Reading 5 The Behavioral Finance Perspective

Question 1

rational investors

Answer 1

individuals who are assumed to be risk-averse, self-interested utility maximizers

Question 2

efficient market

Answer 2

the market where prices incorporate and reflect all available and relevant information

Question 3

Behavioral finance, definition

Answer 3

Behavioral finance attempts to understand and explain observed investor and market behaviors and bases its assumptions on observed financial behavior rather than on idealized financial behavior

Question 4

BFMI, definition

Answer 4

Behavioral finance micro (BFMI) examines behaviors or biases that distinguish individual investors from the rational actors envisioned in neoclassical economic theory. BFMI questions the perfect rationality and decision-making process of individual investors.

Question 5

BFMA, definition

Answer 5

Behavioral finance macro (BFMA) considers market anomalies that distinguish markets from the efficient markets of traditional finance. BFMA questions the efficiency of markets.

Question 6

Behavioral biases of individual investors can be categorized as?

Answer 6

Behavioral biases can be categorized as cognitive errors or emotional biases.

Question 7

utility theory, definition

Answer 7

In utility theory, people maximize the present value of utility subject to a present value budget constraint. Utility may be thought of as the level of relative satisfaction received from the consumption of goods and services.

Question 8

The basic axioms of utility theory

Answer 8

The basic axioms of utility theory are completeness, transitivity, independence, and continuity:

1. Completeness assumes that an individual has well-defined preferences and can decide between any two alternatives.
2. Transitivity assumes that, as an individual decides according to the completeness axiom, an individual decides consistently.
3. Independence also pertains to well-defined preferences and assumes that the preference order of two choices combined in the same proportion with a third choice maintains the same preference order as the original preference order of the two choices
4. Continuity assumes there are continuous (unbroken) indifference curves such that an individual is indifferent between all points, representing combinations of choices, on a single indifference curve.

Question 9

Bayes’ formula

Answer 9

Bayes’ formula is a mathematical rule explaining how existing probability beliefs should be changed given new information: P(A|B) = [P(B|A)/P(B)] P(A) where: P(A|B) = conditional probability of event A given B. It is the updated probability of A given the new information B. P(B|A) = conditional probability of B given A. It is the probability of the new information B given event A. P(B) = prior (unconditional) probability of information B. P(A) = prior probability of event A, without new information B. This is the base rate or base probability of event A.

Question 10

In a perfect world, when people make decisions under uncertainty, they are assumed to do the following:

Answer 10

In a perfect world, when people make decisions under uncertainty, they are assumed to do the following:

1. Adhere to the axioms of utility theory.
2. Behave in such a way as to assign a probability measure to possible events.
3. Incorporate new information by conditioning probability measures according to Bayes’ formula.
4. Choose an action that maximizes the utility function subject to budget constraints (consistently across different decision problems) with respect to this conditional probability measure.

Question 11

REM, definition

Answer 11

1. REM will try to obtain the highest possible economic well-being or utility given budget constraints and the available information about opportunities, and he will base his choices only on the consideration of his own personal utility, not considering the well-being of others except to the extent this impacts REM’s utility.
2. REM is a rational, self-interested, labor-averse individual who has the ability to make judgments about his subjectively defined ends.
3. REM also strives to maximize economic well-being by selecting strategies contingent on predetermined, utility-optimizing goals on the information that he possesses as well as on any other postulated constraints.
4. REM tries to achieve discretely specified goals to the most comprehensive, consistent extent possible while minimizing economic costs.

Question 12

Perfect Rationality, Self-Interest, and Information

Answer 12

1. Rationality is not the sole driver of human behavior. At times, it is observed that the human intellect is subservient to such human emotions as fear, love, hate, pleasure, and pain.
2. Perfect self-interest is the idea that humans are perfectly selfish.
3. It is impossible, however, for every person to enjoy perfect knowledge of every subject. In the world of investing, there is nearly an infinite amount to learn and know, and even the most successful investors don’t master all disciplines.

Question 13

Risk-averse, risk-neutral, risk-seeking person

Answer 13

Given two choices—investing to receive an expected value with certainty or investing in an uncertain alternative that generates the same expected value—someone who prefers to invest to receive an expected value with certainty rather than invest in the uncertain alternative that generates the same expected value is called risk-averse. Someone who is indifferent between the two investments is called risk-neutral. Someone who prefers to invest in the uncertain alternative is called risk-seeking. In traditional finance, individuals are assumed to be risk-averse.

