between the certainty equivalent” and the “expected value” is called the risk premium.

Question 6

Elaborate on behavioral finance perspective on individual behavior

Answer 6

Bonded rationality
Shortcomings of REM are internal conflicts:
Short vs long term and self interest vs societal

Question 7

Elaborate on REM (Rational Economic Man)

Answer 7

REM despite its shortcomings is valuable because it is normative and help define an optimal outcome.

Utility maximization should take into account
exogeneous factor such as risks and attitude toward risks (double inflection utility function: concave-convex-concave) reflecting changing attitude as wealth level change.

Question 8

Words on Decision theory

Answer 8

Decision theory is concerned with identifying values, probabilities, and other uncertainties relevant to a given decision and using that information to arrive at a theoretically optimal decision. Decision theory is normative, meaning that it is concerned with identifying the ideal decision. As such, it assumes that the decision maker is fully informed, is able to make quantitative calculations with accuracy, and is perfectly rational.

• Expected value (Pascal) =/= expected utility(Bernoulli)
• Difference between risk and uncertainty (Frank and Knight)
• Subjective expected utility (SEU)

Question 9

Elaborate on Bonded rationality (Simon)

Answer 9

People are not fully rational when making decisions, they strive to arrive at a satisfactory but not necessarily optimal decision.

Satisfice = Satisfy + suffice
The rationality is bounded by time constrains and informational and cognitive limitations.

Question 10

Elaborate on Prospect theory

Answer 10

Prospect theory describes how individuals make choices in situations in which they have to decide between alternatives that involve risk (e.g., financial decisions) and how individuals evaluate potential losses and gains. Prospect theory considers how prospects (alternatives) are perceived based on their framing, how gains and losses are evaluated, and how uncertain outcomes are weighted.
In prospect theory, based on descriptive analysis of how choices are made, there are two phases to making a choice: an early phase in which prospects are framed (or edited) and a subsequent phase in which prospects are evaluated and chosen. Prospect theory assigns value to gains and losses (changes in wealth) rather than to final wealth, and probabilities are replaced by decision weights.

From empirical studies, we find that people overreact to smaller events but underreact to larger or mid-size events.

People are not so much risk adverse but rather loss-averse.

Prospect theory in contrast to utility theory measures gains and losses but not absolute wealth.

People are risk adverse for smaller possible losses but risk affine for large probability losses.

Question 11

Elaborate on Prospect theory framing (or editing)

Answer 11

Codification: People perceive outcomes as gains and losses rather than final states of wealth or welfare.

Combination: Prospects are simplified by combining the probabilities associated with identical gains or losses

Segregation: The riskless component of any prospect is separated from its risky component.

Cancellation: Cancellation involves discarding common outcome probability pairs between choices.

Simplification: Prospects are likely to be rounded off. A prospect of (51, 0.49) is likely to be seen as an even chance to win 50.

Detection of Dominance: Outcomes that are strictly dominated are scanned and rejected without further evaluation.

Question 12

What are the type of identified market anomalies.

Answer 12

Fundamental
Technical
Calendar

Question 13

What are the alternative models of market behavior and portfolio construction ?

Answer 13

Behavioral approach to consumption and saving
Behavioral approach to asset pricing
Behavioral to portfolio (BTP)
Adaptive Market Hypothesis (AMH)

Question 14

Elaborate on Behavioral approach to consumption and saving

Answer 14

behavioral life-cycle theory incorporates self-control, mental accounting, and framing biases. In behavioral finance, the self-control bias recognizes that people may focus on short-term satisfaction to the detriment of long-term goals. People classify their sources of wealth into three basic accounts: current income, currently owned assets, and the present value of future income (mental accounting).

people lack self-control when it comes to current income, they first spend current income, then to spend based on current assets, and finally to spend based on future income.

Question 15

Elaborate on Behavioral approach to asset pricing (SFD)

Answer 15

The model posits that sentiment is a major determinant of assets pricing model, and sentiment cause assets prices to deviate from intrinsic value.
Sentiments is proxied by dispersions of analysts forecasts. The higher the dispersion, the higher the source of risk.

