BF flash cards
A good bet based on the analysis of something’s value
Real life arbitrage
Four key features of experience effects
Long-lasting effects, Recency bias, most recent experiences get larger weight, and Domain-specific effects
No cost, profits up front, and no risk
Textbook arbitrage
Arbitrage
According to textbook arbitrage, costs equal zero, profit up front, and no risk. This is however not what we observe in real life. Arbitrage in real life is more like a “good bet”, where you most of the time have risk.
When a stock is overvalued, what do you do?
Short the overvalued stock and long a heavily correlated one
When a stock is undervalued, what do you do?
Long the undervalued stock, and short a heavily correlated one
Long short trades
This concept is heavily used when it comes to arbitrage. You are long/short the stock that is under-/overpriced and short/long an asset that is correlated. Since it is almost impossible to be 100% sure of the fundamental value and the correlation, there will always be some risk in real life.
Limits to arbitrage, short sales constraints:
90% of lending balances are less than 1%, and the rest are usually hot stocks that are expensive to borrow, leading to higher risk and less demand. This refers to short-sales constraints where you can’t short a stock. Short selling does not make you popular; after all, you are betting for something to go bad. During crises, there can be short-selling bans, as in 2020 and 2008.
Participants in the shorting market:
- Borrowers, investors looking to short a stock.
- Owners own the share the borrowers want to borrow.
- Intermediaries, banks that manage the shares for the owner, for a %.
When investors disagree on the value of a stock, what risk does it have?
Noise trader risk
Limits to arbitrage, noise trader risk:
When investors do not agree on the price of a security, for example, GameStop, tesla. When this happened there will be noise trader risk, you short something that is worth shorting when other buys it making it go up in value.
What do rational and irrational beliefs and rational preferences affect?
Decision-making
What affects decision-making?
- Rationality concerning beliefs: If people receive new information, they update their beliefs instantly, and correctly.
- Irrationality concerning beliefs: Beliefs are not updated instantly or correctly.
- Rationality concerning preferences: Given their beliefs, people make choices that are consistent with their utility function (more specifically, EUT). Preferences can differ but cannot be irrational. But one can act irrationally given their preferences.
Biases or Heuristics are?
Mistakes when it comes to beliefs
What are mistakes when it comes to belifes called?
Biases or Heuristics
What are the 12 biases?
CARWASH SCOOB
Conservatism, Anchoring, Representativeness, Wishful thinking, Availability, Self-attribution, hindsight, status-quo bias, Confirmation, Optimism, Overconfidence, Belief perseverance
This is when people are too slow to update their beliefs based on evidence. For example, someone might continue to believe that all dogs are dangerous even after meeting several friendly dogs.
Conservatism
Conservatism
This is when people are too slow to update their beliefs based on evidence. For example, someone might continue to believe that all dogs are dangerous even after meeting several friendly dogs.
This is the tendency to hold onto beliefs even after they’ve been proven wrong. For instance, someone may still believe in a false rumor about a celebrity even after it’s been publicly debunked.
Belief Perseverance
Belief Perseverance
This is the tendency to hold onto beliefs even after they’ve been proven wrong. For instance, someone may still believe in a false rumor about a celebrity even after it’s been publicly debunked.
This is when an individual relies too heavily on an initial piece of information when making decisions. For example, if a store first shows you a $500 watch, then a $200 watch, you might perceive the second watch as a bargain.
Anchoring
Anchoring
This is when an individual relies too heavily on an initial piece of information when making decisions. For example, if a store first shows you a $500 watch, then a $200 watch, you might perceive the second watch as a bargain.
This is when individuals attribute successful outcomes to their own skills or traits and unsuccessful outcomes to external factors. For instance, a student might credit their high test score to their intelligence (not their study habits), but blame a low score on an unfair test.
Self-Attribution Bias
Self-Attribution Bias
This is when individuals attribute successful outcomes to their own skills or traits and unsuccessful outcomes to external factors. For instance, a student might credit their high test score to their intelligence (not their study habits), but blame a low score on an unfair test.
This is when one believes they would have predicted an event after it has already happened. For example, after a sports game, a fan might claim, “I knew we were going to win!”
Hindsight Bias
Hindsight Bias
This is when one believes they would have predicted an event after it has already happened. For example, after a sports game, a fan might claim, “I knew we were going to win!”
This bias occurs when a person’s confidence in their judgments is greater than the accuracy of those judgments. For instance, a driver might be confident they can text and drive safely, even though this is generally not true.
Overconfidence
Wishful Thinking
This is when beliefs are based more on what is pleasing to imagine than on evidence or rationality. For instance, a lottery player might overestimate their chances of winning, simply because they like imagining the possibility.
