Revised Behavioural Finance

Question 1

What are the basic differences between traditional and behavioural finance?

Answer 1

1. Traditional is normative (ideal), behavioural is descriptive (actual)
2. Traditional assumes risk averse, self interested, utility maximizing, and rational people.
3. traditional assumes markets are efficient in that prices incorporate all information
4. Behavioural does not assume these things.

Question 2

What is the basic difference between a cognitive error and an emotional bias?

Answer 2

Cognitive errors are processing errors (stats, memory, etc) whereas emotional biases are based on intuition and impulses.

Question 3

What are the basic axioms of utility theory?

Answer 3

1. Completness - well defined preferences that are ranked
2. Transitivity - If a>b and b>c, a>c
3. Independence - when goods are consumed together preferences still hold. If you like win better than beer, adding nachos will not affect this.
4. Continuity - some combination of goods can be added to equal the utility of a third good.

Question 4

What will the rational economic man try to accomplish?

Answer 4

1. Highest utility
2. Does not consider the well being of others
   They are perfectly rational, perfectly self interested, and have perfect information

Question 5

What is the concept of bounded rationality?

Answer 5

This is that choices may be rational but are subject to limitations on knowledge and cognitive capacity

Question 6

What are the two phases of prospect theory?

Answer 6

1. Alternatives are ranked basic on heuristics (rather than algorithmically) - how alternatives are framed will determine this, thus it is called framing
2. Evaluation - what should we do?

Question 7

What are the basic conclusions we can take from prospect theory?

Answer 7

1. Risk preferences are determined by attitudes towards gains & losses
2. People are risk averse when there is a high probability of gains or a low probability of losses.
3. Most people gamble when there is a low probability of gains and high probability of losses

Question 8

What is satisficing? Why do we do it?

Answer 8

This is when you stop analyzing when you arrive at a satisfactory answer

1. We do not have the cognitive resources
2. We have bad memories
3. Cost and time is too high

Question 9

What are the two primary conclusions of efficient markets?

Answer 9

1. Prices are correct

2. No abnormal returns

Question 10

How can you test for EMH?

Answer 10

Weak form - are prices serially correlated?
Semi strong - event studies
Returns on active management

Question 11

What are some common challenges to EMH?

Answer 11

1. Factor outperformance
2. Chart patterns
3. Calendar anomalies
   there is a joint hypothesis problem - when you find anomalies, you just create a new pricing model

Question 12

What are the four basic market behaviour theories based on behavioural finance?

Answer 12

1. Consumption and savings - people will frame their expenditures based on their sources of wealth
2. Asset pricing - Investor sentiment is a stochastic discount factor - add to the discount rate used in modelling
3. Behavioural portfolio theory - people construct portfolios in layers of risk
4. Adaptive markets hypothesis - markets change over time

Question 13

What are the five characteristics of the behavioural portfolio theory?

Answer 13

1. Allocation to layers depends on goals and their importance
2. Allocation within a layer depends on goal set for the given layer - a higher goal means more risk
3. More risk aversion means less concentration and more positions. Diversification is based on utility curves
4. Concentration in positions is a result of perceived informational advantages
5. Loss aversion leads to holding losers longer and holding cash so they don’t need to realize losses
   In general, BPT contend that people maximize expected wealth subject to a safety constraint. This leads to a portfolio that looks like and insurance policy and a lottery ticket

Question 14

What are the practical conclusions drawn for the adaptive market hypothesis?

Answer 14

1. Successful participants adapt
2. Success is survival, not maximizing utility
3. Competition will motivate innovation

Question 15

How should you treat cognitive errors compared to emotional biases?

Answer 15

Cognitive biases are easily corrected, whereas emotional biases are sticky and require adaptation

Question 16

What is a belief perseverance bias?

Answer 16

This is a cognitive bias where we cling to previously held beliefs. This includes..

1. Conservatism
2. Confirmation bias
3. Representativeness
4. Illusion of control
5. Hindsight bias

Question 17

What is conservatism bias? What are the consequences? How do we detect and guide it?

Answer 17

This is a cognitive, belief perserverance bias where we do not update our beliefs for new information. This is when we overweight a base rate. We will be slow to update our views. We will hold losing positions and may add to them. We do not want to incur the mental stress of updating which means we cling to prior beliefs. We can ensure we properly analyze new information and consult experts. We must ask “How does this information change my forecast?” We can avoid retaining old forecasts as the basis for new forecasts.

