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CFA Level III > Session 3 - Behavioral Finance > Flashcards

Session 3 - Behavioral Finance Flashcards

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1
Q

Traditional vs Behavioural

A

1/ traditional
– normative (ideal) how individuals and markets should behave
- grounded in neoclassical economics
- indvls are: risk-averse, self-interested, utility maximized
- markets are: efficient, prices incorporate and reflect all information
2/ behavioral
– descriptive (actual)
– observed indvl and markets behaviors
– grounded in psychology
– neither assume rationality nor efficient markets

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2
Q

Behavioral indvl or market focus

A
  • 1/ individual focus (micro - BFMI)
    • biases/errors impact financial decisions
  • 2/ market focus (macro - BFMA)
    • defects and describes market anomalies
    • markets are subject to behavioral effects
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3
Q

Traditional view

A
  • rational
  • make decisions consistent with utility theory
  • revise expectations consistent with Bayes’ formula
  • self-interested, risk-averse, access to perfect information, process
    all available information in an unbiased way
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4
Q

Utility under Traditional View and Basic Axioms underneath

A
  • max PV of utility subject to a present value budget constraint
  • basic axioms:
    • completeness – well-defined preferences, ranked
    • transitivity – 𝐀≻𝐁,𝐁≻𝐂 ⇒𝐀≻𝐂
    • independence – 𝐀≻𝐁 ⇒ 𝐀 + 𝐱𝐂≻𝐁+ 𝐱𝐂
    • continuity - 𝐀≻𝐁,𝐁≻𝐂⇒𝐬𝐨𝐦𝐞𝐀+𝐂~𝐁
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5
Q

Bayes

A

– given new information, decision maker is assumed to update beliefs about probabilities
𝐏(𝐔𝟏|𝐑) = 𝐏(𝐑|𝐔𝟏)/𝐏(𝐑) 𝐱 𝐏(𝐔𝟏)

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6
Q

Rational Economic Man

A

– will try to obtain the highest possible economic well being (utility) given

  • budget constraints
  • available information
  • will not consider the well-being of others
  • Perfect Rationality, Perfect Self-Interest, Perfert Information
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7
Q

Perfect Rationality

A

ability to reason and make beneficial judgments at all times

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8
Q

Perfect Self-Interest

A

humans are perfectly selfish

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9
Q

Perfect Information

A

all investors know all things at all times

∴ will always make the best decisions

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10
Q

Risk-Aversion

A
  • utility functions are concave and show the diminishing marginal utility of wealth
  • risk evaluation reference-dependent
  • depends on the wealth level and circumstances of the decision-maker
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11
Q

Bounded rationality (under Behavioral view)

A

– choices may be rational but are subject to the limitations of knowledge & cognitive capacity (challenges perfect information)

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12
Q

Inner conflicts (under Behavioral view)

A
  • short-term vs. long-term goals

- individual vs. social goals

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13
Q

Altruism

A
  • challenges perfect self-interest
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14
Q

Prospect Theory/ Kahneman & Tuersky (79)

A
  • an alternative to expected utility theory
  • 2 phases to making a choice
  • preference for risk-seeking or risk-averse behavior determined by attitudes towards gains & losses
  • attitudes are defined relative to a reference point and not total wealth
  • people tend to be risk-averse when there is a moderate to high probability of gains or a low probability of losses
  • risk-seeking when there is a low probability of gains or a high probability of losses
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15
Q

Decision theory

A

– normative, concerned with identifying the ideal decision
- assumes decision-maker is fully informed, is able to make quantitative calculations with accuracy, and is perfectly rational

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16
Q

Simon (57) and satisficing

A
  • people are not fully rational when making decisions and do not necessarily optimize but rather satisfice
  • people have informational, intellectual, and computational limitations
  • stop when they have arrived at a satisfactory decision
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17
Q

Satisfice (satisfy & suffice)

A
  • cost & time of optimal outcomes too high
  • complexity builds
  • humans have ‘bounded rationality’
  • decisions need only be adequate, not optimal
  • individuals lack the cognitive resources to arrive at optimal solutions
    e. g.
  • typically do not know relevant probabilities
  • can rarely identify or evaluate all outcomes
  • have weak & unreliable memories
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18
Q

