Reading 7

Question 1

Contrast traditional and behavioural finance perspectives on investor decision making

Answer 1

Traditional Finance:

• PRESCRIPTIVE; explains how investors SHOULD make investment decisions based on mathematical models and theories

Behavioural Finance:

• DESCRIPTIVE: tries to explain OBSERVED investor decision making

Question 2

Contrast expected utility and prospect theories of investment decision making

Answer 2

Traditional finance based on
1) utility theory
2) an assumption of diminishing marginal return
Two consequences
1) risk-averse utility function is concave; as more and more wealth is added, utility increases at a diminishing rate
2) convex indifference curves due to a diminishing marginal rate of substitution

Decision Theory - making the ideal decision when the decision maker is:

• fully informed
• mathematically able
• rational

The theory has evolved over time:

• Initial analysis: highest probability-weighted payoff
• Later evolution: expected value separated from expected utility (subjective, depending on unique preference of individuals and rate of diminishing marginal utility and substitution)
• Risk (vs. uncertainty) = random variable due to one outcome that will occur. Can be incorporated into analysis by maximising expected utility
• Uncertainty (vs. risk) = unknowable outcomes and probabilities. Immeasurable and not amenable to traditional utility maximisation analysis
• Subjective analysis extends decision theory to situations where probability cannot be objectively measured but its subjective

Question 3

Discuss the effect that cognitive limitations and bounded rationality may have on investment decision making

Answer 3

Bounded rationality = individuals act as rationally as possible, given their:

• lack of knowledge
• lack of cognitive ability

Rather than optimise, individuals satisfice.

• gather info they can
• apply heuristics
• and arrive at an acceptable decision

The result is that the investor takes steps and accepts short-term goals toward the ultimately desired goal

The investor does not necessarily make the theoretically optimal decision from a traditional finance perspective

Question 4

Compare traditional and behavioural finance perspectives on portfolio construction and the behaviour of capital markets

Answer 4

Traditional finance assumptions:

• markets are efficient and prices reflect fundamental value
• new information is quickly and properly reflected in market prices
• portfolio managers can focus on identifying efficient portfolios that meet the client’s objectives of risk and return, whilst observing the investor’s constraints

Behavioural finance challenges these theories, although has not been able to provide a unified, alternative theory.

Four alternative behavioural models have been proposed:

1) Consumption and savings
2) Behavioural asset pricing
3) Behavioural portfolio theory
4) The adaptive markets hypothesis

Question 5

Consumption and savings approach

Answer 5

TF = assumes investors are able to save and invest in earlier stages of life to fund later retirement

Consumption and savings = alternative behavioural life-cycle model: questions the ability to exercise self-control and suggests individuals instead show:

• mental accounting bias
• framing bias

Question 6

Behavioural asset pricing

Answer 6

CAPM:

• assumes market prices are determined through an unbiased analysis of risk and return
• intrinsic value of an asset = expected cash flows discounted at a required return, based on the risk-free rate and a fundamental risk premium

Behavioural asset pricing model
- adds a SENTIMENT PREMIUM (to discount rate)

Question 7

Behavioural portfolio theory (BPT)

Answer 7

BPT

• Based on empirical evidence and observation
• Individual construct a portfolio by layers (rather than a well-diversified portfolio as prescribed by TF)
• Each layer reflects a different expected return and risk
• BPT asserts that individuals tend to concentrate holdings in nearly risk-free and much riskier assets
• Allocation of funds to and investment of each layer depends on the importance of each goal to the investor
• HIGH RETURN = funds allocated to speculative assets
• LOW RISK = larger cash position and low risk bonds
• Risk averse investors will hold larger numbers of assets in each layer
• If an investor believes they have an information advantage, more concentrated positions wlil be held

Question 8

Adaptive markets hypothesis (AMH)

Answer 8

AMH

• assumes successful market participants apply heuristics until they no longer work
• adjust them accordingly
• i.e. success in the market is an evolutionary process
• those who do not or cannot adapt do not survive
• AMH assumes investors SATISFICE rather than maximise utility

Question 9

A rational decision maker will follow four self-evident rules or axioms

Answer 9

1) Completeness

Assumes individuals know their preferences and use them to choose between any two mutually exclusive alternatives

Given a choice between D or E, they could prefer D, E, or be indifferent

2) Transitivity

Assumes individuals consistently apply their completeness rankings. If D > E > F, then D > F

3) Independence

Assumes rankings are also additive and proportional

4) Continuity

Assumes utility indifference curves are continuous, meaning that unlimited combinations of weightings are possible.

If F > D > E, there will be a combination of F and E for which the individual will be indifferent to D