Question 14

certainty equivalent, risk premium

Answer 14

Given an opportunity to participate or to forgo to participate in an event for which the outcome, and therefore his or her receipt of a reward, is uncertain, the certainty equivalent is the maximum sum of money a person would pay to participate or the minimum sum of money a person would accept to not participate in the opportunity. The difference between the certainty equivalent and the expected value is called the risk premium. Certainty equivalents are used in evaluating attitudes toward risk.

Question 15

Utility function of wealth

Answer 15

Question 16

Bounded rationality is

Answer 16

Bounded rationality is proposed as an alternative to the assumptions of perfect information and perfect rationality.

Bounded rationality assumes that individuals’ choices are rational but are subject to limitations of knowledge and cognitive capacity.

Bounded rationality is concerned with ways in which final decisions are shaped by the decision-making process itself.

Question 17

The strongest criticism of REM?

Answer 17

Perhaps the strongest criticisms of REM challenge the underlying assumption of perfect information.

Question 18

The concept of rational economic man is appealing to financial theorists for what reasons?

Answer 18

The concept of rational economic man is appealing to financial theorists for two primary reasons.

First, assuming decision making by REM simplifies economic models and analysis, because it is easier to model human behavior given this assumption.

Second, this allows economists to quantify their findings, making their work easier to understand.

Question 19

Are individuals rational of irrational?

Answer 19

Individuals are neither perfectly rational nor perfectly irrational; instead, they possess diverse combinations of rational and irrational characteristics and benefit from different degrees of knowledge.

Question 20

Indifference curve analysis

Answer 20

Indifference curve analysis may incorporate budget lines or constraints, which represent restrictions on consumption that stem from resource scarcity.

In the work-versus-leisure model, for example, workers may not allocate any sum exceeding 24 hours per day. The number of hours available for work and leisure may be lower than 24 hours depending on other demands on their time.

Question 21

Indifference curve shows

Answer 21

The indifference curve shows the marginal rate of substitution, or the rate at which a person is willing to give up one good for another, at any point.

If the two items are perfect substitutes, then the individual is willing to trade one for the other in a fixed ratio; then, the indifference curve is a line with a constant slope reflecting the marginal rate of substitution.

If the two items are perfect complements, then the curve would be L-shaped.

Question 22

The factors that are not considered under the Utility theory

Answer 22

Utility theory should also consider such other factors as risk aversion, probability, size of the payout, and the different utility yielded from the payout based on the individual’s circumstances.

Question 23

Risk evaluation is dependent on what?

Answer 23

Risk evaluation is reference-dependent, meaning risk evaluation depends in part on the wealth level and circumstances of the decision maker.

Question 24

Double Inflection Utility Function

Answer 24

Double Inflection Utility Function - a utility function that changes based on levels of wealth (also known as Friedman-Savage function).

Question 25

Prospect theory vs. expected utility theory

Answer 25

Prospect theory has been proposed as an alternative to expected utility theory. Prospect theory assigns value to gains and losses (changes in wealth) rather than to final wealth, and probabilities are replaced by decision weights.

Question 26

Neuro-economics and its more interesting results

Answer 26

Neuro-economics is an emerging field of study relevant to understanding how people make economic decisions under uncertainty. Neuro-economics attempts to explain investor behavior based on the functioning of the brain.

Perhaps some of the more interesting insights result from examining chemical levels in the brain.

Question 27

Descriptive vs. normative decision making theories

Answer 27

Prospect theory and bounded rationality are descriptive, describing how people do behave and make decisions. Expected utility and decision theories are normative, describing how people should behave and make decisions.

Question 28

Decision theory is

Answer 28

Decision theory is concerned with identifying values, probabilities, and other uncertainties relevant to a given decision and using that information to arrive at a theoretically optimal decision. Decision theory is normative, meaning that it is concerned with identifying the ideal decision.

Question 29

Historical aspects of decision theory

Answer 29

1. From a historical perspective, the initial focus of decision theory was on expected value. The first person to record explorations of expected value was Blaise Pascal. The action to be chosen should be the one that gives rise to the highest total expected value.
2. Bernoulli describes the difference between expected utility and expected value. Bernoulli’s theory of expected utility, which includes the premise that utility increases at a decreasing rate with increases in wealth, is one of the theories that supports traditional finance perspectives.
3. Frank Knight makes important distinctions between risk and uncertainty. He defines risk as randomness with knowable probabilities and uncertainty as randomness with unknowable probabilities. Risk is measurable, but uncertainty is not.
4. von Neumann and Morgenstern posit that a rational decision maker makes decisions consistent with the axioms of utility theory and chooses the combination of decisions that maximize expected utility. Savage introduces subjective expected utility (SEU).