Return = Rf + fundamental premium + sentiment premium

Question 16

Elaborate on Behavioral to portfolio (BTP)

Answer 16

Investors construct their portfolio in layers and expectations returns and attitudes toward risk vary between layers.
There are 5 layers
Investors maximize expected wealth on a particular portfolio subject to safety constrained.

Question 17

Elaborate on Adaptive Market Hypothesis (AMH)

Answer 17

AMH applies principles of evolution, competition, adaption and natural selection.
Success is defined as survival rather than maximizing utilities.
Five implications of AMH are:
1) The relationship between risk and reward varies over time (risk premiums change over time) because of changes in risk preferences and such other factors as changes in the competitive environment;

2) active management can add value by exploiting arbitrage opportunities;
3) any particular investment strategy will not consistently do well but will have periods of superior and inferior performance
4) The ability to adapt and innovate is critical for survival;
5) survival is the essential objective. In other words, recognizing that things change, the survivors will be those who successfully learn and adapt to changes.

Question 18

Further development

Answer 18

Client considering long term and short term are more consistent with the Utility theory.

People buying options tend to follow the prospects theory of overweighting the probability of high financial impact outcome and underweighting probability of ,loses.

Stop limit are most consistent with BPT. BTP deals with safety net and aspirational wealth as well probability of attaining objectives.

Considering vola and expected return is most consistent with traditional finance.

A loss adverse client will accept lower expected return to avoid losses.

Question 19

How can you classify behavioral biases ?

Answer 19

Cognitive Errors
Emotional Biases

Cognitive Errors are often correlated and can be identified and to some extent relatively moderated.

Emotional biases are more difficult to correct because more spontaneous.

Question 20

Elaborate on Cognitive Errors

Answer 20

They can be classified as either belief perseverance or info processing

Conservatism bias : Maintain old view even in light of new info. Analyst may maintain their forecast even when presented wit new weights.

Confirmation bias: Tend to look for information that confirms their beliefs, and ignore or discount what contradict their belief.

Representativeness bias: Classify new information based on past experiences and classifications. New info are fitted in already existing frame. The investor will tend to believe that a sample is representative of a population.

Illusion of control: Illusion that people have that they can control the outcome of events. This could lead to under diversification.

Hindsight bias: Belief that the outcome could have been self evident and predictable once it has occurred. This could prevent from learning from the past.

Anchoring bias:

Mental accounting: People treat money differently depending on its source or use of it.

Framing bias: To answer a question differently based on how it is frame.

Availability bias: Estimating the probability of an event occurring based on how easily it came to mind or we remember it.

Question 21

Elaborate on Emotional bias

Answer 21

Loss aversion biases: People prefer to more strongly avoid losses than achieve gains as such they ay tend to hold on to loses longer than rational or be quick to sell winners, engage in excessive trading or hold riskier portfolio.

Overconfidence bias: Unwarranted faith in one own intuitive reasoning, judgment or cognitive abilities. This may lead to have very narrow forecast ranges or very concentrated bets. One solution could be to review your own track record over long period.

Self attribution Take credit for success and assign responsibilities for failures.

Self control bias: Failure to control one self when making decisions involving delayed return

Hyperbolic payoff: Prefer small payoff now than larger return in the future.

Status quo bias : Emotional bias in which people do nothing instead of making a change. Position is maintained because of inertia rather than conscious choices.

Endowment bias: People valuing an asset more when they own it.

Regret aversion bias: Avoid making decisions that will result in action out of the fear of loosing out. This can cause you to hold on to a position too long.

Question 22

Elaborate on Goal based investing approach

Answer 22

This approach links portfolios to individual goals but may result in inefficient overall allocation.

Question 23

Guideline for determining a behaviorally modified assets allocation

Answer 23

The wealthier the client, the more we should adapt to its behavioral bias, the less wealthy, the more the practitioner should moderate the bias.

Clients exhibiting cognitive error should be moderated and those with emotional biases should be adapted.

Question 24

Elaborate on the SLR (Standard of living risk)

Answer 24

The risk that the current or desired standard of living may not be sustainable.