Question 18

What is confirmation bias? What are the consequences? How do we detect and guide it?

Answer 18

This is a cognitive, belief perservearance bias where we tend to look for info that confirms our current beliefs and ignore the rest. Consequences are creating bad screening criteria, under diversifying portfolios. We must actively seek out opposing points of view.

Question 19

What is representativeness bias? What are the consequences? How do we detect and guide it?

Answer 19

This is a cognitive, belief perserverence bias where we classify new information based on our past experience or recent experience. This can cause us to ignore base rate probabilities of things normally happening and ignoring sample sizes.
This results in adopting views and forecasts based on small sample sizes. This will result in unjustified portfolio turnover. This could also lead to higher manager turnover as investors are constantly changing. We must be aware of small samples and think of probability before classifying events. We must ask what the actual probability of new information being grouped in with old information should be.

Question 20

What is the illusion of control bias? What are the consequences? How do we detect and guide it?

Answer 20

This is a cognitive, belief perserverance bias where we believe that we have more control over events than possible. This leads people to overtrade, be over concentrated.

Question 21

What is the hinsdight bias? What are the consequences? How do we detect and guide it?

Answer 21

This is a cognitive, belief perserverance bias where we see past events as being predictable and reasonable to expect. This leads to us remember our right predictions. We will then have overconfidence. We will overestimate the degree to which we predicted things. We will unfairly assess the performance of others. We must understand why things happened before making a judgement.
This can be combatted by asking yourself whether you’re rewriting history or being honest about mistakes. it can also be combatted by recording and reviewing decision making.

Question 22

What is the anchoring and adjustment bias? What are the consequences? How do we detect and guide it?

Answer 22

This is a cognitive, information processing bias where we stick to previous estimations and adjust up or down rather than revaluating the number. This will cause us to stick too closely to original estimates.

Question 23

What is the mental accounting bias? What are the consequences? How do we detect and guide it?

Answer 23

This is a cognitive, information processing bias where we treat different fungible amounts of money differently. It will cause us to neglect total return numbers and neglect correlation between buckets of money. It will also cause investors to completely miss out on asset classes that could reduce overall portfolio diversification.
The ways to combat this are to combine all assets together to show the client and incorporate this into their portfolio allocations.

Question 24

What is the framing bias? What are the consequences? How do we detect and guide it?

Answer 24

This is a cognitive, information processing bias where we respond differently to the same situation depending on how it is presented. This may cause us to misidentify risk tolerances and focus on short term price fluctuations. It will cause us to choose suboptimal investments.
To solve, ask:
1) Am i doing this based on whether this position is in a gain or loss?
2) Is this decision based on sunk costs?
3) What are the objective future prospect?

Question 25

What is the availability bias? What are the consequences? How do we detect and guide it?

Answer 25

This is a cognitive, information processing bias where we estimate the probability of an event based on how easily something comes to mind. This comes from issues with retrievability, categorization, narrow ranges of experience, and resonance.
This means we are more likely to base decisions on advertising, limit the opportunity set to the familiar, fail to diversify outside of what we know, and invest in things similar to what we like.
The best way to overcome this is to develop an appropriate IPS, carefully analyze decisions before making them, and be very focused on long term results.

Question 26

What is the loss aversion bias? What are the consequences? How do we detect and guide it?

Answer 26

This is an emotional bias where people tend to strongly prefer avoiding losses to achieving gains. This will lead to selling winners too soon and holding on to losers too long. This can manifest in myopic loss aversion (short term focus). It may lead to more risk averse choices. It will result in risk aversion on the up side and risk seeking on the downside. You must focus on fundamental analysis and consider real probabilities to guide rational decisions.

Question 27

What is the overconfidence bias? What are the consequences? How do we detect and guide it?

Answer 27

This is an emotional bias where people demonstrate unwarranted faith in their own abilities. This could mean that you have overconfidence in your predictions or your conviction. You will have the illusion of knowledge and have the fundamental attribution bias. We will underestimate risk and not diversify. We will trade excessively.
This can be corrected by…
1) Reviewing trading records
2) Post trade analysis of why you made money
3) Make note of common mistakes or tendencies

Question 28

What is the self-control bias? What are the consequences? How do we detect and guide it?

Answer 28

This is an emotional bias where people fail to act in pursuit of their long term goals because they don’t have self discipline. They may not plan for the future, which could lead to them trying to catch up by taking additional risks. This can be counteracted by ensuring you have a proper investment plan and asset allocation from the onset.