Question 30

What assumptions of decision making theory are relaxed under bounded rationality and prospect theories?

Answer 30

Bounded rationality theory relaxes the assumptions that perfect information is available and that all available information is processed according to expected utility theory. Bounded rationality acknowledges that individuals are limited in their abilities to gather and process information.

Prospect theory relaxes the assumptions that individuals are risk-averse and make decisions consistent with expected utility theory. Prospect theory assumes that individuals are loss-averse.

Question 31

Bounded rationality

Answer 31

Simon introduced the terms bounded rationality and satisfice to describe the phenomenon where people gather some (but not all) available information, use heuristics to make the process of analyzing the information tractable, and stop when they have arrived at a satisfactory, not necessarily optimal, decision.

Question 32

The term satisfice

Answer 32

The term satisfice combines “satisfy” and “suffice” and describes decisions, actions, and outcomes that may not be optimal, but they are adequate.

Decision makers may choose to satisfice rather than optimize because the cost and time of finding the optimal solution can be very high.

Another reason - this search for an optimum will often become so complicated and time consuming that it is eventually infeasible.

Question 33

A decision maker is said to exhibit bounded rationality when …

Answer 33

A decision maker is said to exhibit bounded rationality when he violates some commonly accepted precept of rational behavior but nevertheless acts in a manner consistent with the pursuit of an appropriate set of goals or objectives.

Question 34

Two phases to make a choice in prospect theory

Answer 34

In prospect theory, based on descriptive analysis of how choices are made, there are two phases to making a choice: an early phase in which prospects are framed (or edited) and a subsequent phase in which prospects are evaluated and chosen.

Question 35

Prospect theory definition

Answer 35

Kahneman and Tversky introduce prospect theory as an alternative to expected utility theory. Prospect theory describes how individuals make choices in situations in which they have to decide between alternatives that involve risk (e.g., financial decisions) and how individuals evaluate potential losses and gains.

Question 36

six operations in the editing process, the ultimate purpose of the evaluation phase

Answer 36

Depending on the number of prospects, there may be up to six operations in the editing process: codification, combination, segregation, cancellation, simplification, and detection of dominance.

The ultimate purpose behind editing is to simplify the evaluation of choices available by reducing the choices to be more thoroughly evaluated. People use editing when making choices because of cognitive constraints.

Question 37

Examples of six operations in the editing phase

Answer 37

Codification: Prospects are coded as (gain or loss, probability; gain or loss, probability; …) such that the probabilities initially add to 100 percent or 1.0.

Combination: Prospects are simplified by combining the probabilities associated with identical gains or losses. For example, a prospect initially coded as (250, 0.20; 200, 0.25; 200, 0.15; 150, 0.40) will be simplified to (250, 0.20; 200, 0.40; 150, 0.40).

Segregation: The riskless component of any prospect is separated from its risky component. For example, a prospect initially coded as (300, 0.8; 200, 0.2) is decomposed into a sure gain of (200, 1.0) and a risky prospect of (100, 0.8; 0, 0.20). The same process is applied for losses.

The above operations are applied to each prospect separately. The following operations are applied to two or more prospects:

Cancellation: Cancellation involves discarding common outcome probability pairs between choices. For example, the pairs (200, 0.2; 100, 0.5; 20, 0.3) and (200, 0.2; 300, 0.4; –50, 0.4) are reduced to (100, 0.5; 20, 0.3) and (300, 0.4; –50, 0.4).

Simplification: Prospects are likely to be rounded off. A prospect of (51, 0.49) is likely to be seen as an even chance to win 50. Also, extremely unlikely outcomes are likely to be discarded or assigned a probability of zero.

Detection of Dominance: Outcomes that are strictly dominated are scanned and rejected without further evaluation.

Question 38

isolation effect

Answer 38

An example of a preference anomaly is the isolation effect. This results from the tendency of people to disregard or discard outcome probability pairs that the alternatives share (cancellation) and to focus on those which distinguish them.

Question 39

experimantal evidence on gamling preferences of people

Answer 39

Experimental evidence shows that most people reject a gamble with even chances to win and lose, unless the amount of the possible win is at least twice the amount of the possible loss.

Preferences appear to be determined by attitudes toward gains and losses, which are defined relative to a reference point that frames the situation.