This is when beliefs are based more on what is pleasing to imagine than on evidence or rationality. For instance, a lottery player might overestimate their chances of winning, simply because they like imagining the possibility.
Wishful Thinking
Optimism Bias
This is when a person believes they are less at risk of experiencing a negative event compared to others. For example, a smoker might think they are less likely to get lung cancer than other smokers.
This is when a person believes they are less at risk of experiencing a negative event compared to others. For example, a smoker might think they are less likely to get lung cancer than other smokers.
Optimism Bias
Representativeness Bias
This is when people judge probabilities according to measures of representativeness. For example, upon hearing that someone loves books and is quiet, you might assume they’re a librarian, even though many people who aren’t librarians also love books and are quiet.
This is when people judge probabilities according to measures of common traits. For example, upon hearing that someone loves books and is quiet, you might assume they’re a librarian, even though many people who aren’t librarians also love books and are quiet.
Representativeness Bias
Status quo bias
Preference for the current state of affairs, people tend to hold on to what they have
Preference for the current state of affairs, people tend to hold on to what they have
Status quo bias
Availability Bias
This is a mental shortcut that relies on immediate examples that come to mind when evaluating a specific topic. For instance, if someone asks you whether dogs or sharks are more dangerous, you might say sharks because shark attacks are more memorable, even though dogs actually injure more people each year.
This is a mental shortcut that relies on immediate examples that come to mind when evaluating a specific topic. For instance, if someone asks you whether dogs or sharks are more dangerous, you might say sharks because shark attacks are more memorable, even though dogs actually injure more people each year.
Availability Bias
This leads individuals to only see evidence that confirms their pre-existing beliefs. For example, if you are a racist, you only look for information that confirms your hatred.
Conformation bias
Confirmation bias
This leads individuals to only see evidence that confirms their pre-existing beliefs. For example, if you are a racist, you only look for information that confirms your hatred.
Overconfidence
This bias occurs when a person’s confidence in their judgments is greater than the accuracy of those judgments. For instance, a driver might be confident they can text and drive safely, even though this is generally not true.
What is the economic theory that assumes individuals are rational and always make decisions that provide them with the highest expected utility?
EUT
Expected Utility Theory (EUT):
Individuals maximize their utility under uncertainty relative to a final wealth position. The utility is defined as consumption of goods and services
is a behavioral economic theory that describes how people make choices when faced with potential gains and losses. It was developed by psychologists Daniel Kahneman and Amos Tversky in 1979.
Prospect theory
Prospect theory
Prospect Theory is a behavioral economic theory that describes how people make choices when faced with potential gains and losses. It was developed by psychologists Daniel Kahneman and Amos Tversky in 1979.
Here are the key points of Prospect Theory:
Value Function: People make decisions based on the potential value of losses and gains rather than the final outcome. This value function is believed to be concave for gains (indicating risk aversion), convex for losses (indicating risk-seeking behavior), and steeper for losses than for gains (indicating loss aversion).
Reference Point: People’s choices depend on how they perceive gains and losses, and this perception is influenced by a reference point. Anything below the reference point is considered a loss and anything above it is considered a gain.
Loss Aversion: People tend to prefer avoiding losses to acquiring equivalent gains. In other words, the pain of losing is psychologically about twice as powerful as the pleasure of gaining.
Probability Weighting: People tend to overestimate the probability of unlikely events and underestimate the probability of likely events. This leads to risk-seeking behavior in the realm of low-probability gains and high-probability losses, and risk-averse behavior in the realm of high-probability gains and low-probability losses.
In essence, Prospect Theory suggests that people’s decisions are not always rational, especially when it comes to risk and uncertainty. It has been widely used to explain various economic and financial behaviors, including investment decisions and insurance purchasing behavior.
Probability weighting:
People do not weight outcomes by their objective probabilities p, but rather transformed probabilities or decision weights. They overweight low probabilities and underweight high probabilities.
What is the reference point?
People’s choices depend on how they perceive gains and losses, and this perception is influenced by a reference point. Anything below the reference point is considered a loss and anything above it is considered a gain.
When the probabilities are unknown
Ambiguity
Ambiguity
When the probabilities are unknown.
People don’t like choices where they don’t know the probability of the outcomes
Ambiguity aversion
Ambiguity aversion
If people can pick between two choices, and they only know the probability of one of them, they will most likely pick the one they can forecast.
Selling winners too quickly and holding losers too long
Disposition effect
Disposition effect
Selling winners too fast and selling losers too late.
Positive correlation in stock returns over shorts horizons, especially after earnings announcements
Short-term momentum
Short-term momentum:
Positive correlation in stock returns over short horizons, especially after earnings announcements.
