Behaviour Finance Flashcards
Behavioral Finance vs Traditional Finance
Behavioral Finance
- Descriptive (what investors do)
- Cognitive limits and Emotional biases
- Bounded rationality, loss averse and prospect Theory
- Market prices may not be efficient
Traditional Finance
- Normative (what investors should do)
- Rational, risk-averse and consistent with utility theory to max satisfaction
- Updated expectations (perfect info) and unbiased
- The price is right (i.e. Market is efficient)
- No free lunch (i.e. No alpha for port managers)
4 axioms of Utility Theory
If all holds, individual is rational
- Completeness: “choices and preferences” - well-defined preference and clearly decides b/w 2 choices (A > B)
- Transitivity: rankings are applied consistently (if A > B and B > C, then A > C)
- Independence: new item does not change independent utility of original items (if A > B then [A + C] > [B + C]) – utilities are additive and divisible
- Continuity: smooth and continuous (unbroken) indifference curve
Bayes’ Formula
Bayes Formula – With new information, investors revise expectations applying baysian analysis (i.e. conditional probability)
P (A | B) = [P (B | A) * P (A)] / P (B) = probability of A given B (eg. A urns, B red ball.)
Decision tree under Traditional Finance
- Adhere to the axioms of the utility function
- Assign probabilities and analyse using Bayes’ Formula (conditional probability)
- Chose the max. exp. utility subject to budget constrains
Rational Economic Man (REM)
- Perfectly rational
- Perfectly informational
- Prefectly selfish
Review all information and ajust all info thinking only about yourself
Risk premium
Expected return = risk premium + risk free
Risk Premium = E(r) - Certainty Equivalent (ie. rf)
Utility Function - Traditional Finance vs. Behaviour Finance
Traditional finance - Continous where individous are risk averse (concave, eg. insurance, low probability, avoiding risk), risk loving (convex, eg. lottery ticket, with low probability, but seeking risk) or risk neutral
Behaviour Finance - Double inflection utility function, where utility function may change based on the level of wealth (eg. risk seeking for gains and risk averse for losses)
Prospect Theory
Prospect Theory - Alternative to utility theory, dependent on framing effects
- Focus on perceived gains / losses (Δ wealth) based on a reference point
- Subjective decision weights replace objective probability
Behavior Finance Decision making in 2 phases:
(i) Editing phase - Organize and reformulate options to simplify the choice (subject to isolation effect, where investors focus on one factor and ignore others)
(ii)Evaluation phase - people are loss-averse and reference dependent (evaluate decisions based on its gain/loss, level of wealth or income) – decisions are made based on wpv (weight * probability * value), assigning discretionary weights depending on the possible outcome (gain / loss)
Bounded Rationality
Bounded Rationality
Relaxes perfect information and process according to expected utility theory.
People will satisfice (satisfy + suffice) when pursuing a specific goal while finding solutions that are bounded by constraints (such as time and money). It may not be optimal, but it is acceptable / adequate meeting the criteria specified.
When some (but not all) information is available, use heuristics (rule of thumb).
