Behaviour Finance Flashcards
•Behaviour Finance•
Cognitive - Hindsight bias
Hindsight bias - see past events as having been predictable, resulting in regret or forgetting errors
- taking too much risk or clients who unfairly blame their manager
- keep and review records to determine successes and failures
•Behaviour Finance•
Cognitive - Illusion of control bias
Illusion of control bias - assuming they can influence the outcome
- trade too quickly
- under-diversify
•Behaviour Finance•
Cognitive - Representativeness bias
Representativeness bias – classify new information based on past experiences/stereotype heuristics.
- overemphasizing data covering short time periods
- reacting too quickly to new information
•Behaviour Finance•
Cognitive - Confirmation bias
Confirmation bias – Look for / notice what confirms beliefs (ignore contrary data)
- under-diversification (e.g. over concentration in employer stock)
•Behaviour Finance•
Cognitive - Conservatism bias
Conservatism bias
- emphasizing initial information (maintain prior forecast)
- slow to update views (hold securities too long)
- overweight past info
•Behaviour Finance•
4 axioms of Utility Theory
If all holds, individual is rational
1. Completeness: defined preference and decides b/w 2 choices (A > B)
2. Transitivity: rankings are applied (if A > B and B > C, then A > C)
3. Independence: new item does not change independent utility (if A > B then [A + C] > [B + C]) – utilities are additive and divisible
4. Continuity: smooth and continuous (unbroken) indifference curve
•Behaviour Finance•
Bayes’ Formula
Bayes Formula – how probabilities should change given new information (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.)
•Behaviour Finance•
Decision tree under Traditional Finance
- 4 axioms of the utility function
- Use Bayes’ Formula (conditional probability)
- Max. exp. utility subject to budget constraints
Rational Economic Man (REM)
- Perfectly rational
- Perfectly informational
- Perfectly selfish
•Behaviour Finance•
Utility Function - Traditional Finance vs. Behaviour Finance
Traditional finance - risk averse (concave, eg. insurance), risk-loving (convex, eg. lottery ticket) or risk neutral
Behaviour Finance - Double inflection utility function (utility change based on the level of wealth) + Prospect Theory
•Behaviour Finance•
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
- Risk-averse for gains
- Risk-seeking for losses
•Behaviour Finance•
Behavior Finance Decision Tree
(i) Editing phase - Organize and reformulate simplify option
- Isolation Effect - Focus on one while ignoring other factors
(ii)Evaluation phase - people are loss-averse and reference dependent – decisions are made based on wpv (weight * probability * value)
•Behaviour Finance•
Bounded Rationality
Bounded Rationality - Relaxes perfect information and process according to expected utility theory.
Satisfice (satisfy + suffice) when bounded by constraints (e.g. time and money). It may not be optimal, but it is acceptable / adequate
When some (but not all) information is available, use heuristics (rule of thumb).
