Chapter 14 - Behavioral Finance

Question 1

What is behavioral finance?

Answer 1

Studies the psychology of market
participants to help explain why markets
are inefficient and exploitable.

Question 2

What is behavioral finance macro (BFMA) and behavioral finance micro (BFMI)?

Answer 2

Behavioural Finance Micro (BFMI) examines the behavioural biases (that is, irrational behaviours) of individual investors. It compares irrational investors to rational investors envisioned in classical economic theory, known as Homo economicus or “rational economic human being.”

Behavioural Finance Macro (BFMA), on the other hand, describes “anomalies” or irregularities in the overall market that contradict the efficient market hypothesis.

The two are very closely related. BFMI suggests that these biases impact an individual’s economic decisions, and BFMA asserts that markets are subject to the effects of these collective decisions.

Question 3

How does the term bias apply to the study of behavioral finance?

Answer 3

Bias is an irrational assumption or belief that affects the ability to make a decision based on facts and evidence. Investors are as vulnerable as anyone to making decisions clouded by prejudices or biases. Smart investors avoid two big types of bias—emotional bias and cognitive bias.

Question 4

What is a calendar anomaly?

Answer 4

A calendar anomaly is an irregular securities pattern that emerges during certain times of the
year, such as the January Effect mentioned earlier. The January Effect shows that stocks in
general, and small stocks in particular, move abnormally higher during the month of January.
Haugen and Jorion, two researchers in this area, have observed that the January Effect is, perhaps,
the best-known worldwide example of anomalous behaviour in security markets.

Question 5

Explain what a cognitive bias is.

Answer 5

A cognitive bias can be technically defined as basic statistical, information processing or memory
errors that are common to all human beings. They can be thought of also as “blind spots” or
distortions in the human mind. One of the most common cognitive biases is anchoring bias.
Here, clients get anchored to the price of a stock or the level of the market and hold on to that
price before being willing or able to make an investment decision. Cognitive biases were first
identified by Amos Tversky and Daniel Kahneman as a foundation of behavioural economics.
Tversky and Kahneman argue that cognitive biases are used in problem-solving through heuristics
that include the availability heuristic and the representativeness heuristic.

Question 6

Explain the concept of the efficient market hypothesis.

Answer 6

The efficient market hypothesis was developed from the doctoral dissertation of Professor
Eugene Fama of the University of Chicago. Fama believed and demonstrated that, in a securities
market populated by many well-informed investors, investments will be accurately priced and
reflect all available information.1 There are three forms of the efficient market hypothesis:
* Weak form: all past market prices and data are fully reflected in current securities prices; that
is, technical analysis is of little or no value.
* Semi-strong form: all publicly available information is fully reflected in current securities
prices; that is, fundamental analysis is of no value.
* Strong form: all information (including insider information) is fully reflected in current
securities prices.

Many market efficiency studies point to evidence that supports the efficient market hypothesis.
Researchers have documented numerous, persistent anomalies, however, that contradict the
efficient market hypothesis. There are three main types of market anomalies that advisors should
know about:
* Fundamental anomalies
* Technical anomalies
* Calendar anomalies

Question 7

Explain the concept of emotional bias.

Answer 7

On the opposite side of the spectrum from illogical or distorted reasoning are the emotional
biases. An emotion is a mental state that arises spontaneously, rather than through conscious
effort. Emotions are physical expressions, often involuntary, related to feelings, perceptions or
beliefs about elements, objects or relations between them, in reality or in the imagination.
Emotions can be undesired to the individual feeling them; she may wish to control them but
often cannot. Investors can be presented with investment choices, and may make sub-optimal
decisions by having emotions affect these decisions. Often, because emotional biases originate
from impulse or intuition rather than from conscious calculations, they are difficult to correct.
Emotional biases include endowment, loss aversion and self-control.

Question 8

What is a fundamental anomaly?

Answer 8

A fundamental anomaly is an irregularity in a security’s current price when compared to a
fundamental assessment of its intrinsic value. There is a large body of evidence documenting,
for example, that investors consistently overestimate the prospects of growth companies and
underestimate the value of out-of-favour companies. In a totally efficient market, this would
not happen. Professors Ken French and Eugene Fama performed a study of low price-to-book-
value ratios that covered a period of 38 years.2 The study considered all equities listed on NYSE,
AMEX, and/or NASDAQ in the United States. The stocks were divided into 10 groups by book/
market and were re-ranked annually.
The highest book/market stocks outperformed the lowest book/market stocks 21.4% to 8%, with
each decile (representing one-tenth of the sample or population) performing more poorly than
the previously ranked, higher-ratio decile. They also ranked the deciles by beta (the measure of
an investment’s volatility relative to the market as a whole) and found that the value stocks posed
lower risk and the growth stocks had the highest risk. This result encouraged many investors to
buy value stocks. The methodology contained in the analysis is widely used today and is based on
inefficient market conditions.

