BF Flashcards
(45 cards)
Present a list with the three Judgment heuristics and define them
Representativeness, availability and anchoring are the three heuristic rules, or “rules of thumb” used to evaluate the likelihood of events.
Representativeness:
The tendency to evaluate the likelihood of an event on the basis of how similar the event is to the stereotype of a parent population. (conjunction fallacy).
How much its features are representative of the overall process by which it was generated.
this might lead to base rate neglect
Availability:
The availability heuristic is a mental shortcut towards an idea about the likelihood of an event. The mental shortcut depends on how easily the event comes to mind. Important factors which strengthen the availability heuristic are Recency, Salience and Imaginability
Anchoring:
As it is called, this is the tendency to anchor beliefs to a reference point. the reference point can be both relevant and irrelevant.
The causes of anchoring are “selective accessibility” or “anchoring and adjusting”.
What are the challenges to market efficiency presented in the course?
Excess volatility:
Higher volatility in price compared to the dividends contradicts P_t =D+u_t
Past winners tend to perform badly compared to past losers
Siamese Twins should perform proportionally.
However, Royal dutch and Shell Transport should be similar on a 1.5:1 basis, but there are clear deviations from this ratio in the prices.
There should be no reaction to no news, but 1987 proved otherwise.
Also, the 50 largest price movements since WWII was accompanied by no news.
In relation to prospect theory, what is the argument behind the weights that are added to probabilities?
Irrational high weights on low probabilities and low weights on average probabilities.
What does prospect theory describe?
prospect theory describes decisions under uncertainty and therefore risk (descriptive model).
Prospect theory is modelled through two different steps, the editing phase and the evaluation phase.
What does the editing phase consist of?
Editing phase consist of heuristic rules used to organize, simplify and reformulate choices under uncertainty. Five major operations in editing:
simplification:
Prospect are likely to be rounded off. 49 % is 50 %,
and very small probabilities are discarded
Coding: outcomes are percieved as gains or losses and not as a final state of welfare. This, of course, needs a reference point
Combination:
similiar outcomes will be combined into a higher probability of one outcome.
Segregation:
The riskless outcome is seperated from its risky component so with the prospect (300,0,8;200;0,2), the riskless 200 is sperated and the game is simply perceived as 0,8 probability of 100.
Cancellation:
Any similar outcomes between two choices are cancelled out from the choice.
Detection of dominance: Outcomes are scanned and rejected if strictly dominated.
Prospect theory is modeled through two different steps, the editing phase and the evaluation phase.
What does the evaluation phase consist of? also explain subadditivity, subcertainty and subproportionality (because I cant)
The evaluation phase consist of a choice by the decision maker which chooses the outcome with the highest value V.
V is expressed as a function of v(x) and pi(p). v(x) reflects the decision makers valuation of the outcome x and pi(p) is an assigned weight to the probability p.
The values of pi(p) and v(x) reflect experimental evidence.
Possible valuefunction v(x) captures riskaversion in gains, riskseeking in losses and that losses are given more weigth than gains even if the amplitude is the same.
pi(p) is of course increasing, but contains subadditivity, subcertainty and subproportionality.
What does the value function suggested by KT in 1979 look like? what about the wighting function?
v(x)=(x^a) if x>0
v(x)=(-lambda(-x)^b) if x<0
“a” is the factor of risk aversion
“b” is the factor of risk loving
the weighting function:
(p^y)/((p^y+(1-p)^y)^(1/y)) with y being different depending on whether or not p>0
In which areas of finance could prospect theory be relevant? (areas mentioned in the course)
There are three different areas of connection.
Cross section of average returns:
consistent with PT, a security’s skewness can explain over or underpricing of assets, and therefore changes the expected return.
a positive skew would mean a small change of a big return, and with small propabilities being overweighted
investors will push the price higher than in an economy with EU investors. takeoff from empirical results:
positive skewed returns are positively negatively correlated with average returns. (IPO is positively skewed)
Aggregate stock market :
equity premium puzzle
Trading of financial assets over time:
PT is used to explain the disposition effect, which is the tendency to keep losers and sell winners.
what is the disposition effect and how can prospect theory explain it?
The disposition effect is the observed phenomena of traders selling their winning assets and keeping their losers. This is, of course, defined given a certain reference point. This is particular puzzling due to the observed momentum effect in asset prices, which indicates that winners will win more in the future.
The disposition effect is particularly salient when selling apartment or houses as presented by Genesove and Mayer (2001)
Prospect theory says that investors are risk-averse in the gain domain and risk seeking in the loss domain, hence explaining the disposition effect.
Which underlying psychological mechanism can explain the observed ambiguity aversion?
Trying to avoid criticism, since decisions are backed up by fewer facts.
Under which tradition framework is the equity premium indeed a puzzle?
How can behavioral finance explain this?
using simple risk aversion to explain the willingness to hold the riskfree assets.
Myopic Loss Aversion is a combination of loss aversion, the relatively larger fear of losses and a relative frequent update of price information. The short-term view of investments puts a higher weight on losses and therefore risk-free assets becomes more attractive.
Which type of assets is prone to a high level of ambiguity aversion?
How can ambiguity aversion explain the equity home bias puzzle?
IPO’s, shares of smaller firms, small privately held companies.
