Behavioral Finance (Review Everyday) Flashcards
4 basic premises of Traditional Finance
- investors are rational
- markets are efficient
- the mean variance portfolio theory governs (investors choose portfolios by viewing and evaluating mean returns and variance for their entire portfolios)
- returns are determined by risk (the CAPM is the basic theory that links return and risk for all assets by combining a risk free asset with risky assets from an efficient market
Behavioral Finance makes the following assumption
- investors are ‘normal’ (may be mislead by emotions while they are trying to achieve their wants)
- markets are not efficient
- the behavioral portfolio theory governs (people ‘compartmentalize’ certain goals to be accomplished in different categories based on risk rather than viewing their entire portfolio as a whole— may result in very different risk preferences)
- risk alone does not determine returns
affect heuristic
deals with judging something, whether it is good or bad.. do they like or dislike some company based on non financial issues
anchoring
attaching or anchoring one’s thoughts to a reference point even though there may be no logical relevance or is not pertinent to the issue in question. also known as conservatism or belief perseverance
availability heuristic
when a decision maker relies upon knowledge that is readily available in his or her memory, the cognitive heuristic known as ‘availability’ is invoked
may cause investors to overweight recent events or patterns while paying little attention to longer term trends
bounded rationaility
when individuals make decisions, their rationality is limited by the available information, the tractability of the decision problem, the cognitive limitations of their minds and the time available to the decision
decision makers in this view act as ‘satisficers’ seeking a satisfactory solution rather than an optimal one.
consequence -> having additional information does not lead to an improvement in decision making de to the inability of investors to consider significant amounts of information
confirmation bias
“you do not get a second chance at a first impression”
people tent to filter information and focus on information supporting their opinion
disposition effect aka ….
Aka Regret Avoidance or “faulty framing” where normal investors do not mark their stocks to market prices
investors create mental accounts when they purchase stocks and continue to mark their value to purchase prices even after market prices have changed
familiarity bias
investors tend to overestimate / underestimate the risk of investments with which they are unfamiliar/familiar
gambler’s fallacy
investors often have incorrect understanding of probabilities which can lead to faulty predictions
investors may sell stock when it has been successful in consecutive trading sessions because they may not believe the stock is going to continue its upward trend
herding
people tend to follow the masses or the herd
hindsight bias
looking back after the fact is known and assuming they can predict the future as readily as they can explain the past
illusion of control bias
the tendency for people to overestimate their ability to control events
overconfidence bias
mostly rely on their skills and capabilities to do their own homework or make their own decisions
may cause investors to overstate their risk tolerance
overreaction
common emotion towards the receipt of news or information
