Behavioural Finance

Question 1

What is Framing?

Answer 1

tendency of investors to change preference due to that way an investment is “framed” eg in terms of risk and rewards

Question 2

What is Mental Accounting?

Answer 2

form of framing where investor takes a lot of risk with one investment account but little risk with another

Question 3

What is Regret Avoidance?

Answer 3

investor blames themselves for an unconventional investment that was unsuccessful rather than conventional investment that was unsuccessful

Question 4

What is Prospect Theory (loss avoidance)?

Answer 4

Suggests investors are willing to take on more risk when they experiences losses and take on less risk when they experience gains .. similar to how a GAMBLER acts

Question 5

What is confirmation bias?

Answer 5

Refers to investors seeking out answers to support their beliefs

Question 6

What is illusion of control?

Answer 6

investor believes they can control the outcome of an events (in the case of Nick with the IBM shares) - just because you work there doesnt mean you have control of the outcome!

Question 7

What should you make aware of an investor if they have illusion of control?

Answer 7

1. they may feel strongly because they work there
2. investment management should be done based on risk tolerance, return objectives and other influences of personal circumstances
3. Their behavior may expose them to too much risk, which is not consistent with their tolerance
4. investments should be evaluated in an unbiased way on company financials, industry outlook and economic princples

Question 8

How should investments be evaluated?

Answer 8

-unbiased
-by company financials, industry outlook and economic principles

Question 9

What should an investors investments reflect?

Answer 9

• risk profile
  -time horizon
• financial objectives overall

Question 10

What are heuristic?

Answer 10

A heuristic is a mental shortcut commonly used to simplify problems and avoid cognitive overload. Heuristics are part of how the human brain evolved and is wired, allowing individuals to quickly reach reasonable conclusions or solutions to complex problems. These solutions may not be optimal ones but are often sufficient given limited timeframes and calculative capacity.

Question 11

What is Buy and Hold practices?

Answer 11

Buying for long term

Selection could be active or passive

Question 12

What is Efficient Market Hypothesis?

Answer 12

Says finding pricing inefficiences and therefore beating the market is impossible

Question 13

Keynesian Economic Theory

Answer 13

is used to explain cycles in the economy

Question 14

Market Segmentation Theory

Answer 14

used to explain why bond yields are generally higher on longer bonds

Question 15

What is Familiarity Heuristics?

Answer 15

employed when same decision is made over and over again because that decision made sense in a prior set of circumstances

Question 16

What is Representativeness Heuristics?

Answer 16

normally applied when trying to create a linkage between two potentially unrelated events or facts

Question 17

What is Anchoring Heuristics?

Answer 17

might apply if Pearl gave indication the she were getting the types of returns that GICs provided years or decades ago - but she seems aware of the consequences of her investments

Question 18

What is Availability Heuristics?

Answer 18

applied when a decision is made on what is mentally readily available. This is typically avoided when dealing with a larger institution that would expose someone to a number of investment choices

Question 19

What is Prospect Theory?

Answer 19

It means the investor is “loss adverse” and would take a chance to avoid a loss while taking the same chance to make a larger gain is not attractive

Question 20

What is a heuristic?

There are 18 to note in finance:

Answer 20

A mechanism that we use to make a decision or analysis without necessarily going through all the steps normally involved in the decision making.

Eg a driver sees a red sign and without reading the sign stops

Good for more things in life but not necessarily finance.

What heuristics to consider when dealing with clients in finance are:

1. Availability - since Jill averaged 10% from 02-07 she figures she will be able to again today
2. Hindsight - Leon will tell anyone who will listen he “saw 2008 crisis coming” despite not changing his financial status prior to 08
3. Induction - Norm sees an andex chart and makes a decision based on a few stats without any relevance to his situation
4. Conjunction -

5.Confirmation

6. Contamination - your friend is busy in the oil and gas sector, you assume that corp is doing well and invest
7. Affect - too strong of an emotional connection, do what your family does
8. Scope Neglect
9. Overconfidence in Calibration
10. Bystander Apathy
11. Herd Mentality
12. Mental Accounting- treats different pools of money differently for example is fluff about a bonus
13. Prospect Theory - you understand but when it comes time to pull trigger you can’t commit because you can’t stand the prospect of a loss
14. Smart People - watch an expert do a move
15. Endowment Effect - we overvalue things we put effort and work into
16. Sunk Costs
17. Opportunity Costs - Bill paid 500 in tools to fix it himself and missed a game with his friends when the hired help was 500
18. Gambler Fallacy

Question 21

What are the two categories of risk?