The equity home bias puzzle is the observation of investors having a large share of national equity, even though historical data suggests benefits from international diversification. This could be explained by less knowledge about foreign assets and therefore higher ambiguity for the individual investor.
french and Poterba (1991) shows an average sacrifice of 3%
What is the most important facets of overconfidence?
Miscalibration:
Overestimate the precision of their knowledge
Positive illusion:
Tendency of people to see themselves as better than average
Illusion of control:
Illusion of control over acutally random processes or processes with no posiblity to influence.
Unrealistic optimism:
almost the same as positive illusion but its an overly relative positive forecast about the individuals future.
Which psychological biases contribute to overconfidence?
Self-attribution bias
to attribute succes to one self and failure to others
Hindsight bias
“i knew it all along”
Confirmation bias
searching for evidence consistent with prior beliefs.
Overconfidence in finance is among other things seen as excessive trading volume. How does Glaser and Weber (2007) test the relation between overconfidence and trading volume?
First, with more overconfidence among traders there will be more different believes about the value of an asset which opens up trades.
Glaser and Weber (2007) tests this hypothesis through internet questionaire testing the participants for overconfidence ( testing miscalibration, positive illusion, illusion of control and unrealistic optimism), one finds that the overconfident tend to trade more.
People who trade more tend to think they are better than average
They also find that the predicted variance of the asset tend på to be lower than what historical data shows. They give themselves a too narrow confidence interval.
In the context of Behavioral corporate finance, what are the goals of managers
Managers have three goals: maximizing fundamental value, catering to the wishes of the short-term investors and market timing.
What was Barber and Odean’s findings in relation to genders and overconfidence? Can something else than overconfidence explain their result?
Barber and Odean (2001)
Their study assumes that men are more overconfident than women, given research suggesting this.
They test if men trade more than women
And if trading more hurts the performance of their portfolio
they find highly significant results supporting this.
A difference in risk aversion among could explain their results and not overconfidence. However, with lower risk aversion comes more trades, which should improve the portefolio, but the results show bad performance. Therefore, risk aversion could not explain it alone.
Gasmbling is also a plausible alternative. Trading for intertainment could explain higher trading volume among men, and worse performance.
What underlying psychological phenomena could explain the heuristic judgment called anchoring?
selective accessibility:
Selectively retrieve knowledge that is consistent with an anchor, hence a valuation relatively closer to the anchor.
Tversky and Kahneman’s “Anchoring and adjusting” is the idea that people set an anchor as a starting point and adjust away to a supposedly final answer. However,m pople adjust insuffeciently making the final answer biased towards starting point.
Mention how the three judgments heuristics Representativeness, availability and anchoring can affect financial decision making.
The representativeness heuristic can affect the belief of what is a good or a bad investment. If a company has a high-quality management and a strong image and growth, one might think it is a good investment, but all this should already be embedded in the price.
Shefrin and Statman (1995) use a survey from fortune magazine asking executives about their belief about companies quality of long term investment. They find that the quality of management, size and the book to market ratio is positively correlated with the idea of a good long-term investment.
Momentum-chasing can also affect financial decision making. Given a stock has risen a lot, investors are prone to invest more in that stock. This can be seen as representativeness, as the past performance represents the future. It can also be seen as availability since the near past performance is easier to imagine.
Availability can also be seen considering a specific market. If a company in a particular market encounters bad news, then bad news in the whole market is seen as more “available”.
The level of the price of a stock or index is arbitrary, but the changes in the price is consistent with the news. It can, therefore, be said that stock prices are anchored to yesterdays price.
anchoring can also be seen on the real estate market. Northcraft and neale finds that only 25 % of real estate agents mentions list price as a factor they use to price a house, but th data shows otherwise using two different groups of real estate agents who are given a different listing price for the same house. They also find that higher list price gives a higher influence which in behavioral finance can be explained by salience.
With attention being a scarce resource, it would be natural to think that the availability heuristic has an influence on the trading volume of stocks that is usually mentioned in the news.
How is time preferences tested and what is the usual main result?
Time preferences are often tested via simple choice experiments where the participants can choose between “sooner and smaller” or “later and larger”
Thaler finds that short-run discount rates are higher in the short run compared to the long run. Said differently, we tend to become more patient the further away the consequences lie.
Define Conservatism Bias. Which underlying psychological mechanism could explain the conservatism bias?
conservatism bias is a tendency among people to not sufficiently change their beliefs when given new information. (compared to Bayes’ rule). This phenomenon can be explained by anchoring and costly information processing.
Mention one or more experiments capturing the judgment heuristics called anchoring
Ariely, Loewenstein and Prelec (2003), conducted an experiment on 55 students who were asked if they wanted to buy goods for the prices equal to the last digits of their social security number. Afterward, they should state their Maximum willingness to pay for the good. They find a clear positive correlation between the social security number and the Maximum willingness to pay.
Mention one experiment capturing the judgment heuristics called availability
K and T askes the question if it is more likely that a random word starts with a K og that K is its third letter
People tend to believe the K at the beginning is more likely since it easier comes to mind -> more available
TRUE OR FALSE
Investors usually react with the self-attribution bias after a market bubble bursts.
FALSE
They react with hindsight bias, they think they knew it all along.
