Behavioural Finance Flashcards
What is Framing?
tendency of investors to change preference due to that way an investment is “framed” eg in terms of risk and rewards
What is Mental Accounting?
form of framing where investor takes a lot of risk with one investment account but little risk with another
What is Regret Avoidance?
investor blames themselves for an unconventional investment that was unsuccessful rather than conventional investment that was unsuccessful
What is Prospect Theory (loss avoidance)?
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
What is confirmation bias?
Refers to investors seeking out answers to support their beliefs
What is illusion of control?
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!
What should you make aware of an investor if they have illusion of control?
- they may feel strongly because they work there
- investment management should be done based on risk tolerance, return objectives and other influences of personal circumstances
- Their behavior may expose them to too much risk, which is not consistent with their tolerance
- investments should be evaluated in an unbiased way on company financials, industry outlook and economic princples
How should investments be evaluated?
-unbiased
-by company financials, industry outlook and economic principles
What should an investors investments reflect?
- risk profile
-time horizon - financial objectives overall
What are heuristic?
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.
What is Buy and Hold practices?
Buying for long term
Selection could be active or passive
What is Efficient Market Hypothesis?
Says finding pricing inefficiences and therefore beating the market is impossible
Keynesian Economic Theory
is used to explain cycles in the economy
Market Segmentation Theory
used to explain why bond yields are generally higher on longer bonds
What is Familiarity Heuristics?
employed when same decision is made over and over again because that decision made sense in a prior set of circumstances
What is Representativeness Heuristics?
normally applied when trying to create a linkage between two potentially unrelated events or facts
What is Anchoring Heuristics?
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
What is Availability Heuristics?
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
What is Prospect Theory?
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
What is a heuristic?
There are 18 to note in finance:
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:
- Availability - since Jill averaged 10% from 02-07 she figures she will be able to again today
- Hindsight - Leon will tell anyone who will listen he “saw 2008 crisis coming” despite not changing his financial status prior to 08
- Induction - Norm sees an andex chart and makes a decision based on a few stats without any relevance to his situation
- Conjunction -
5.Confirmation
- Contamination - your friend is busy in the oil and gas sector, you assume that corp is doing well and invest
- Affect - too strong of an emotional connection, do what your family does
- Scope Neglect
- Overconfidence in Calibration
- Bystander Apathy
- Herd Mentality
- Mental Accounting- treats different pools of money differently for example is fluff about a bonus
- 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
- Smart People - watch an expert do a move
- Endowment Effect - we overvalue things we put effort and work into
- Sunk Costs
- Opportunity Costs - Bill paid 500 in tools to fix it himself and missed a game with his friends when the hired help was 500
- Gambler Fallacy
What are the two categories of risk?
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
Common Risks we should be aware of are?
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
What does the Efficient Market Hypothesis Say?
Finding price inefficiencies and beating the market is not possible
What does Keynesian Economic Theory Explain?
Cycles in the Economy
