Behavioural Finance

Question 1

What is the core principle of Behavioural Finance?

Answer 1

Investors are not entirely rational

They exhibit “Cognitive Biases”

Question 2

What is Intertia?

What Bias is associated with it?

Answer 2

Inertia is the tendency to leave decisions unchanged.

“Status Quo Bias”

Question 3

Give an example of the Status Quo Bias (inertia)

Answer 3

Asset Allocation

Remains unchanged even when no longer optimal

Question 4

What makes Status Quo Bias worsen?

Answer 4

Complexity of decisions

(may misuse info, be distracted by the complexity)

Question 5

What is Loss Aversion

Answer 5

Investors do not experience gains and losses equally.

Greater emotional discomfort form a loss than positive emotion from gains.

Question 6

What behaviour is exhibited due to loss aversion.

Answer 6

Preference for a smaller certain gain vs risky larger gain.

Preference for risky lower loss than a guarenteed smaller loss.

Question 7

What investment outcomes happen due to Loss Aversion

Answer 7

premature realisation of gains & loss avoidance

(disposition effect)

Question 8

What is prospect theory?

Answer 8

People respond differently based on whether a scenario is presented as a gain or loss

Question 9

Why does prosepect theory occur?

Answer 9

Investors weight gains and losses as 50%/50% probability.

Regardless of their actual weighting

Question 10

What is framing?

Answer 10

The way in which a situation is presented.

E.g. 70% of meeting targets vs 30% of falling short

Question 11

What is regret aversion?

Answer 11

Avoidance of feeling regret

e.g. holding on to falling shares to avoid acknoledging the loss

Question 12

What is anchoring?

Answer 12

Individuals fix on a specific reference point

Usually the initival value

Question 13

What is herd behaviour?

Answer 13

Bandwagon effect when investors follow one another.

Can lead to asset bubbles / volatility

e.g. Dotcom bubble or GME

Question 14

What is overconfidence?

Answer 14

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)

Question 15

What is the Gambler’s Fallcy

Answer 15

Seeing patterns in random / indiscernible sequences.

Over beleif in mean reversion occuring

similar to hot hand (good performance expected to continue)

Question 16

How can an investment manager help prevent overconfidence

investors under interpret risk of loss

Answer 16

Present accurately the risk/reward (make risk feel real)

Carefully frame info to help individuals be able to infer facts.

Question 17

What is bounded rationality

Answer 17

rationality is limited when individuals make decisions,

individuals will select a decision that is satisfactory rather than optimal.

Question 18

How can you prevent bounded rationality

Answer 18

Limit the number of suggestions made

• small number of carefully thought through ideas
• makes it easier for clients to select optimal offering

Question 19

How should starting out investing be approached?

Answer 19

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

Question 20

How should an IM act during the client relationship

Answer 20

Avoid Intertia + Regret aversion by reguarly updating portfolios

sell poor performing assets / confront issues.

Question 21

What is the familiarity bias?

Answer 21

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

Question 22

What is availability bias?

Answer 22

Relying on recent or readily available information to make decisions

This can lead to investors beleiving recent events are more likely to occur

Question 23

What is subjective scaling?

Answer 23

incorporating person scaling when calculating utility

Question 24

Why is subjective scaling used?

Answer 24

1) Everyone has a unique perception of risk
2) Holistic View (combines subjective & objective)
3) Improved decision making