Ch13 - Behavioral Finance: Markets and Theories

Question 1

In prospect theory, framing is a bias where decisions can be changed when facts or options present as loss versus gain. Gain frames typically result in ______ and loss frames typically result in ______.

Answer 1

gain frames = risk aversion

loss frames = risk tolerance

Question 2

What are the FOUR elements of prospect theory?

Answer 2

(a) reference dependence - people use different reference points to make decisions
(b) loss aversion - people go out of their way to avoid loss more than they desire to gain
(c) diminished sensitivity to gains and losses - as consumption increases incrementally, utility (satisfaction) begins to decrease.
(d) nonlinear probability weighting - people tend to underweight high probability occurrences and overweight low probability occurrences

Question 3

What is the difference between rational preference and satisficing?

Answer 3

A rational preference (aka - decision) describes a decision made after rational considerations. Satisficing is done to “get the job done” quickly without necessarily rational considerations or thought.

Question 4

What is anchoring in behavioral finance?

Answer 4

The tendency to heavily rely on the first piece of information offered when making a decision. Example, if an item costs $100 and is placed next to a similar item priced at $200, then it gives us confidence that it is a good price, even though nothing about the original item has changed.

Question 5

The tendency for a client to have an emotional attachment to what they already own MORE than something that they do not yet own is known as…

Answer 5

endowment effect

Question 6

This theory suggests that investors build board ranging portfolios that meet a variety of interest that is adverse to the idea of ultimately maximizing their portfolio returns.

Answer 6

Behavioral Portfolio Theory

Question 7

The two systems theory recognized that we have separate brain regions that are often simultaneously responsible for processing information. What is the difference between System 1 and System 2?

Answer 7

system 1

The limbic system that produces fast and emotional responses.

Short-run (impulsive) self

SYSTEM 2

Prefrontal cortex stem that analyzes information and images consequences.

Long-run (patient) self

Question 8

The ________ theory is the dominant framework for thinking about consumer welfare and customer choice.

Answer 8

standard economic (neoclassical)

Question 9

This describes the behavior of an investor who would sell assets only when the prices rise and would hold assets even when prices are falling.

Answer 9

disposition effect

Question 10

Define risk tolerant and risk averse.

Answer 10

risk tolerant = more willing to accept a loss for a potential gain

risk averse = need a big gain to accept a possible loss

Question 11

How do people act with full internal knowledge vs full external knowledge?

Answer 11

People have full internal knowledge are aware of their own preferences today and in the future. People with full external knowledge are aware of the economic environment and are considered to have full information.

Question 12

Why do people choose investments rationally?

Answer 12

To maximize their welfare (rational preferences and maximize utility)

Question 13

Neoclassical economic theory ​assumes investors have ________ on which to make choices reflecting preferences.

Answer 13

full information

Question 14

Neoclassical economic theory is highly useful at creating models based on how rational, well-informed people should behave. How does the prescriptive model differ from the descriptive model?

Answer 14

prescriptive model – how rational people should behave

descriptive model – how rational people actually behave

Question 15

Research has revealed evidence of bias which are examples of violations of…

Answer 15

neoclassical economic theory identified through descriptive analyses or experiments.

Question 16

The limited capability of households to process and retain information needed to make effective decisions is known as _________.

Answer 16

bounded rationality (we can’t possibly have all information)

Question 17

Biases appearing in economic decision making seem to relate to relative comparisons and past experiences. Describe what this means.

Answer 17

We compare our situation to those around us and choose options based on our past reference points. Example, going from $100,000 to $80,000 of spending is hard. Even if we were spending $80,000 and was perfectly happy with it 5 years ago.

Question 18

This is when changes in income or experiences temporarily affect happiness, but as people become accustomed to the new situation, the impact diminishes.

Answer 18

hedonic adaptation (The Hedonic Treadmill where your satisfaction returns to previous level)

Question 19

The tendency to prefer to avoid moving from one’s current situation because a move might generate a negative change from a reference point is known as ________.

Answer 19

status quo bias

Question 20

Explain the “house money effect”.

Answer 20

The tendency of investors and traders to take on greater risk when reinvesting profit earned. When gamblers don’t know when to walk away from the table. They see unearned money, the house money, can be lose without experiencing unhappiness because a loss is much easier to accept from money above the gamblers reference point (the money he started with).

Question 21

When an advisor reframes an investment account by labeling it based on how and when it will be spent.

Answer 21

bucketing

Question 22

What are the THREE market anomalies in behavioral finance?

Answer 22

• low volatility anomaly
• small stock effect
• value effect