•Behaviour Finance•
Forms of Efficient Market Hypothesis
(and market anomalies)
(i) Weak form: price and volume (i.e. technical analysis do not work)
(ii) Semi-strong form: public information, prices, volume (i.e. technical and fundamental analysis do not work)
(iiI) Strong form: public and private information (i.e. technical, fundamental or insider information do not work)
Market anomalies: Fundamental (small vs large cap), Technical (moving avg) and Calendar (January effect)
•Behaviour Finance•
Behavioral Finance Portfolio Construction
Asset Pricing (equity discount rate)
CAPM + SDF = rf + risk premium + sentiment premium (i.e. stochastic discount factor considering dispersion of analysts forecast)
•Behaviour Finance•
Cognitive Errors
Confirmation bias - Related bias
- Confirmation bias – Look for / notice what confirms beliefs
- Base-rate neglect (rely on stereotypes)
- Sample-size neglect (assume that small data size reflects the whole)
•Behaviour Finance•
Cognitive Errors
Believe Perseverance Biases
CC-RIH’der
- Conservatism bias – emphasizing initial information
- Confirmation bias – Look for / notice what confirms beliefs (“stock love bias”)
- Base-rate neglect (rely on stereotypes)
- Sample-size neglect (assume that small data size reflects the whole)
- Representativeness bias – once classification is made, do consider the accuracy of it
- Illusion of control bias
- Hindsight bias - see past events as having been predictable, resulting in regret or forgetting errors
•Behaviour Finance•
Cognitive Errors
Information-Processing Biases
FAMA
- Framing bias - how information is presented changes the decision made
- Anchoring & Adjustment
- Mental accounting bias
- Availability bias - likelihood based on how easily recall information
•Behaviour Finance•
Emotional Biases
Loss aversion bias - Related bias
-
Loss aversion bias - strongly prefer avoiding losses than earning gains
(i) Myopic loss aversion - Avoiding equity to avoid short-run declines in value
Disposition Effect - Selling winners and holding on to losers
•Behaviour Finance•
Emotional Biases
Overconfidence bias - Related bias
-
Overconfidence bias (illusion of knowledge)
(i) Prediction overconfidence - overestimate accuracy
(ii) Certainty overconfidence - confidence increasing faster than accuracy
(iii) Self-Attribution bias:
a. Self-Enhancing bias - Take all the credit
b. Self-Protecting bias - Place blame on others
•Behaviour Finance•
Emotional Biases
Self-control bias - Related bias
-
Self-control bias - Lack of self-discipline
(i) Hyperbolic discounting - fail to balance short-term satisfaction with long-term goal
•Behaviour Finance•
Emotional Biases
Regret-aversion bias - Related bias
-
Regret-aversion bias
(i) Error of commission - from action taken
(i) Error of omission - from action not taken
•Behaviour Finance•
Emotional Biases
LOSERS
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Loss aversion bias - strongly prefer avoiding losses than earning gains
(i) Myopic loss aversion - Avoiding equity to avoid short-run declines in value -
Overconfidence bias (illusion of knowledge)
(i) Prediction overconfidence - overestimate accuracy
(ii) Certainty overconfidence - confidence increasing faster than accuracy
(iii) Self-Attribution bias - taking credit for success and blaming others for failure -
Self-control bias - Lack of self-discipline
(i) Hyperbolic discounting - fail to balance short-term satisfaction with long-term goal - Endowment bias - what is owned is more valuable
-
Regret-aversion bias
(i) Error of commission - from action taken
(i) Error of omission - from action not taken - Status quo bias - Do nothing instead of making changes (inertia)
•Behaviour Finance•
Barnewall 2-way Model
Active - wealth creators = higher confidence and willingness to assume risk. Usually more ability
Passive - inherited wealth, “employees” = higher security needed, less willing to take risk.
•Behaviour Finance•
Bailard, Biehl, and Kaiser 5-way Model
(BB&K 5-way model)
- Individualist: Confident, hard facts, careful research. Listen to advice
- Guardian: Security and loss aversion. Seek advice.
- Straight Arrow: Sensible and secure, appropriate risk return.
- Adventurer: Undiversified, overconfident, self-assured. No advice.
- Celebrity: Center of attention, strong opinions. Seek advice
•Behaviour Finance•
Pompian Model
- Passive Preserver (PP) - Passive + Emotional
- Friendly Follower (FF) - Passive + Cognitive
- Independent Individualist (II) - Active + Cognitive
- Active Accumulator (AA) - Active + Emotional
•Behaviour Finance•
Bias in Portfolio Construction
- Inertia and Default - investors do not rebalance (status quo bias)
2. Naive Diversification – to avoid regret, 1/n
3. Investing in familiar (company stock) - Lack diversification = status quo + loyalty + financial incentives + framing + etc.
4. Excessive trading - Overconfident investors.
- Disposition effect (hold losers too long, sell winners).
5. Home Bias
6. Behavior Portfolio Theory
