Chapter 3 Stochastic Dominance And Behavioral Finance Flashcards
Absolute Dominance
Said to exist when one investment portfolio provides a higher return than another in all possible circumstances.
First Order Stochastic Dominance
Theorem states that assuming an investor prefers more to less, A will dominate B (ie: the investor will prefer portfolio A to portfolio B) if:
F(x) of A <= F(x) of B for all x, and
F(x) of A < F(x) of B for some value of x.
The probability of portfolio B producing a return below a certain value is never less than the probability of portfolio A producing a return below the same value, and exceeds it for at least some value of x
Second Order Stochastic Dominance
Theorem applies when the investor is risk Averse as well as preferring more to less.
In this case the condition for A to dominate B is that the integral from a to x of F(x) of A <= integral from a to x of F(x) of B for all x
With the strict inequality holding for some value of x and where a is the lowest return that the portfolio can possibly provide.
Risk Averse investor will accept a lower probability of a given extra return at a low absolute return in preference to the same probability of extra return at a higher absolute level.
A potential gain of a certain amount is not valued as highly as a loss of the same amount.
Advantages of using Stochastic Dominance
It does not require explicit formulation of the investor’s utility function.
Can instead be used to make investment decisions for a wide range of utility functions
Disadvantages of using Stochastic Dominance
May be unable to choose between two investments.
Generally involves pair wise comparisons of alternative investments, which may be problematic if there is a large number of investments between which to choose.
Behavioural finance
It looks at a variety of mental biases and decision making errors affect financial decisions.
It relates to the psychology that underlies and drives financial decision making behavior.
Prospect Theory
Sought to detail how human decision making differs systematically from that predicted by EUT, and how human beings consistently violate the rationality axioms that form its basis.
What does Prospect Theory suggest?
1) Utility is based on gains and losses relative to some reference point.
Blue
2) The reduction in utility from a loss is typically twice as much as the increase in utility from the same sized monetary gain.
Orange
3) People are typically risk averse when considering gains relative to the reference point and risk seeking when considering losses relative to the reference point.
Pink/purple
4) People experience diminishing sensitity to gains and losses, so, for example, an initial gain has a greater impact on utility than a subsequent gain of the same size.
Green
Think of graph illustration. Convex then concave
Decision making process consists of what two phases
Editing/Framing
Where outcomes of a decision are initially appraised and ordered.
Leads to representation of the acts, outcomes and contingencies associated with a particular choice problem
Evaluating
Choosing amongst the appraised option.
Decision makers then move on to the evaluation stage where they make their choice.
Discuss the two operations involved in the editing process and how choices can be affected.
Acceptance
People are unlikely to alter the formulation of choices presented
Segregation
People tend to focus on the most “relevant” factors of a decision problem.
Withing this process
Framing effects refers to the way in which a choice can be affected by the order or manner in which it is presented.
Standard economic theory considers such transformations to be innocuous with no substantive impact on decisions.
Discuss behavioral patterns in people when evaluating various alternatives.
1) Reference dependence:
People derive utility from gains and losses measured relative to some reference point rather than in absolute levels of wealth.
This emerges from the idea that people are more attuned to changed in attributes rather than absolute magnitudes.
This generates utility curves with a point of inflexion at the chosen reference point.
2) Loss Aversion
People are much more sensitive to losses(even small ones) than to gains of the same magnitude.
Pain from a loss is estimated to be twice as strong as the pleasure from an equivalent gain
Utility curves are steeper in the domain of losses than they are in the domain of gains.
3) Endowment Effects
The endowment effect occurs when a person’s preference depends upon what they already possess. This implies that a person’s preference depends upon a certain reference point, perhaps determined by a person’s possession. Ownership itself creates satisfaction.
Discuss other behavioral patterns in the people when evaluating various alternatives.
1) Changing risk attitudes
Individuals tend to be risk averse in domains of gains and risk seeking when pondering losses
2) Diminishing Sensitivities
As you gain (or lose) more, the marginal impact on utility of additional gains(losses) falls.
Thus a utility function is concave in region of gains but convex in regions of losses.
3) Probability Weighting
People do not weigh outcomes by their objective probabilities, but by transformed probabilities or decision weights.
4) Certainty Effect
When an outcome is certain and becomes less probable, the impact on your utility is greater than simple reduction in probability for an outcome that was previously probable.
5) Isolation Effect
When choosing between alternatives, people often disregard components that alternatives share and instead focus on what sets them apart, in order to simplify to decision. Since different choices can be decomposed in different ways, this invariably lead to inconsistent choices and preferences.
Heuristics
Instinctive part of brain that takes quick and effortless decisions rely on heuristics to deliver quick decisions.
1) Anchoring and Adjustment
Term used to explain how people produce estimates. People start with an initial idea of the answer(“the anchor”) and then adjust away from this initial anchor to arrive at their final judgment.
Adjustments allow for evident differences to current conditions.
2)Representativeness
Decision makers often use similarity as a proxy for probabilistic scenarios
3) Availability
Assessing the probability of an even occurring by the ease at which instances of its occurance can be brought to mind.
4) Familiarity
Process by which people favour situations or options that are familiar with rather than others that are new.
Behavioral biases proposing deviation from rational outcomes proposed by standard economic thought represented by EUT
1)Overconfidence
Occurs when people systematically overestimate their own capabilities, judgement and abilities.
Accuracy increases to a modest degree but confidence to a much larger degree.
Hindsight Bias
Events that happen will be thought of as having been predictable prior to the event and events that don’t happen will be thought of as having been unlikely prior to the event.
Confirmation Bias
People will tend to look for evidence that confirms their point of view (and will tend to dismiss evidence that does not justify it).
2) Self-serving Bias
Occurs when people credit favorable or positive outcomes to their own capabilities or skills, while blaming external forces or others for negative outcomes
3) Status quo bias
The inherent tendency of people to stick to their current situation in the presence of more favourable alternatives and even when no transaction costs are involved. Reason being loss aversion and endowment effects.
4) Herd behaviour
Tendency of people to follow or mimic the actions and decisions taken by others, as a mechanism to deal with uncertain situations.
Myopic loss aversion
Investors at less risk averse when faced with a multiperiod series of ‘gambles’ and that the frequency of choice or length of reporting period will also be influencial.investors are generally extremely concerned by losses rather than equivalent gains, leading them to focus on short term returns and volatility rather than long run earnings.
