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 framing?

Answer 8

The way in which a situation is presented.

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

Question 9

What is regret aversion?

Answer 9

Avoidance of feeling regret

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

Question 10

What is anchoring?

Answer 10

Individuals fix on a specific reference point

Usually the initival value

Question 11

What is herd behaviour?

Answer 11

Bandwagon effect when investors follow one another.

Can lead to asset bubbles / volatility

e.g. Dotcom bubble or GME

Question 12

What is overconfidence?

Answer 12

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 13

What is the Gambler’s Fallcy

Answer 13

Seeing patterns in random / indiscernible sequences.

Over beleif in mean reversion occuring

similar to hot hand (good performance expected to continue)

Question 14

How can an investment manager help prevent overconfidence

investors under interpret risk of loss

Answer 14

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

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

Question 15

What is bounded rationality

Answer 15

rationality is limited when individuals make decisions,

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

Question 16

How can you prevent bounded rationality

Answer 16

Limit the number of suggestions made

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

Question 17

How should starting out investing be approached?

Answer 17

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 18

How should an IM act during the client relationship

Answer 18

Avoid Intertia + Regret aversion by reguarly updating portfolios

sell poor performing assets / confront issues.

Question 19

What is the familiarity bias?

Answer 19

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 20

What is availability bias?

Answer 20

Relying on recent or readily available information to make decisions

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

Question 21

What is subjective scaling?

Answer 21

incorporating person scaling when calculating utility

Question 22

Why is subjective scaling used?

Answer 22

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

Question 23

What is mental accounting?

Answer 23

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

Question 24

What is Prospect Theory?

Answer 24

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.

Question 25

What is the core idea behind prospect theory?

Answer 25

Loss Aversion

The emotion from a loss is 2x that of a gain. Therefore investors avoid loss where possible.

Question 26

What experiment proves the disposition effect

Answer 26

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.

Question 27

What is hyperbolic discounting?

Answer 27

People place higher value on immediate rewards over larger, but delayed rewards.

Sometimes referred to as Present Bias

Question 28

What is an example of testing hyperbolic discounting bias?

Answer 28

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

Question 29

How does present bias affect saving for pensions?

Answer 29

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.

Question 30

How to help overcome present bias

particuarly in pensions

Answer 30

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)

Question 31

What is prospect theory?

Answer 31

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.

Question 32

What behaviours cause prospect theory?

Answer 32

1) Loss Aversion
2) Disposition Effect
3) Anchoring

Question 33

How do you relate prospect theory to investing?

Answer 33

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.

Question 34

What do investors experience differently due to prospect theory?

Answer 34

Equal gains and losses (emotionally)

Question 35

What behaviours / outcomes happen as a result of prospect theory?

Answer 35

1) Anchoring
2) Holding onto losers
3) Selling winners early
4) Chasing past performance (overweight likelihood of rare events occurring)