Question 9

What are heuristics?

Answer 9

Some refer to biases
as heuristics (simple, efficient rules of thumb); others call them beliefs, judgments or preferences;
still others classify biases along cognitive or emotional lines.

Question 10

What is the concept of homo economicus?

Answer 10

First established in neo-classical economics, Homo economicus (or rational economic human
being) is a model of human economic behaviour that hypothesizes that three principles rule
economic decisions made by individuals:
* Perfect rationality
* Perfect self-interest
* Perfect information
Homo economicus is a model that academics and practitioners believe in with varying degrees of
stringency. A few believe in a “strong” form, which holds that irrational behaviour does not exist.
Others have adopted a “semi-strong” form; this version sees an abnormally high occurrence of
rational economic traits. Other economists support a “weak form” of Homo economicus, in which
the irrational traits exist but are not strong.
All of these versions share the core assumption that humans are “rational economic maximizers,”
who are self-interested and make rational economic decisions. Economists like to use this as a
principle for two primary reasons. First, Homo economicus makes economic analysis relatively
simple. Second, it allows economists to quantify their research findings, which makes their work
easier to teach and disseminate. If humans are perfectly rational, possess perfect information and
display perfect self-interest, then perhaps their behaviour can be quantified.
Most criticisms of Homo economicus proceed by challenging the bases for these three underlying
assumptions (criticisms of the three bullet points above).

Question 11

What is the January effect?

Answer 11

Th e tendency of all markets to end the year
higher if prices rally in January, or end the
year lower if they decline in January.

Question 12

What does fungible mean?

Answer 12

Being something (such as money or a commodity) of such a nature that one part or quantity may be replaced by another equal part or quantity in paying a debt or settling an account.

Question 13

What does non-fungible mean?

Answer 13

Non-fungible means that something is unique and can’t be replaced.

Question 14

What are the two types of traders?

Answer 14

Those who want to be right, and those who want to make money. You can’t be both.

Question 15

What is standard deviation?

Answer 15

A quantity calculated to indicate the extent of deviation for a group as a whole. Remember 68-95-99.7 empirical rule.

Question 16

What is technical analysis?

Answer 16

The process of analyzing historical market
action in an effort to determine probable
future price trends; market action is defined
by price, volume, time, and in the case of
futures markets, open interest.

Question 17

What is a technical anomaly?

Answer 17

A technical anomaly is rooted in technical analysis and represent patterns that emerge that in
themselves impact market prices, such as moving average cross-overs, extreme oscillator readings
(overbought/oversold), break-outs from chart formations, and Dow Theory (etc.). In other
words, while market price movements create patterns, sometimes, once the pattern is established
and confirmed it can then lead to market prices becoming somewhat of a self-fulfilling prophecy.

Question 18

Provide an introduction to the topic of behavioral finance.

Answer 18

Technical analysis provides a snapshot of investor sentiment and expectations. As discussed throughout
this course, technical analysts believe that all market influences are fully reflected in market prices. Those
market influences are generally thought to be based on perceptions of market value determined through
fundamental analysis. However, in the world of finance there are two camps. The first of these is standard
finance, which embodies the notion that investors are inherently rational economic beings. The second
camp, behavioural finance, holds that investors are human beings, rather than idealized logical creatures,
and therefore market prices are not only influenced by fundamentals but also by the collective impact
of investor’s personal beliefs and biases. This chapter takes a closer look at behavioural finance and its
implications.

Question 19

Describe the theory of behavioural finance and differentiate between behavioural finance
micro and behavioural finance macro.

Answer 19

• Behavioural finance is commonly defined as the application of psychology to
  understand human behaviour in finance or investing.
• The discussion of behavioural finance can be split into two subtopics:
  – Behavioural Finance Micro, which looks at the irrational behaviour of individual
  investors.
• Criticizes perfect rationality, perfect self-interest, and perfect information.
  – Behavioural Finance Macro, which looks at irregularities in the overall market.
• Three main types of market anomalies are fundamental anomalies, technical
  anomalies, and calendar anomalies.

Question 20

Identify cognitive and emotional client biases.

Answer 20

• A cognitive bias can be technically defined as basic statistical, information processing or
  memory errors that are common to all human beings.
• Common cognitive biases are: overconfidence, representativeness, anchoring and
  adjustment, cognitive dissonance, availability, self-attribution, illusion of control,
  conservatism, ambiguity aversion, mental accounting, confirmation, hindsight, recency,
  framing.
• An emotional bias originates from impulse or intuition rather than from conscious
  calculations.
• Common emotional biases are: endowment, self-control, optimism, loss aversion, regret
  aversion, status quo.

