SS3-Behavioral Finance Flashcards
Barnewall two-way behavioral model classifies investors as either:
1) Active investors - have risked their own capital to gain wealth & usually take an active role in investing their money
- much less risk averse than passive investors & willing to give up security for control over their own wealth creation
2) Passive investors - have not had to risk their own capital to gain wealth
- gained wealth through long steady employment & saving or inherited wealth
- ten to be more risk averse & have greater need for security
3 behavioral finance models that attempt to explain investor behavior
1) Barnewall two-way behavioral model
2) Bailard, Bhiel, & Kaiser (BB&K) five-way model
3) Pompian model
BB&K 2 dimensions of investors
1) Confidence - refers to the level of confidence exhibited when the individual makes decisions
- ranges from Confident to Anxious
2) Method of Action - measures the individuals approach to decision making (i.e. the speed at which they take action)
- ranges from Careful to Impetuous
BB&K 5 classifications of investors
1) Adventurer
2) Celebrity
3) Individualist
4) Guardian
5) Straight Arrow
Describe an adventurer investor
- confident & impetuous
- might hold highly concentrated portfolio
- willing to take chances
- likes to make own decisions
- unwilling to take advice
- advisors find them difficult to work with
- dangerous individual, looks at info quickly & makes trade
Describe a celebrity investor
- anxious & impetuous
- makes knee jerk decisions
- might have opinions but recognizes own limitations
- seeks & takes advice about investing
- easy to advise
Describe an individualist investor
- confident & careful
- very methodical
- like to make own decisions after careful analysis (less emotional)
- good to work with b/c they listen & process info rationally
Describe a guardian investor
- anxious & careful
- concerned with the future & protecting assets
- may seek the advice of someone they perceive as more knowledgable than themselves
Describe a straight arrow investor
- average investor (REM)
- neither overly confident nor anxious
- neither overly careful nor impetuous
- willing to take increased risk for increased expected return
Explain Traditional Finance
Prescribes how investors should make decisions (prescriptive).
Assumes investors exhibit risk aversion & make unbiased utility maximizing decisions that a REM would make.
Explain Behavioral finance.
It tries to explain why investors make the decisions they make (descriptive).
Assumes investors employ a combination of traditional finance & psychological biases when making investment decisions.
What are the 2 general categories of behavioral finance?
Describe them.
Micro behavioral - concerned w/ describing the decision-making process of individuals. Tries to explain why investors deviate from traditional finance.
Macro behavioral - why markets deviate from what we would term efficient in traditional finance.
A REM will make decisions conforming to the 4 Axioms of Utility. What are they?
1) Completeness
2) Transitivity
3) Independence
4) Continuity
Explain this Axiom of Utility: Completeness
Choices & preferences are known.
Can rank the order of investment choices.
Explain this Axiom of Utility: Transitivity
Rankings are applied consistently.
The choices that lie above the preferred choice are preferred to those below that choice.
Explain this Axiom of Utility: Independence
Utilities are additive & divisible.
If the investor prefers X to Y, adding any proportion (p) of Z, the investor will prefer (X+pZ) to (Y+pZ).
Explain this Axiom of Utility: Continuity
Indifference curves are smooth & unbroken.
If given 3 choices (L,M, & N), & the investor prefers L to M & M to N, then there must be some combination of L&N (portions a&b) that makes the investor indifferent between (aL + bN) and M.
Bayes’ formula
A conditional probability model.
With the receipt of new, relevant info, the rational investor will revise his expectations utilizing a this framework.
P(A|B) = {[P(B|A)] / P(B)}*P(A)
Explain Utility Theory
Traditional finance is based on this theory.
It assumes individuals base decisions on all available information. The rational investor will select the portfolio on the efficient frontier that provides the highest expected utility. This is the portfolio that lies at the tangency of the efficient frontier & the investor’s indifference curve.
Name the 3 types of investors in Utility Theory
Given two alternatives with the same expected return but different standard deviations:
1) Risk-averse
2) Risk-seeking
3) Risk-neutral
Describe a risk-averse investor
A rational investor who will always seek to maximize expected return for a given level of risk.
Concave utility function: decreasing marginal utility.
As the level of wealth (x axis) increases the marginal utility (y axis) derived from increasing wealth increases at a decreasing rate.
Describe a risk-seeking investor
An investor that would actually prefer (derive more utility from) the riskier alternative.
Convex utility function: increasing marginal utility
Describe a risk-neutral investor
An investor that acts as-if unaware of risk (considers only returns) & indifferent between the two alternatives
Linear utility function: constant marginal utility.
Explain Prospect Theory
This theory assumes investors analyze risk relative to possible gains & losses. Investors are more concerned with the change in wealth than they are in the resulting level of wealth. Investors are assumed to place a greater value on a loss than on a gain of the same amount. Investors tend to fear losses & can become risk seeking in an attempt to avoid them.
Prospect theory says investors make decisions in 2 phases:
1) Editing phase
2) Evaluation phase
In the Editing Phase of Prospect Theory, investors clarify their choices utilizing 6 steps:
1) Codification
2) Combination
3) Segregation
4) Cancellation
5) Simplification
6) Dominance
Editing phase: Codification
investor “codes” outcomes as gain/loss & assigns a probability to each
(what step of editing phase?)
Editing phase: Combination
investor combines outcomes w/ identical values
like combining projects
(what step of editing phase?)
Editing phase: Segregation
investor separates the certain & uncertain components of a gamble
(what step of editing phase?)
Editing phase: Cancellation
identical outcomes between choices can be eliminated.
Can lead to the preference anomaly the Isolation Effect.
(what step of editing phase?)
Editing phase: Simplification
investor will tend not to think in precise probabilities
what step of editing phase?
Editing phase: Dominance
dominated choices are eliminated
what step of editing phase?
What is the isolation effect?
Can arise from the cancellation step of the editing phase.
Investors focus on one factor or outcome while consciously eliminating or subconsciously ignoring others. It is an anomaly b/c it can lead to different editing &, hence, different decisions.
In the Evaluation Phase of Prospect Theory,…
(In this phase)…investors place values on alternatives in terms of expected utility: the probability-weighted average of the utilities of possible outcomes.
Utility alternative = PxUx + PyUy + PzUz
Calculating utility in this manner overlooks subjectivity.
Explain Subjective Probability Weighting & how to calculate it.
Individuals tend to overweight to low-probability events (e.g. extreme gains/losses) and underweight to higher probability events.
This can be incorporated into an individual’s expected utility expression:
Subjective utility (alternative i) = wPxUx,i + wPyUy,i + wPzUz,i