Traditional at the market level

A

– prices incorporate and reflect all relevant info.
- individual-level ⇒ market participants are rational economic beings acting in their own self-interest and making optimal decisions
- when new relevant info. appears, expectations are updated and freely available to all participants
∴ markets are efficient
– prices are correct (i.e. = IV)
– no abnormal returns (i.e. risk-adjusted)

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19
Q

Weak form market efficiency

A
  • no past price or volume info. can be used to generate abnormal returns
  • technical analysis will not generate excess return
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20
Q

Semi-strong market efficiency

A
  • all publicly available info. is reflected in prices - both TA & fund. the analysis will not generate excess r.
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21
Q

Strong Form market efficiency

A
  • all public & private info is fully reflected in prices

- inside info will not generate excess return

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22
Q

Challenges to efficient market hypothesis

A

1) fundamental (e.g. small-cap & value companies)
2) technical
3) calendar (e.g. January effect)

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23
Q

Portfolio construction under the Traditional approach

A

– mean-variance efficient

⇒ the optimal portfolio given the investor’s risk tolerance

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24
Q

4 Approaches under Behavioural

A

1/ a behavioral approach to Consumption & Savings/
2/ a behavioral approach to asset pricing/
3/ behavioral portfolio theory/
4/ adaptive markets hypothesis/ (AMH

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25
Q

Behavioral approach to Consumption & Savings/

A
  • people may focus on short-term satisfaction to the detriment of long-term goals
  • people classify sources of wealth as:
    1/ current income - high MPC (people lack self-control when it comes to current income)
    2/ currently owned assets
    3/ PV of future income - low MPC ∴ less likely to be consumed in short-term
  • people tend to frame their expenditure decisions taking into account their sources of wealth
  • spend current income first, then spend based on current assets, then future income
  • in contrast to the balance of short & long-term consumption plans of the life-cycle models
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26
Q

Behavioral approach to asset pricing/

A
  • behavioral stochastic discount factor-based (SDF-based) asset pricing
    models
    SDF ⇒ investor sentiment relative to fundamental value
  • discount factor = TVM + fundamental factors + sentiment factor
    = rf + fundamental premiums + sentiment premiums
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27
Q

Behavioral portfolio theory

A

– investors construct their portfolios in layers
Layer 1 – bonds, riskless assets
Layer 2 – investor is willing to take risk with residual wealth
Layer 3 – riskier, etc. …
➀ allocation to layers depends on investor goals (safety vs. growth)
➁ allocation within a layer depends on the goal set for the layer
➂ the more risk-averse, the less concentrated each position will be ⇒ greater the number of securities held
➃ concentrated positions result from a perceived informational advantage
➄ loss aversion may lead to holding losers that may offer no upside

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28
Q

Adaptive markets hypothesis

A

– applies principles of evolution to financial markets
(competition, adaptation, natural selection)
- successful participants will adapt to changing markets (greater competition for return) by changing strategies
- success = survival rather than maximizing utility
AMH = EMH + bounded rationality + satisficing + evolutionary principles
- individuals act in their own self-interest, make mistakes, learn and adapt - competition motivates adaptation and innovations
- natural selection and evolution determine market dynamics

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29
Q

Cognitive errors

A

– biases based on faulty cognitive reasoning

  • stem from basic statistical, information-processing or memory errors
  • are more easily corrected than emotional biases (better information, education, advice)
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30
Q

Emotional biases

A

– reasoning influenced by feelings or emotions

  • stem from impulse or intuition
  • are best adapted to – decisions are made that recognize and adjust for these biases
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31
Q

Belief perseverance biases

A
  • tendency to cling to one’s previously held beliefs irrationally or illogically (conservatism, confirmation, representativeness, illusion of control, hindsight)
  • related to cognitive dissonance – new information conflicts with previously held beliefs
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32
Q

How is Belief perseverance basis shown?

A

➀ Selective exposure – notice only information of interest
➁ Selective perception – ignore or modify info that conflicts with existing
cognitions
➂ Selective retention – remember and consider info that confirms existing cognitions

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33
Q

Conservatism bias

A

– inadequately incorporating new information
- overweight initial beliefs about probabilities
- under-react to new information
i.e. overweight the base rate (prior probabilities)
∴ may underreact or fail to act on new information and continue to maintain beliefs close to those based on previous estimates & information
- once a position has been taken, people find it very hard to move away from that view
- When movement does occur, it does so only very slowly