Forms of Efficient Market Hypothesis
(and market anomalies)
(i) Weak form: Prices reflect all past price and volume (i.e. technical analysis will not generate excess return)
(ii) Semi-strong form: Prices reflect all public information, including prices, volume and data (i.e. technical and fundamental analysis will not generate excess return)
(iiI) Strong form: Prices reflect all public and private information (i.e. technical, fundamental or insider information will not generate excess return)
Market anomalies: Fundamental (small vs large cap), Technical (moving avg) and Calendar (January effect)
Traditional Finance Portfolio Construction
Mean-variance efficient (rational portfolio), subject to investment constraints and objectives
Behavioral Finance Portfolio Construction
Consumption and Savings
People are subject = Self -control (people may focus on short term satisfaction) + Mental accounting (treat a sum of money different from another sum of money) + Framing bias (different response for different forms of asking the same question)
Behavioral Finance Portfolio Construction
Asset Pricing
CAPM + SDF = rf + risk premium + sentiment premium (i.e. stochastic discount factor considering dispersion of analysts forecast)
Behavioral Finance Portfolio Construction
Behavioral Portfolio Theory (BPT)
Behavioral Portfolio Theory (BPT) - Correlation between layers is not considered (sub-optimal from TF perspective, but is the portfolio that the client can live with)
(i) Portfolio built in layers according to goal (risk-return) and importance given to each
(ii) Goal in each layer determine how much it is allocated to it
(iii) # of assets depends on the shape of utility curve (the greater the concavity, the greater the # of securities)
(iv) Investors with perceived info advantage will hold more concentrated positions
(v) Investors that are highly loss averse may hold cash to avoid selling assets and realize losses
Behavioral Finance Portfolio Construction
Adaptive Markets Hypothesis (AMH)
Adaptative Markets Hypothesis (AMH) – Principles of evolution to financial markets. Bounded rationality and satisficing via trial and error
(i) Investors make decisions to help them survive (satisfice) rather than to maximize utility (optimal).
(ii) Investors must adapt and innovate to survive.
(iii) No investment strategy can continually out-perform.
(iv) Risk premiums vary over time with changes in (1) risk aversion and (2) the level of competition.
(v) Active management can add value by arbitrage opportunities
Behavioral Biases:
Cognitive errors vs Emotional biases
Cogntive errors:
- processing shortcuts or heuristics / memory errors, such as inability to do complex math calcs or processing and filtering information.
- Result of faulty reasoning.
- Better info, education, and advice can often correct it.
Emotional biases:
- Emotional or motivational factors, steamed by impulse or intuition.
- Reasoning influenced by feelings.
- Less easily corrected, recognize and adapt
Cognitive Errors
Belief Perseverance Biases
CC-RIH’der
Conservatism bias
Confirmation bias
Representativeness bias
Illusion of control bias
Hindsight bias
Cognitive Errors
Information-Processing Biases
FAMA
- Anchoring & Adjustment
- Mental accounting bias
- Framing bias
- Availability bias
Emotional Biases
LOSERS
-
Loss aversion bias
(i) Myopic loss aversion -
Overconfidence bias (illusion of knowledge)
(i) Prediction overconfidence
(ii) Certainty overconfidence
(iii) Self-Attribution bias -
Self-control bias
(i) Hyperbolic discounting - Endowment bias
- Regret-aversion bias
- Status quo bias
Modified Portfolio
Behaviorally Modified Asset Allocation (Goals-based investing - pyramids ∆): Portfolio that consider behavior bias (cognitive and emotional) and deviates from the mean-variance (MVO)
Portfolio built in layers to meet individual goals or subsets of goals. Bottom layer constructed first and comprised of assets designated to meet the investor’s most important goals. Each successive layer consists of increasingly risky assets used to meet less and less import goals.
- Consistent with: Prospect Theory’s Loss aversion & Mental accounting
- Adapt to bias: Accept that exists and adjust portfolio accepting it. Recommended to wealthy investors and to emotional bias
- Moderate bias effect: attempt to reduce or even eliminate the bias with the individual. Recommended to less wealthy, since there is more danger to the client’s standard of living and to cognitive errors, because better information / advice may correct the error
obs: wealth depends on the standard of living risk (SLR) of the investor
Barnewall 2-way Model
Psychographic Characteristics
Active - wealth creators = higher confidence and willingness to assume risk (control of investments). Usually more ability to assume risk
Passive - inherited wealth, “employees” = higher security needed, less willing to take risk.
Bailard, Biehl, and Kaiser 5-way Model
(BB&K 5-way model)
Straight arrow is the difference between the 4-way and the 5-way model.
Vertical - How confident approaches life?
Horizontal - Method of action
Pompian Model
- Passive Preserver (PP) - Passive + Emotional
- Friendly Follower (FF) - Passive + Cognitive
- Independent Individualist (II) - Active + Cogn.