Question 40

the main difference between prospect and expected utility functions

Answer 40

In contrast to expected utility theory, the prospect theory value function measures gains and losses but not absolute wealth and is reference-dependent. Reference dependence is incompatible with the standard interpretation of expected utility theory. Reference dependence is a feature of prospect theory and is central to prospect theory’s perspective on how people make decisions under uncertainty.

Question 41

Two main aspect of EMH and its critics

Answer 41

Two aspects of the EMH. He terms these “The Price is Right” and “No Free Lunch.” The price is right assumes that asset prices fully reflect available information and that securities’ prices can be used as a means to allocate resources. This assumption is likely to be fallacy.

No free lunch assumes that it is difficult for any investor to consistently outperform the market after taking risk into account given the inherent unpredictability of prices. There is a myriad of studies over several decades have resulted in the same basic conclusion.

Question 42

An efficient market is

Answer 42

An efficient market is a market wherein prices fully reflect available information because of the actions of a large number of rational investors (the population of investors). Underlying market efficiency is the assumption that market participants are rational economic beings, always acting in their own self-interest and making optimal decisions by trading off costs and benefits weighted by statistically correct probabilities and marginal utilities.

Question 43

Grossman–Stiglitz paradox

Answer 43

Grossman and Stiglitz argue that prices must offer a return to information acquisition, otherwise information will not be gathered and processed. If information is not gathered and processed, the market cannot be efficient. This is known as the Grossman–Stiglitz paradox.

A market is inefficient if, after deducting such costs, active investing can earn excess returns. An investor or researcher should consider transaction costs and information acquisition costs when evaluating the efficiency of a market.

Question 44

Forms of market efficiency

Answer 44

Fama proposes three forms of market efficiency: the weak form, the semi-strong form, and the strong form.

Weak-form market efficiency assumes that all past market price and volume data are fully reflected in securities’ prices. Thus, if a market is weak-form efficient, technical analysis will not generate excess returns.

Semi-strong-form market efficiency assumes that all publicly available information, past and present, is fully reflected in securities’ prices. Thus, if a market is semi-strong-form efficient, technical and fundamental analyses will not generate excess returns.

Strong-form market efficiency assumes that all information, public and private, is fully reflected in securities’ prices. Thus, if a market is strong-form efficient, even insider information will not generate excess returns.

Question 45

Support if weak form of the EMH

Answer 45

A number of studies conclude that the path of securities’ prices cannot be predicted based on past prices.

Fama concludes that daily changes in stock prices had nearly zero positive correlation. He proposes that the stock market works in a way that allows all information contained in past prices to be incorporated into the current price. In other words, markets efficiently process the information contained in past prices.

Question 46

Support of the Semi-Strong Form of the EMH

Answer 46

Two test that support the Semi-Strong Form of the EMH:

1. Stock split price changes. These results indicate that the implications of a stock split appear to be reflected in price immediately following the announcement of the split and not the event itself. This research supports the semi-strong form of market efficiency, because investors would not earn abnormal returns after the stock split information is publicly available.
2. Historical ineffectiveness of active management

Question 47

Fundamental anomalies

Answer 47

A fundamental anomaly is an irregularity that emerges when one considers a stock’s future performance based on a fundamental assessment of the stock’s value.

The apparent size and value stock anomalies may be a function of incomplete models being used in testing for inefficiency rather than actual anomalies.

Question 48

Three main types of identified market anomalies?

Answer 48

There are three main types of identified market anomalies: fundamental, technical, and calendar.

Support exists for both efficient markets and anomalous markets.

In reality, markets are neither perfectly efficient nor completely anomalous; market efficiency is not black or white, but rather gray.

Question 49

Technical anomaly

Answer 49

A technical anomaly is an irregularity that emerges when one considers past prices and volume levels. Technical analysis encompasses a number of techniques that attempt to forecast securities prices by studying past prices and volume levels. Common technical analysis strategies are based on relative strength and moving averages, as well as on support and resistance.

Question 50

Calendar anomaly

Answer 50

A calendar anomaly is an irregularity identified when patterns of trading behavior that occur at certain times of the year are considered. A well known calendar anomaly is the January effect.

Question 51

Theory of limited arbitrage

Answer 51

Shleifer and Vishny develop a theory of limited arbitrage. They assume that implicit restrictions are placed on a fund’s ability to arbitrage by investors’ ability to withdraw their money.

Theory of limited arbitrage is in stark contrast to the EMH, which assumes that whenever mispricing of a publicly traded stock occurs, an opportunity for arbitrage profit is created for rational traders who should act on those opportunities, resulting in rational pricing (efficient markets). Why might rational traders choose not to act on observed opportunities?

