Behavioural Finance Flashcards
What is the core principle of Behavioural Finance?
Investors are not entirely rational
They exhibit “Cognitive Biases”
What is Intertia?
What Bias is associated with it?
Inertia is the tendency to leave decisions unchanged.
“Status Quo Bias”
Give an example of the Status Quo Bias (inertia)
Asset Allocation
Remains unchanged even when no longer optimal
What makes Status Quo Bias worsen?
Complexity of decisions
(may misuse info, be distracted by the complexity)
What is Loss Aversion
Investors do not experience gains and losses equally.
Greater emotional discomfort form a loss than positive emotion from gains.
What behaviour is exhibited due to loss aversion.
Preference for a smaller certain gain vs risky larger gain.
Preference for risky lower loss than a guarenteed smaller loss.
What investment outcomes happen due to Loss Aversion
premature realisation of gains & loss avoidance
(disposition effect)
What is framing?
The way in which a situation is presented.
E.g. 70% of meeting targets vs 30% of falling short
What is regret aversion?
Avoidance of feeling regret
e.g. holding on to falling shares to avoid acknoledging the loss
What is anchoring?
Individuals fix on a specific reference point
Usually the initival value
What is herd behaviour?
Bandwagon effect when investors follow one another.
Can lead to asset bubbles / volatility
e.g. Dotcom bubble or GME
What is overconfidence?
Individuals have exaggerated views of one’s own abilities.
Can effect retail and professionals.
(can lead to client’s filling in risk questionnaires inaccurately - taking more risk than is good for them)
What is the Gambler’s Fallcy
Seeing patterns in random / indiscernible sequences.
Over beleif in mean reversion occuring
similar to hot hand (good performance expected to continue)
How can an investment manager help prevent overconfidence
investors under interpret risk of loss
Present accurately the risk/reward (make risk feel real)
Carefully frame info to help individuals be able to infer facts.
What is bounded rationality
rationality is limited when individuals make decisions,
individuals will select a decision that is satisfactory rather than optimal.
How can you prevent bounded rationality
Limit the number of suggestions made
- small number of carefully thought through ideas
- makes it easier for clients to select optimal offering
How should starting out investing be approached?
Low risk start - with regular contributions can lead to long term habits
A high risk bumpy start can put the investor off for life
3yrs of bad returns at start = off for life
How should an IM act during the client relationship
Avoid Intertia + Regret aversion by reguarly updating portfolios
sell poor performing assets / confront issues.
What is the familiarity bias?
investing in assets/markets we are familiar with or consider good quality/brand names, rather than because valuations tell us to
E.g. home bias, attention grabbing stocks
What is availability bias?
Relying on recent or readily available information to make decisions
This can lead to investors beleiving recent events are more likely to occur
What is subjective scaling?
incorporating person scaling when calculating utility
Why is subjective scaling used?
1) Everyone has a unique perception of risk
2) Holistic View (combines subjective & objective)
3) Improved decision making
What is mental accounting?
the tendency for people to categorise and treat money differently depending on where it came from or how it will be used. For example, people may be more willing to spend money won in a lottery than money earned through work.
e.g. a gambler more likely to gamble in order to chase wins
What is Prospect Theory?
Explains how investors make decisions that involve risk and uncertainty.
Argues that investors do not make rational decisions, due to their irrational perception of risk, gain and probability.
What is the core idea behind prospect theory?
Loss Aversion
The emotion from a loss is 2x that of a gain. Therefore investors avoid loss where possible.
What experiment proves the disposition effect
1) Chance of certain gain vs risky higher gain
2) Chance of certain loss vs risky lower loss
Investors avoid gambling in A, but will gamble for a loss in B.
What is hyperbolic discounting?
People place higher value on immediate rewards over larger, but delayed rewards.
Sometimes referred to as Present Bias
What is an example of testing hyperbolic discounting bias?
Offered £100 today, or £110 tomorrow (takes today)
Offered £100 in 30 days or £110 in 31 days (takes 31 days)
The additional day seems trivial given the long time frame
How does present bias affect saving for pensions?
Requires sacrificing current income for future benefit
Immediate reduction in disposable income outweighs “abstract” future benefit
Might also explain why people pull money out early.
How to help overcome present bias
particuarly in pensions
1) auto-enrollment
2) Auto-escalation
3) Target Date Funds (adjust risk automatically)
4) Give messages to investors (in their 50s - you are now maximising your gains, do not withdraw now)
What is prospect theory?
A theory which challenges the notion that investors make rational decisions based upon utility.
Instead, this theory states that when faced with, gains losses and uncertain risks. Investors are irrational.
What behaviours cause prospect theory?
1) Loss Aversion
2) Disposition Effect
3) Anchoring
How do you relate prospect theory to investing?
Game of chance to win / lose a certain and uncertain amount. Investors gain the certain amount and gamble the loss.
This is the same as selling winners and holding onto losers.
What do investors experience differently due to prospect theory?
Equal gains and losses (emotionally)
What behaviours / outcomes happen as a result of prospect theory?
1) Anchoring
2) Holding onto losers
3) Selling winners early
4) Chasing past performance (overweight likelihood of rare events occurring)
Hyperbolic discounting makes pension saving harder, what issues arise when the pension is taken?
1) Crystalized as early as possible (may not of finished working yet)
2) Frontload the benefits - not caring the consider later life
How can the issues that arise due to hyperbolic discounting when taking a pensoin be mitigated
1) limits on how much can be crystalzied immediately
2) Pensions in the form of annuities
3) Pensions in the form of deferred annuities