Answer 21

Systematic Risk - risks that impact the entire market and cannot be reduced by diversification

and

Non-Systematic Risk - only affect one company or portion of market like low oil prices and can be diversified down

Question 22

Common Risks we should be aware of are?

Answer 22

Business Risk - related to Beta

Call or Timing Risk

Concentration Risk

Credit Risk - bond investors

Counter-party Risk - derivatives

Default Risk

Emerging Markets Risk

Event Risk

Foreign Exchange Risk

Inflation Rate Risk

Interest Rate Risk

Large Investor Risk

Liquidity Risk

Market Risk

Marketability Risk

Political Risk

Regulatory Risk

Reinvestment Risk

Sovereign Risk

Volatility Risk

Question 23

What does the Efficient Market Hypothesis Say?

Answer 23

Finding price inefficiencies and beating the market is not possible

Question 24

What does Keynesian Economic Theory Explain?

Answer 24

Cycles in the Economy

Question 25

What does Market Segmentation Theory explain?

Answer 25

Why Bond yields are generally higher on longer bonds

Question 26

Actively managed =

Answer 26

more risky, attempt to beat the market. PASSIVELY managed reduces non-systematic risk

Question 27

Familiarity Heuristic

Answer 27

Same decision made over and over because decision made sense prior

Question 28

Representativeness Heuristic

Answer 28

Applied when trying to create a linkage between two potentially unrelated events or facts

Question 29

Anchoring Heuristics

Answer 29

Validated a decision by some returns they got years ago and applied to them today

Question 30

Availability Heuristic

Answer 30

Applied when a decision is made based on what is mentally readily available - unlikely when you have a credit union or large bank with lots of investment choices and insight

Question 31

What is a heuristic?

Answer 31

Mental shortcuts used to avoid cognitive overload

Question 32

What is a passive investment strategy?

Answer 32

Index fund

Question 33

What are Investment Strategies?

Answer 33

1 – Passive and Active Strategies.

#2 – Growth Investing (Short-Term and Long-Term Investments)
#3 – Value Investing.
#4 – Income Investing.
#5 – Dividend Growth Investing.
#6 – Contrarian Investing.
#7 – Indexing.

Question 34

Define types of belief perseverance biases that an individual may possess,

Answer 34

Conservatism bias: the tendency to revise one’s belief insufficiently when presented with new evidence

Confirmation bias: the tendency to focus on and interpret information in a way that confirms one preconceptions

Cognitive dissonance: tendency to experience mental stress or discomfort when holding two or more contradictory ideas, beliefs or values at the same time, or when performing an action contradictory to one’s ideas, beliefs or values, or when confronted by new information that contradicts existing ideas, beliefs or values

Hindsight bias: the belief that past events were predictable at the time they occurred

Illusion of control: the overestimation of one’s control over external events

Question 35

Define types of emotional biases that an individual may possess, such as:

Answer 35

Affinity bias: the tendency to be drawn to those people, things or decisions that one views as being similar to themselves

Disposition bias: the tendency to sell an asset that has accumulated in value and resist selling an asset that has declined in value

Endowment bias: the tendency to overvalue an object because they possess it

Loss aversion bias: the tendency to view losses as more painful than similar amounts of gains

Overconfidence bias: the tendency to be overly sure of oneself and their ideas

Regret aversion bias: the tendency to avoid making decisions for fear of experiencing regret

Self-control bias: the tendency to choose those actions that provide gratification in the short-term over the long-term

Status quo bias: the tendency to choose to maintain the current situation rather than

Question 36

Mental accounting example

Answer 36

When people are willing to pay more for something on their credit card than with cash