Behavioural Finance Flashcards
What are the basic axioms of utility theory?
- Completeness - well defined preferences
- Transitivity - consistent
- Independence - additive
- Continuity - smooth indifference curves
When is someone exhibiting bounded rationality?
Bounded rationality is when people gather some, but not all information. They will look for answers to satisfice and move towards their goal even if not optimal.
What are the phases of prospect theory?
- Framing/editing is when you set the reference point to which prospects are evaluated.
- Choose highest perceived outcome
What is adaptive market hypothesis?
Markets change over time to reflect competition, natural selection, etc
what is the certainty equivalent?
This is the max sum of money someone would pay to participate, or minimum accept to not participate
what is prospect theory?
This is the theory that we assign value to gains and losses rather than to final wealth, and that our value function differs between gains and losses
what is the difference between cognitive and emotional biases?
- Cognitive errors are based on faulty reasoning (information processing, memory errors, statistical), whereas emotion biases stem from impulses and intuition
- Cognitive errors can be moderated through education - they are simply blind spots. Emotional errors are spontaneous and can only be corrected by recognizing and adapting.
What are the two categories of cognitive errors?
- Belief perseverance (cognitive dissonance) - ignoring new information
- Processing errors
What is conservatism bias?
This is a cognitive bias that is related to belief perserverance. This is when you maintain current beliefs in the face of new evidence. In bayesian terms, you overrate the base case and do not make necessary adjustments to probabilities.
What are the biggest consequences of conservatism bias?
- Slow to update forecasts
2. Opt to maintain current beliefs when new data is complex. You do not decipher the impact of new information
How do you overcome conservatism bias?
- Be aware it exists
- Always ask how new information effected current beliefs
- Don’t be scared to change course
- Seek professionals who can interpret the data
What is confirmation bias?
Excessively weighting confirmatory information
What are the biggest consequences of confirmation bias?
- Ignoring relevant information
2. under diversifying leading to excessive risk
How can we overcome confirmation bias?
- Actively seeking out things that could change your mind
2. Getting corroborating support
What is representative bias?
This is when people classify new information based on past experiences. You attempt to derive meaning from new information by relating it to past experiences.
What are the biggest consequences of representative biases?
- Base rate neglect - relying on stereotypes and ignoring base rates
- Sample size neglect
What is illusion of control bias?
We believe the probability of our success if higher than what it would be objectively
What is hindsight bias?
Seeing past events as reasonably predictable
What are the biggest consequences of hindsight bias?
- Overestimate degree in which something was predicted
2. Unfairly assessing performance
What is anchoring and adjustment bias?
This is an information processing bias where you set a default expectation and make adjustments up or down from there. This is closely related to conservatism. An example of this is when you tie a stock price to its high or low marks, or round numbers.
What are the consequences of anchoring and adjustment bias?
You will stick too closely to initial estimates.
How do you detect and overcome anchoring and adjustment bias?
Look to see whether recommendations are anchored to previous assumptions. Am i trying to attain a price that I am anchored to?
What is mental accounting bias?
This is an information processing bias where people treat different sums of money differently even though it is fungible.
What are the consequences of mental accounting bias?
- Neglect opportunities to reduce risk
2. Irrationally distinguish between returns derived from income and capital appreciation.
What is framing bias?
This is an information processing bias where people answer questions differently based on how it is asked.
What are the consequences of the framing bias?
- Misidentify risk tolerances
- Choose suboptimal investments
- Focus on short term price fluctuations
What is the availability bias?
This is an information processing bias where we tend to overweight situations that are easier to remember
What are the consequences of availability bias?
- Choosing investments based on advertising
- Limit opportunity sets
- Failing to diversify
How can you overcome availability bias?
- Develop an investment policy with focus on appropriate goals.
- Having a disciplined, well defined process for investment selection and asset allocation.
What is loss aversion bias?
This is an emotional bias where people prefer to avoid losses as opposed to achieving gains. This is related to prospect theory. Utility curves are risk seeking when they’ve already experienced losses, but risk averse when experiencing gains.
What are the consequences of loss aversion?
- Holding a stock longer than fundamental analysis would indicate
- Sell a position in a gain because you fear profit will erode
- Trade excessively after you sell winners
- Hold riskier portfolios because you won’t sell losers
What is myopic loss aversion?
This is when investors evaluate returns on an annual basis and on a short time horizon rather.
How do you overcome loss aversion?
You do this by developing a disciplined investment process.
What is overconfidence bias?
This is an emotional bias where people have unwarranted faith in their reasoning. There is prediction overconfidence (too narrow of a distribution) and certainty overconfidence (probability too high).
What are the consequences of overconfidence bias?
- Underestimate risks and overestimate returns
- Poor diversification
- Excessive trading
- Experience lower returns
How can you detect and overcome overconfidence bias?
- Go over trades to see whether you were actually performing
What is self control bias?
This is when people are unable to act in pursuit of long term goals.
What is status quo bias?
This is an emotional bias where people do nothing instead of making a change. If there is no current problem, they will not change. Positions are maintained because of inertia.
What are the consequences of status quo bias?
- Unknowingly take risks
- Fail to explore opportunities
Must overcome with education
What is endowment bias?
This is an emotional bias where someone value’s an asset higher because they own it. An example of this would be holding inherited investments when it is not appropriate.
What are consequences of the endowment bias?
- Fail to sell certain securities
- Inappropriate AA
- Holding unfamiliar asset classes
How can you overcome the endowment effect?
Is this suitable?
What is regret aversion bias?
This is an emotional bias where people tend to avoid making decisions that could end up poorly. An example would be not selling because you’re scared of missing out on future gains. This can create FOMO or herd mentality
What are the consequences of regret aversion bias?
- Being too conservative
2. Following the crowd
What are the two guidelines for behaviorally modified asset allocation?
- The more wealth the client, the more than can afford biases (you should adapt)
- In general, you should adapt to emotional biases and moderate cognitive biases
What are the two axes in the BBK 5 way investor profile model?
- Confident-Anxious
2. Careful-Impetuous
What are the 5 investor profiles under BBK 5 way?
- Adventurer (Impetuous, Confident) - big risk taker
- Celebrity (Impetuous, Anxious) - like getting advice, some beliefs
- Guardian (Careful, Anxious) - Perceive others as more knowledgeable
- Individualist - (Confident, Careful) - independent and confident, willing to listen
- Straight Arrow
What is the gambler’s fallacy?
When we wrongly predict mean reversion within a specific period of time.