Negative correlation in stock returns, especially over long horizons (3-5 years)
Long run reversal
Long run reversals
Negative correlation in stock returns, especially over long horizons (3-5 years).
How do prices react to news in an efficient market?
Price reacts to reflect new information immediately to the right level.
the historical fact that the stock market has earned a significantly higher return than short-term commercial paper.
Equity premium puzzle
Equity premium puzzle:
Refers to the historical fact that the stock market has earned a significantly higher return than short-term commercial paper.
Stock prices fluctuate more than the fundamental value
The excess volatility puzzle
The excess volatility puzzle
is related to fundamentals and is an important anomaly. Excess volatility is the volatility that comes from movements that should not be there. The price of the stock should not be more volatile than the fundamental value of the stock. Why? Because of optimal forecasting. Price changes (seem to) occur for no fundamental reasons.
Stock returns are forecastable to some extent
Predictability puzzle
Predictability puzzle
Stock returns are forecastable to some extent.
Changing expectations of future dividend growth
Changing discount rates - expectations of future risk-free change
Risk premium changes - forecasts of risk change and a change in risk aversion
This 3 things are some reasons for what?
Excess volatility
Some reasons for excess volatility
- Changing expectations of future dividend growth
- Changing discount rates - expectations of future risk-free change
- Risk premium changes - forecasts of risk change and a change in risk aversion
Something different, abnormal, peculiar, or not easily classified: something anomalous. Can also be defined as: “Deviation from the common rule: IRREGULARITY”.
Anomaly
Anomaly
Something different, abnormal, peculiar, or not easily classified: something anomalous. Can also be defined as: “Deviation from the common rule: IRREGULARITY”.
When something is not priced right according to CAPM
Asset pricing anomaly
Asset pricing anomaly
An asset pricing irregularity, something you cannot explain (the common rule is to compare with CAPM).
rank stock based on equity size into ten groups. If you long the first portfolio and short the last, you will earn abnormal returns.
Size puzzle
Size premium
rank stock based on equity size into ten groups. If you long the first portfolio and short the last, you will earn abnormal returns.
Rank stocks based on the past three years’ return and split them into ten groups. In the next three years, loser portfolios outperform the winners.
Long-term reversal
Long-term reversal
Rank stocks based on the past three years’ return and split into ten groups. In the next three years, loser portfolios outperform the winners.
rank stocks based on the book-to-marked ratio (or earnings-to-price, or other based on fundamentals and market price). Value stocks (high B/M) outperform growth stocks (low B/M).
Value premium
- Value premium
rank stocks based on the book-to-marked ratio (or earnings-to-price, or other based on fundamentals and market price). Value stocks (high B/M) outperform growth stocks (low B/M).
Investors can’t process all information
Limited attention
Limited attention
Investors can’t process all information. Two implications:
1. People have limited attention to important pieces of information-
2. They may also pay excessive attention to the salient and easily available information.
People’s ability to process economic information and make informed decisions
Financial literacy
Financial literacy
is people’s ability to process economic information and make informed decisions about financial planning, wealth accumulation, debt, and pensions. Three roots for this are (1) numeracy and capacity to do calculations related to interest rates, (2) understanding inflation, and (3) understanding risk diversification.
the environment in which people make decisions.
Choice architecture
Choice architecture:
the environment in which people make decisions.
Choosing actions that are intended to make the affected parties better off as defined by themselves.
Paternalism
Paternalism
Choosing actions that are intended to make the affected parties better off as defined by themselves.
no one is ever forced to do anything.
Libertarian
Libertarian
no one is ever forced to do anything.
Doing actions, without being forced, to help others according to their perspective.
Libertarian paternalism
Libertarian paternalism
Doing actions, without being forced, to help others according to their perspective.
Features of the choice architecture that influence the decisions people make without changing either objective payoffs or incentives
Nudge
Nudge
Features of the choice architecture that influence the decisions people make without changing either objective payoffs or incentives
earlier experience affects your individual beliefs, risk attitudes, and choices
Experience effects
Experience effects
are when your earlier experience affects your individual beliefs, risk attitudes, and choices. This can be connected to recency bias: most recent experiences get larger weight.
is the study of how social processes shape economic and financial outcomes.
Social finance
Social finance
is the study of how social processes shape economic and financial outcomes.
When someone in your network influences your decision-making
Peer effect
Peer effect
is when someone in your network influences your decision-making process.
he combination of economics, neuroscience, and psychology to determine how individuals make economic decisions.
Neuroeconomics
Neuroeconomics
is the combination of economics, neuroscience, and psychology to determine how individuals make economic decisions.