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34
Q

Consequences of Conservatism bias

A
  • maintain or be slow to update a view or forecast

- opt to maintain a prior belief

35
Q

Detection & Guidance of Conservatism bias

A
  • properly analyzing and weighting new information

- if info is cognitively costly (difficult to understand) seek advice from experts

36
Q

Confirmation bias

A

– people tend to look for and notice what confirms their beliefs and to ignore or undervalue what contradicts their beliefs

37
Q

Consequences of Confirmation bias

A
  • consider only positive information about an existing investment & ignore any negative info
  • develop screening criteria and ignore information that refutes the validity of the screening criteria
  • under-diversify portfolios (may hold on to stocks too
    long waiting for them to recover or work out)
38
Q

Detection & Guidance of Confirmation bias

A
  • activity seek out information that challenges your belief

- get corroborating support

39
Q

Representativeness Bias

A

– people tend to classify new info based on past experiences & classifications e.g. Stereo-typing

40
Q

Types of Representativeness Bias

A

base-rate neglect – categorization without considering
the probability
sample-size neglect – assume small samples are representative of populations
- both lead to:
- under-weight analysis of base rates, overweight importance/relevance of new information

41
Q

Consequences of Representativeness Bias

A
  • adopt a view or forecast based almost exclusively on new information or a small sample
  • update beliefs based on simple classifications
42
Q

Detection & Guidance of Representativeness Bias

A
  • be aware of statistical mistakes
  • think about the probability before classification
  • be sensitive to sample sizes
43
Q

Illusion of Control

A
  • people tend to believe that they can control or influence outcomes when, in fact, they cannot
44
Q

Consequences of Illusion of Control

A
  • overtrading, especially online investors - under-diversification
45
Q

Detection & Guidance of Illusion of Control

A
  • understand that you cannot control the market, only your reaction to it
  • keep a trade log/diary
46
Q

Hindsight Bias

A

see past events as having been predictable and reasonable to expect
- tend to remember our own predictions as having been more accurate

47
Q

Consequences of Hindsight Bias

A
  • overestimate the degree to which a prediction was accurate ⇒ leads to overconfidence
  • unfairly assess the performance of others (not give chance its fair due)
48
Q

Detection & Guidance of Hindsight Bias

A
  • understand why investments did or did not work vs. what you originally thought
49
Q

Biases that fall under Belief perseverance biases

A 
1/ conservatism
2/ confirmation
3/ representativeness
4/ illusion of control
5/ hindsight
50
Q

Information-processing biases

A

1/ Anchoring & adjustment bias
2/ Mental Accounting Bias
3/ Framing Bias
4/Availability bias

51
Q

Anchoring & adjustment bias

A

– when required to estimate a value with unknown magnitude, people generally begin by envisioning some initial default number (anchor) which they then adjust up or down to reflect subsequent information and analysis
– the adjustment is usually insufficient
- too much weight on the anchor
- relative comparisons are often easier than absolute figures
e.g. IV today vs. last estimate rather than some new absolute IV

52
Q

Consequences and Detection & Guidance of Anchoring & adjustment bias

A

Consequences - stick too closely to original estimates of value - hold too long or sell too early
Detection & Guidance/ - awareness

53
Q

Mental Accounting Bias

A
  • people will treat one sum of money differently from another equal-sized sum based on which mental account the money is assigned to
    e. g. current income, current assets, future income
54
Q

Consequences of Mental Accounting Bias

A
  • neglect of correlations among investments in different layers
  • neglect opportunities to reduce risk by combining assets with low correlation
  • neglecting total return
    – instead separating income from cap. gains
55
Q

Detection & Guidance of Mental Accounting Bias

A
  • awareness

- take a traditional portfolio approach

56
Q

Framing Bias

A
  • a person responds differently based on how the problem is framed
57
Q

Consequences of Framing Bias

A
  • misidentify risk tolerances
  • may choose suboptimal investments
  • focus on short-term price fluctuations
58
Q

Detection & Guidance of Framing Bias

A
  • reframe the problem

- try not to focus on gains vs. losses

59
Q

Availability bias

A

estimate probability based on how easily something comes to mind (rule of thumb, mental shortcut)
- easily recalled outcomes are perceived as more likely

60
Q

Sources of Availability Bias

A

• Retrievability – an answer or idea that comes to mind more quickly will likely be chosen as correct
• Categorization – if you can’t name an instance of something, may
conclude that the category is small
• Narrow Range of Experience – generalizing based on your experience, and
lack of experience
• Resonance – biased by how closely a situation parallels their own personal situation