The possibility of an extended period of mispricing and the potential need for liquidity makes market participants less prone to take advantage of arbitrage opportunities. This action has the tendency to exacerbate the problem of pricing inefficiency.

Question 52

Traditional Perspectives on Portfolio Construction

Answer 52

From a traditional finance perspective, a “rational” portfolio is one that is mean–­variance efficient.
However, this approach to portfolio construction implicitly assumes that investors (or their advisers) have perfect information and that investors behave rationally in forming their portfolios. If these assumptions do not apply, then portfolios may be constructed using other approaches resulting in portfolios that have too much or too little risk when compared to the optimal portfolio. Further, although a portfolio based on mean–variance optimization may be theoretically sound, it may fail to meet the needs of the investor because of behavioral considerations.

Question 53

A Behavioral Approach to Consumption and Savings

Answer 53

Shefrin and Thaler developed a behavioral life-cycle theory that incorporates self-control, mental accounting, and framing biases.

In behavioral finance, the self-control bias recognizes that people may focus on short-term satisfaction to the detriment of long-term goals. Mental accounting is the phenomenon whereby people treat one sum of money differently from another sum of money even though money is fungible (interchangeable). Framing bias results in different responses based on how questions are asked (framed).

Shefrin and Thaler suggest that people classify their sources of wealth into three basic accounts: current income, currently owned assets, and the present value of future income.

Question 54

A Behavioral Approach to Asset Pricing

Answer 54

Shefrin proposes a behavioral approach to asset pricing using models, which Shefrin terms behavioral stochastic discount factor-based (SDF-based) asset pricing models.

The stochastic discount factor to reflect this bias is a function of investor sentiment relative to fundamental value.

The discount rate captures the effects of the time value of money, fundamental risk, and sentiment risk.

Shefrin proposes that the dispersion of analysts’ forecasts serves as a proxy for the sentiment risk premium in the model.

Question 55

Behavioral Portfolio Theory

Answer 55

In behavioral portfolio theory, however, investors construct their portfolios in layers and expectations of returns and attitudes toward risk vary between the layers. The resulting portfolio may appear well-diversified, but diversification is incidental to and not necessarily an objective of the portfolio construction.

Shefrin and Statman contend that portfolio construction is primarily a function of five factors.

A BPT investor maximizes expected wealth subject to the constraint that the probability of the wealth being less than some aspirational level cannot exceed some specified probability.

As a result, the optimal portfolio of a BPT investor is a combination of bonds or riskless assets and highly speculative assets. The BPT investor is essentially constructing a portfolio equivalent to an insurance policy and a lottery ticket.

A BPT consistent portfolio is usually constracted in layers which may be the result of mental accounting.

Question 56

Adaptive Markets Hypothesis

Answer 56

The AMH applies principles of evolution—such as competition, adaptation, and natural selection—to financial markets in an attempt to reconcile efficient market theories with behavioral alternatives.
The AMH is a revised version of the EMH that considers bounded rationality, satisficing, and evolutionary principles. Under the AMH, individuals act in their own self-interest, make mistakes, and learn and adapt; competition motivates adaptation and innovation; and natural selection and evolution determine market dynamics. Five implications of the AMH are: 1) The relationship between risk and reward varies over time (risk premiums change over time) because of changes in risk preferences and such other factors as changes in the competitive environment; 2) active management can add value by exploiting arbitrage opportunities; 3) any particular investment strategy will not consistently do well but will have periods of superior and inferior performance; 4) the ability to adapt and innovate is critical for survival; and 5) survival is the essential objective.

Question 57

Mental Accounting In Investing

Answer 57

The mental accounting bias also enters into investing. For example, some investors divide their investments between a safe investment portfolio and a speculative portfolio in order to prevent the negative returns that speculative investments may have from affecting the entire portfolio. The problem with such a practice is that despite all the work and money that the investor spends to separate the portfolio, his net wealth will be no different than if he had held one larger portfolio.

Question 58

Friedman-Savage vs. Traditional utility function

Answer 58

• Friedman-Savage utility function* is characterized by an inflection point where the function turns from concave to convex - risk-seeking (conves) utility function for gains and a risk-avarese (concave) utility function for losses. This type of function explains why people may take low-probability, high payoff risks (e.g., out-of-money options) ahile at the same time insuring against low-probability, low-payoff risks (e.g. earthquake insurance).
• Traditional finance theory* assumes risk aversion (concave utility function) at all levels of wealth, which would lead to rejection of all gambles having a non-positive expected return.