Session 3 - Behavioral Finance Flashcards
Traditional vs Behavioural
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
Behavioral indvl or market focus
- 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
Traditional view
- 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
Utility under Traditional View and Basic Axioms underneath
- 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
Bayes
– given new information, decision maker is assumed to update beliefs about probabilities
𝐏(𝐔𝟏|𝐑) = 𝐏(𝐑|𝐔𝟏)/𝐏(𝐑) 𝐱 𝐏(𝐔𝟏)
Rational Economic Man
– 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
Perfect Rationality
ability to reason and make beneficial judgments at all times
Perfect Self-Interest
humans are perfectly selfish
Perfect Information
all investors know all things at all times
∴ will always make the best decisions
Risk-Aversion
- 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
Bounded rationality (under Behavioral view)
– choices may be rational but are subject to the limitations of knowledge & cognitive capacity (challenges perfect information)
Inner conflicts (under Behavioral view)
- short-term vs. long-term goals
- individual vs. social goals
Altruism
- challenges perfect self-interest
Prospect Theory/ Kahneman & Tuersky (79)
- 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
Decision theory
– 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
Simon (57) and satisficing
- 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
Satisfice (satisfy & suffice)
- 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
Traditional at the market level
– 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)
Weak form market efficiency
- no past price or volume info. can be used to generate abnormal returns
- technical analysis will not generate excess return
Semi-strong market efficiency
- all publicly available info. is reflected in prices - both TA & fund. the analysis will not generate excess r.
Strong Form market efficiency
- all public & private info is fully reflected in prices
- inside info will not generate excess return
Challenges to efficient market hypothesis
1) fundamental (e.g. small-cap & value companies)
2) technical
3) calendar (e.g. January effect)
Portfolio construction under the Traditional approach
– mean-variance efficient
⇒ the optimal portfolio given the investor’s risk tolerance
4 Approaches under Behavioural
1/ a behavioral approach to Consumption & Savings/
2/ a behavioral approach to asset pricing/
3/ behavioral portfolio theory/
4/ adaptive markets hypothesis/ (AMH
Behavioral approach to Consumption & Savings/
- 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
Behavioral approach to asset pricing/
- 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
Behavioral portfolio theory
– 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
Adaptive markets hypothesis
– 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
Cognitive errors
– 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)
Emotional biases
– 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
Belief perseverance biases
- 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
How is Belief perseverance basis shown?
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
Conservatism bias
– 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
Consequences of Conservatism bias
- maintain or be slow to update a view or forecast
- opt to maintain a prior belief
Detection & Guidance of Conservatism bias
- properly analyzing and weighting new information
- if info is cognitively costly (difficult to understand) seek advice from experts
Confirmation bias
– people tend to look for and notice what confirms their beliefs and to ignore or undervalue what contradicts their beliefs
Consequences of Confirmation bias
- 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)
Detection & Guidance of Confirmation bias
- activity seek out information that challenges your belief
- get corroborating support
Representativeness Bias
– people tend to classify new info based on past experiences & classifications e.g. Stereo-typing
Types of Representativeness Bias
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
Consequences of Representativeness Bias
- adopt a view or forecast based almost exclusively on new information or a small sample
- update beliefs based on simple classifications
Detection & Guidance of Representativeness Bias
- be aware of statistical mistakes
- think about the probability before classification
- be sensitive to sample sizes
Illusion of Control
- people tend to believe that they can control or influence outcomes when, in fact, they cannot
Consequences of Illusion of Control
- overtrading, especially online investors - under-diversification
Detection & Guidance of Illusion of Control
- understand that you cannot control the market, only your reaction to it
- keep a trade log/diary
Hindsight Bias
see past events as having been predictable and reasonable to expect
- tend to remember our own predictions as having been more accurate
Consequences of Hindsight Bias
- overestimate the degree to which a prediction was accurate ⇒ leads to overconfidence
- unfairly assess the performance of others (not give chance its fair due)
Detection & Guidance of Hindsight Bias
- understand why investments did or did not work vs. what you originally thought
Biases that fall under Belief perseverance biases
1/ conservatism 2/ confirmation 3/ representativeness 4/ illusion of control 5/ hindsight
Information-processing biases
1/ Anchoring & adjustment bias
2/ Mental Accounting Bias
3/ Framing Bias
4/Availability bias
Anchoring & adjustment bias
– 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
Consequences and Detection & Guidance of Anchoring & adjustment bias
Consequences - stick too closely to original estimates of value - hold too long or sell too early
Detection & Guidance/ - awareness
Mental Accounting Bias
- 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
Consequences of Mental Accounting Bias
- 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
Detection & Guidance of Mental Accounting Bias
- awareness
- take a traditional portfolio approach
Framing Bias
- a person responds differently based on how the problem is framed
Consequences of Framing Bias
- misidentify risk tolerances
- may choose suboptimal investments
- focus on short-term price fluctuations
Detection & Guidance of Framing Bias
- reframe the problem
- try not to focus on gains vs. losses
Availability bias
estimate probability based on how easily something comes to mind (rule of thumb, mental shortcut)
- easily recalled outcomes are perceived as more likely
Sources of Availability Bias
• 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
Consequences of Availability Bias
- select investments/options based on recall & top-of-mind awareness
- fail to consider international or alternative investments - fail to diversify
Detection & Guidance of Availability Bias
- develop an appropriate investment policy strategy
- focus on long-term results
List of Emotional Biases
1/ loss aversion 2/ overconfidence 3/ self-control 4/ status-quo 5/ endowment 6/ regret aversion
Loss-Aversion Bias
- 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
Consequences of Loss-Aversion Bias
- 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
Myopic loss aversion
- an overemphasis on short-term gains & losses vs. a long-term view
- may lead to more risk-averse choices
Overconfidence bias
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
Consequences of Overconfidence bias
- underestimate risks, overestimate returns
- hold poorly diversified portfolios
- trade excessively
- experience lower returns than the market
Detections & Guidelines of Overconfidence bias
- keep a record of all trades & outcomes, review past performance, calculate portfolio return
- conduct post-investment analysis on both winners and losers
Self-Control Bias
- people fail to act in pursuit of their long-term goals because of lack of self-discipline
Consequences of Self Control Bias
- save insufficiently for the future, which may lead to
• accepting too much risk to catch up
• asset allocation imbalances
Detection & Guidelines of Self Control Bias
- proper investment plan + budget
Status Quo Bias
- people do nothing instead of making a change
- largely the result of inertia rather than conscious choice
Consequences of Status Quo Bias
- maintain portfolios with risk characteristics that are inappropriate for their circumstances
- fail to explore other opportunities
Endowment Bias
- people value an asset more when they have rights to it than when they do not
Consequences of Endowment Bias
- 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
Regret-Aversion Bias
- 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
Consequences of Regret-Aversion Bias
- too conservative in investment choices as a result of poor past outcomes
- engage in herding behavior – stay with that is popular
Investment Policy & Asset Allocation
⇒ 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
High Wealth Level, Low SLR (standard of living risk) + emotional bias
- Adapt
- stronger asset allocation change
+/- 10-15% per asset class
Lower Wealth Level – High SLR + emotional bias
Moderate & Adapt
- modest asset allocation change
+/- 5-10% per asset class
Lower Wealth Level – High SLR + Cognitive ERRORS
- Moderate
- close to rational asset allocation
+/- 0-3% per asset class
High Wealth Level, Low SLR High Wealth Level, Low SLR
Moderate & Adapt
- modest asset allocation change
+/- 5-10% per asset class