61
Q

Consequences of Availability Bias

A
  • select investments/options based on recall & top-of-mind awareness
  • fail to consider international or alternative investments - fail to diversify
62
Q

Detection & Guidance of Availability Bias

A
  • develop an appropriate investment policy strategy

- focus on long-term results

63
Q

List of Emotional Biases

A 
1/ loss aversion
2/ overconfidence
3/ self-control
4/ status-quo
5/ endowment
6/ regret aversion
64
Q

Loss-Aversion Bias

A
  • people tend to strongly prefer avoiding losses as opposed to achieving gains (losses are significantly more powerful, emotionally than gains)
  • may lead to the disposition effect - selling winners too soon and holding losers too long
65
Q

Consequences of Loss-Aversion Bias

A
  • hold positions longer than justified by the fundamentals (∴ hold riskier portfolios)
  • sell investments in gains too early (∴ trade excessively)
  • both together limit upside potential of the portfolio
66
Q

Myopic loss aversion

A
  • an overemphasis on short-term gains & losses vs. a long-term view
  • may lead to more risk-averse choices
67
Q

Overconfidence bias

A

people demonstrate unwarranted faith in their own abilities, reasoning & judgement

  • may believe they are smarter and more informed than what they are (illusion of knowledge)
  • take credit for successes, blame external events for failures (self attribution bias, FAE)
    a) prediction overconfidence ⇒ incorporating far too little variation in their prediction
  • tend to underestimate downside risk
    b) certainty overconfidence ⇒ probabilities assigned to outcomes tend to be too high
68
Q

Consequences of Overconfidence bias

A
  • underestimate risks, overestimate returns
  • hold poorly diversified portfolios
  • trade excessively
  • experience lower returns than the market
69
Q

Detections & Guidelines of Overconfidence bias

A
  • keep a record of all trades & outcomes, review past performance, calculate portfolio return
  • conduct post-investment analysis on both winners and losers
70
Q

Self-Control Bias

A
  • people fail to act in pursuit of their long-term goals because of lack of self-discipline
71
Q

Consequences of Self Control Bias

A
  • save insufficiently for the future, which may lead to
    • accepting too much risk to catch up
    • asset allocation imbalances
72
Q

Detection & Guidelines of Self Control Bias

A
  • proper investment plan + budget
73
Q

Status Quo Bias

A
  • people do nothing instead of making a change

- largely the result of inertia rather than conscious choice

74
Q

Consequences of Status Quo Bias

A
  • maintain portfolios with risk characteristics that are inappropriate for their circumstances
  • fail to explore other opportunities
75
Q

Endowment Bias

A
  • people value an asset more when they have rights to it than when they do not
76
Q

Consequences of Endowment Bias

A
  • fail to sell off certain assets and replace them with other assets
  • maintain an inappropriate asset allocation
  • continue to hold classes of assets with which the investor may be familiar
77
Q

Regret-Aversion Bias

A
  • people tend to avoid making decisions that will result in action out of fear the decision will turn out poorly
  • may hold losing positions too long for fear the price may rise after they sell
  • error of comission – regret from an action taken
  • error of omission – regret from an action not taken
78
Q

Consequences of Regret-Aversion Bias

A
  • too conservative in investment choices as a result of poor past outcomes
  • engage in herding behavior – stay with that is popular
79
Q

Investment Policy & Asset Allocation

A

⇒ behavioral biases can and should be accounted for in the investment policy development and asset allocation selection process

  • can use goals-based investing (consistent with loss aversion and mental accounting)
  • financial goals: obligations & needs, priorities & desires, aspirations
  • investment characteristics: low risk, moderate risk, high risk
  • results in a diversified but not efficient portfolio
80
Q

High Wealth Level, Low SLR (standard of living risk) + emotional bias

A
  • Adapt
  • stronger asset allocation change
    +/- 10-15% per asset class
81
Q

Lower Wealth Level – High SLR + emotional bias

A

Moderate & Adapt
- modest asset allocation change
+/- 5-10% per asset class

82
Q

Lower Wealth Level – High SLR + Cognitive ERRORS

A
  • Moderate
  • close to rational asset allocation
    +/- 0-3% per asset class
83
Q

High Wealth Level, Low SLR High Wealth Level, Low SLR

A

Moderate & Adapt
- modest asset allocation change
+/- 5-10% per asset class

CFA Level III (12 decks)

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