- Active Accumulator (AA) - Active + Emotional
Limitations of Behavioral Types Classification
- Investors may display Cognitive + Emotional Biases at the same time
- Investors may have traits of more than one type
- Behavior changes with age
- Each investor is unique (no standard treatment)
- Investors act irrationally and unpredictably
Behavioral insights for client / adviser relationship
- Understand the “why” of client’s financial goals
- Best way of presenting advice
- Best way to meet and satisfy client’s expectations
- Ensure that the relationship benefits both client and adviser
Evidence of Behavior Bias in Portfolio Construction (Defined Contribution)
Evidence of Behavior Bias in Portfolio Construction (Defined Contribution)
1. Inertia and Default - investors do not rebalance (status quo bias)
- Target date funds (adjust portfolio as time passes) – may be too generalist
2. Naive Diversification – to avoid regret, equally spread the assets in a portfolio (1/n)
3. Investing in familiar (company stock) - Lack diversification = status quo + loyalty + financial incentives + framing + etc.
4. Excessive trading - Usual for overconfident investors. Disposition effect (hold losers too long, sell winners).
5. Home Bias - High concentration on domestic and familiar stocks = status quo + endowment + etc.
6. Behavior Portfolio Theory - Portfolios constructed risk layer by risk layer (mental accounts).
Confirmation bias
Believe perseverance
-
Confirmation bias – Look for / notice what confirms beliefs (ignore contrary data)
- under-diversification (e.g. over concentration in employer stock)
- seek out contrary information and alternate methods of analysis
Conservatism bias
Believe perseverance
1.Conservatism bias – emphasizing initial information (maintain prior forecast). The more difficult processing, the likelier it happens
- slow to update views
- overweight past info
- hold securities too long
- seek new information and alternative views
Representativeness bias
Believe perseverance
1.Representativeness bias – classify new information based on past experiences / stereotype heuristics.
Base-rate neglect (rely on stereotypes, w/o considering the probability of that classification being right)
Sample-size neglect (assume that small data size reflects the whole)
- overemphasizing data covering short time periods
- reacting too quickly to new information
- understand statistical analysis
- develop a suitable long-term strategic asset allocation for the portfolio
Illusion of control bias
Believe perseverance
1.Illusion of control bias - assuming they can influence the outcome even when they cannot (> when + past w/ active involv.)
- trade too quickly
- under-diversify
- apply probabilistic analysis
- consider alternative views and worst-case scenarios
Hindsight bias
Believe perseverance
1.Hindsight bias - selectively remembering what was right (overweight initial knowledge and forget errors)
- taking too much risk or clients who unfairly blame their manager
- keep and review records to determine successes and failures
- Don’t confuse value added with an up market
Framing bias
Information-Processing errors
-
Framing bias - How information is presented changes the decision made
- short-term trading
- sub-optimal asset allocation
- focus on expected return and risk, not perceived gain or loss from a past value
Anchoring & Adjustment
Information-Processing errors
1.Anchoring & Adjustment - Similar to conservatism except changes are made from an initial anchored default value (#, not belief).
- failing to make a large enough adjustment from the initial anchor point. Use of heuristics.
- consider the result of a new analysis instead of starting from the initial anchor.
- establish a periodic review process
Availability bias
Information-Processing errors
1.Availability bias – assess the likelihood of an outcome based on how easily recall information
- choices based on irrelevant information (no thorough analysis)
- inadequate diversification / inappropriate asset allocation
- follow a disciplined research process
- develop investment policy strategy
Mental accounting bias
Information-Processing errors
1.Mental accounting bias - Funds are categorized and buckets of money are treated differently (the layers in BPT).