Investing based on the data
Positive
Investing based on models
Normative, large body of empricial research says no
What does positive and normative mean in finance?
Positive Analysis: Positive analysis is objective and fact-based. In finance, it involves the examination of financial information and economic data to describe or predict financial behavior as it currently exists. For instance, a positive statement could be, “If the central bank lowers interest rates, businesses will increase investment.”
Normative Analysis: On the other hand, normative analysis is subjective, based on opinions or beliefs about what ought to be or what should happen. It involves value judgments and personal perspectives. An example of a normative statement could be, “The central bank should lower interest rates to encourage businesses to invest more.”
when individuals look at each decision or each part of a situation in isolation rather than as part of a bigger picture or in the context of other related decisions.
Narrow framing
Narrow framing
In simple terms, narrow framing is when individuals look at each decision or each part of a situation in isolation rather than as part of a bigger picture or in the context of other related decisions.
For example, an investor might obsess over the daily fluctuations of a single stock in their portfolio, causing undue stress and potentially leading to hasty selling if the stock has a bad day. However, if the investor looked at their portfolio as a whole and considered the overall long-term trend, they might see that the daily changes of one stock have little impact on their total investment.
Article 1
Exposure, experience, and Exper#se: Why personal histories ma;er in Economics.
Introduc3on
Ulrike Malmendier examines how experience affects belief forma;on and decision-making in various economic applica;ons.
Learning, Informa3on, and Brain Plas3city
Neural plas;city allows for structural brain changes, leading to four key features of experience effects:
- Long-las;ng effects of past experiences
- Recency bias
- Different processing of s;muli
- Personal experiences affec;ng even experts
Empirical Evidence
Personal shopping experiences significantly influence individual’s percep;ons and expecta;ons of infla;on.
Key Features and Next Steps
Behavioural Finance Summary Sivert Soltun 11.05.2023
Experiences have long-las;ng effects on beliefs and choices, recent experiences have the strongest impact. However, any prolonged or repeated exposure can rewire the brain. Further research in needed.
Broader Applica3ons and Implica3ons
To remedy persistent imbalances, ac;vely expose underrepresented groups to similar environments where others thrive.
Conclusion
Past experiences have a more significant effect on current beliefs and behaviour.
Article 2
Prospect Theory and Stock Market Anomalies
The paper explores the implica;ons of prospect theory and narrow framing on asset prices and investor behaviour.
Authors build a new model that incorporates these concepts and examine its explanatory power on 23 prominent stock market anomalies. The model successfully explains 14. (return vola;lity, return skewness and capital gain overhang influence)
People evaluate decisions based on a reference point and are more sensi;ve to losses than gains. The theory predicts biases (loss aversion, endowment effect and framing effect)
The study highlights the usefulness of prospect theory in understanding various financial anomalies but acknowledges its limita;ons in explaining some specific cases.
Article 3
Investigate whether limited attention among investors affect stock returns. Done by comparing the response to earnings announcements on Friday, when investor ina^en;on is believed likely, versus responses on other given days.
The model obtained estmates that imply the share of distracted investors in the economy at least 60% on Friday, and 40% on other days. Investors are more likely to underreact to Friday announcements.
Assumtions made under EUT
Completeness: An individual has well defined preferences and can always decide between any two alternatives;
Transitivity: Choices are consistent.
Continuity: A>B>C> -> (pA + (1-p) C)=C
Completeness, transitivity, and continuity are?
Assumptions under EUT.
What biases affect Post-earnings announcement drift?
Conservatism -> Underreactions
Representativeness -> Overreaction -> Long run reversal
Excessive trading
Trading too much, risk-seeking or sensation seeking
Arguments that findings can be wrong because of data mining?
Searching over t periods of past returns and h periods of future returns will yield something at some point
According to Article 2, are preferences all that matter? What about beliefs?
For most of those 9 anomalies that could not be explained, authors suggest that these anomalies are driven by incorrect beliefs about firms’ future outcomes - not by the risk attitudes embedded in prospect theory
Overarching finding
People struggle with probabilities
People struggle with probabilities
Overarching finding
Do people have the cognitive ability or financial knowledge to make rational financial decisions?
No way jose
We have two types of experiences, what are they?
Individual- and common (2008) experiences
Social Learning channel
Social networks can serve as a source of (actual or perceived) information.
Social networks can serve as a source of (actual or perceived) information
Social learning channel
Social perception channel
Social interactions can serve as a tool for the enforcement of norms, rules and agreements
Social interactions can serve as a tool for the enforcement of norms, rules, and agreements
Social perception channel
Social utility channel
When your peers’ actions directly enter your utility function
When your peers’ actions directly enter your utility function
Social utility channel