Question 21

Demonstrate the link between biases and technical formations and trends.

Answer 21

• An overconfidence bias might contribute to overbought market conditions as indicated
  by an oscillator reading; also, overconfidence tends to lead to overtrading and the failure
  to diversify.
• Investors display many behaviour biases that influence their decision-making processes
  and are demonstrated through technical analysis formations and trends.
• The key is to rein in emotions and develop and follow objective investment strategies
  and trading rules

Question 22

TRUE or FALSE: Most people are too quick to take profits and too slow to cut losses and this is why their systems fail.

Answer 22

TRUE!

Question 23

What are the two subtopics that behavioral finance can be split up into?

Answer 23

• Behavioural Finance Micro, which looks at the irrational behaviour of individual investors,
  and
• Behavioural Finance Macro, which looks at irregularities in the overall market.

Question 24

What are the criticisms of perfect rationality, perfect self-interest, and perfect information?

Answer 24

Perfect Rationality: It argues that humans are not solely driven by logical and rational thinking; emotions and subjective experiences also heavily influence human behavior. Thus, perfect rationality is more a theoretical construct than a reality.

Perfect Self-Interest: It points out that if people were completely self-interested, altruistic behaviors like charity and kindness would not exist. Therefore, humans are not perfectly self-interested as they often engage in selfless acts.

Perfect Information: It notes that it is unrealistic to expect that everyone has complete and perfect information about everything. Even experts do not know everything about their fields, making perfect information unattainable.

Question 25

What is the difference between standard finance and behavioral finance?

Answer 25

Standard finance is characterized by rules about how investors should behave rather than by
principles describing how they actually behave. Behavioural finance, on the other hand, identifies
with and learns from human behaviour demonstrated by individual investors in financial
markets. Behavioural finance, like standard finance, contains underlying assumptions, but
standard finance grounds its assumptions in idealized financial behaviour; behavioural finance,
in observed financial behaviour.

Question 26

What are the fourteen cognitive biases that were covered?

Answer 26

Overconfidence: Believing too strongly in one’s own reasoning and abilities, leading to overestimating one’s capabilities and under-learning from mistakes.
Representativeness: Categorizing new situations based on similar past experiences, which can lead to incorrect assumptions because of perceived similarities.
Anchoring and Adjustment: Relying heavily on an initial piece of information (anchor) when making decisions, and inadequately adjusting from that baseline.
Cognitive Dissonance: Experiencing mental discomfort when new information conflicts with existing beliefs, leading individuals to rationalize to relieve discomfort.
Availability: Estimating the likelihood of outcomes based on how readily examples come to mind, which can distort perception of how common or probable events are.
Self-Attribution: Attributing successes to personal skill and failures to external factors, skewing one’s perception of responsibility.
Illusion of Control: Believing one can control or influence outcomes that are actually determined by chance.
Conservatism: Holding on to prior beliefs despite new evidence suggesting a need for change, leading to under-reacting to new information.
Ambiguity Aversion: Preferring to avoid decisions where the probabilities of outcomes are unknown, leading to potentially missing out on beneficial risks.
Mental Accounting: Treating money differently based on its source or intended use, which can affect spending and investment decisions irrationally.
Confirmation: Focusing on information that confirms existing beliefs and overlooking contradictory evidence.
Hindsight: Believing in retrospect that events were predictable even when they were not, often leading to overconfidence in one’s predictive abilities.
Recency: Overemphasizing recent events when making decisions, which can lead to biased judgments about future probabilities.
Framing: Being influenced by how information or questions are phrased, which can lead to different decisions based on the presentation rather than the content.

Question 27

What are the six emotional biases that were covered?

Answer 27

Endowment Bias: Valuing assets more simply because one owns them, even if the same assets are valued less by others not owning them.

Self-Control Bias: The tendency to favor immediate gratification over long-term benefits, such as spending now rather than saving for future expenses.

Optimism Bias: The inclination to be overly optimistic about the outcome of planned actions, underestimating the likelihood of negative outcomes.

Loss Aversion: The tendency to prefer avoiding losses to acquiring equivalent gains because the pain of losing is psychologically more impactful than the pleasure of an equivalent gain.

Regret Aversion: Avoiding decision-making or necessary actions due to the fear of future regret, leading to potentially missed opportunities.

Status Quo Bias: Preferring to maintain current conditions rather than change, often irrationally favoring the familiar and resisting changes even when they might lead to better outcomes.