- ignores correlation b/w buckets, causing risk to be overstated
- shifts focus from total return to income received
- look at the total return and risk of the overall portfolio
Loss aversion bias
Emotional biases:
1.Loss aversion bias - Prospect theory. Investors strongly prefer avoiding losses than earning gains. Myopic loss aversion = time horizon framing + mental accounting + Loss aversion = more concern for short term loss than long term diversification
- selling winners may reduce upside and holding losers may increase risk (disposition effect)
- trade too much
- objectively forecast expected return and risk
Overconfidence bias
Emotional biases:
-
Overconfidence bias (illusion of knowledge) – Unjustified faith in own knowledge and cognitive abilities than reality
(i) Prediction overconfidence – tendency to overestimate accuracy (i.e. narrow confidence interval)
(ii) Certainty overconfidence – confidence increasing faster than accuracy (quantity = quality)
(iii) Self-Attribution bias – taking credit for success and blaming others for failure- underestimate risk and overestimate return
- under diversify
- trade too much
- maintain and review records of what works and what does not
Self-control bias
Emotional biases:
-
Self-control bias - Lack of self-discipline. Individuals fail to balance the need for short-term satisfaction with long-term goals
(i) Hyperbolic discounting – prefer small payoff now vs. large payoffs in the future - save too little and then take too much risk to compensate
- hold too many bonds for higher current income
- establish and follow a budget
- investment policy statement
Endowment bias
Emotional biases:
1.Endowment bias - what is owned is more valuable (better) than what could replace it, leading to status quo bias
- holding what is owned leading to inappropriate asset allocation
- if essential, mitigation may have to be done in stages
Regret-aversion bias
Emotional biases:
1.Regret-aversion bias – avoid making decisions for fear of making the wrong one or it turning out poorly. Leads to status quo bias.
- Portfolios that are too conservative or aggressive
- educate the client on what combinations of return and risk are reasonable
Status quo bias
Emotional biases:
1.Status quo bias – Do nothing instead of making changes (inertia)
- Inappropriate risk and return
- This is a hard bias to overcome; try to educate the client
Pompian behavioral model
Active Accumulator
- Active Accumulator: Emotional biases with high risk tolerance. Most aggressive, strong-willed and confident.
- Emotional*: Overconfidence and self-control
- Cognitive*: Illusion of control
- Most difficult. Like to be deeply involved. Too optimistic.
Pompian behavioral model
Independent Individualist
- Independent Individualist: Cognitive biases with high risk tolerance. Self-assured, seeks info and May invest advice.
- Emotional*: Overconfidence and self-attribution
- Cognitive*: Conservatism, Availability, Confirmation and Representativeness
- Willing to listen to sound advice. Tendency to make contrarian positions.
Pompian behavioral model
Friendly Follower
- Friendly Follower: Cognitive biases with low risk tolerance. Follow advice investing.
- Emotional*: Regret aversion (herding behavior)
- Cognitive*: Availability, Hindsight and Framing biases
- Education on the best portfolio
Pompian behavioral model
Passive Preserver
- Passive Preserver: Emotional biases with low risk tolerance and focus on short term performance (e.g. older and wealthier)
- Emotional*: Endowment, Loss Aversion, Status Quo and Regret Aversion
- Cognitive*: Anchoring and Mental Accounting
- Big picture advice
Analyst Biases in Research
- Confirmation Bias
- Gambler’s Fallacy – wrongly predicting reversion to the mean (e.g. misunderstand of prob. “exp. toss heads b/c the last was tail”)
- Representative Bias
Influence of company management on Analysts:
(i) framing, (ii) anchoring and adjustment and (iii) availability + Self-attribution (overconfidence = optimism)
Analyst Forecast & Behavioral Finance
Analyst Forecast & Behavioral Finance - Analysts exhibit overconfidence due to:
- illusion of knowledge,
- representativeness,
- availability bias,
- self-attribution,
- hindsight and
- failure to utilize Bayes formula
Mitigate by:
- Self-calibrating – forecast vs. actual outcome
- Seeking counterargument and reviewing sample size
- Using Bayesian formula
- Use systematic approach (research)
Committee Decision-Making Biases
Social proof bias – bias towards the beliefs of a group