Question 29

What is the status-quo bias? What are the consequences? How do we detect and guide it?

Answer 29

This is an emotional bias where people do nothing instead of making a logical change. This causes people to maintain inappropriate portfolios for their circumstances. They will also miss out on exploring other opportunities.
This can be combatted through education and quantification.

Question 30

What is the endowment bias? What are the consequences? How do we detect and guide it?

Answer 30

This is an emotional bias where people value their own assets more than they would if they were not their own. This may cause us to hold on to assets too long.

Question 31

What is the regret aversion bias? What are the consequences? How do we detect and guide it?

Answer 31

This is an emotional bias where people tend to avoid situations where they may have regret. This is composed of errors of commissions - we actually did it, and omissions - we didn’t do it.

Question 32

What are the four situations within the behaviourally modified asset allocation framework and how should we treat them?

Answer 32

1. High wealth and cognitive errors - we should moderate and adapt by making a modest asset allocation change
2. high wealth and emotional biases - we should adapt and make more significant asset allocation changes
3. Low wealth and cognitive errors - we should moderate and not shift SAA
4. Low wealth and emotional biases - moderate and adapt - modest SAA changes

Question 33

What are the two categories of the Barnewell Two-way model? What do they mean?

Answer 33

1. Passive. These people did not get wealthy by risking their own capital, or just have less money. They have a much greater need for security.
2. Active. They took risk to get wealthy. Their need for security is lower. They care about control.

Question 34

What are the categories of the 5 way personality model?

Answer 34

There is a chart with two axes - Confident to anxious and careful and impetuous.

1. Adventurer - high confidence and impetuous. They do not take advice and take too much risk
2. Celebrity - they are impetuous but anxious and will hire a professional as they know their limitations
3. Guardian - they are anxious and careful. They may seek advice but are very cautious.
4. Individualist - they are confident and careful. They are easy to advise and will process information rationally.
5. Straight arrow.

Question 35

What are the four categories of the bevhavioural investor types philosophy? Describe their risk tolerance and biases. How do they make decisions?

Answer 35

1. Passive Preserver - this is a passive type who have primarily emotion biases. They have a low risk tolerance. They make decisions slowly and don’t like change. As people age and wealth grows, they move to this point. What is the big picture?
2. Friendly Follower - this is a passive type with a moderate risk tolerance. They have primarily cognitive biases. They will behave herd behaviour and overestimate their risk tolerance.
3. Independent Individualist - this is an active type who has primarily cognitive biases. They have a med-high risk tolerance. They trust their gut and are often contrarian.
4. Active Accumulator - this is an active type who takes a lot of risk and has emotional biases. They are entrepreneurial and will chase returns.

Question 36

What are the issues with behavioural investor types?

Answer 36

1. Investors will exhibit a range of biases and categories
2. Changes over time
3. Clients are unique
4. Investors are irrational at different times

Question 37

What are the biggest benefits to using a behavioural investor framework?

Answer 37

1. Understand the financial goals and emotions behind them
2. Advisor maintains a systematic approach
3. Advisor invests as the client expects and results take into account the clients characteristics.
4. Clients feel understood

Question 38

What are some common issues that behavioural biases cause in portfolio instruction?

Answer 38

1. Inertia & default - people don’t want to change over time, set it and forget it.
2. Naïve diversification
3. Investing in familiar due to overconfidence
4. Excessive trading
5. Home bias

Question 39

How do analysts suffer from behavioural biases?

Answer 39

1. Overconfidence driven by the illusion of knowledge, self attribution, and hindsight bias
2. Confirmation bias
3. Gambler’s fallacy - expecting reversion to the mean
4. Management biases in financial reporting

Question 40

How do we protect analysts from behavioural biases?

Answer 40

1. Proper documented feedback
2. Documents decisions and reasons in real time
3. Make the counter arguement
4. Maximize the amount of comparable data
5. Minimize the amount of non-comparable data

Question 41

How do investment committees suffer from behavioural biases?

Answer 41

Groups may mitigate some biases, but create others…

1. Social proof bias (groupthink)

Question 42

How do we protect investment committees from behavioural biases?

Answer 42

1. Diverse views
2. Culture of tolerance to dissenting views
3. Members are actively contributing

Question 43

What are some behavioural explanations for bubbles and crashes?

Answer 43

1. Overconfidence
2. Confirmation bias
3. Self-attribution bias
4. Regret aversion
5. Illusion of knowledge