The Behavioral Finance Perspective Flashcards
a contrast traditional and behavioral finance perspectives on investor decision making; b contrast expected utility and prospect theories of investment decision making; c discuss the effects of cognitive and knowledge capacity limitations on investment decision making; d compare traditional and behavioral finance perspectives on portfolio construction and the behavior of capital markets.
Traditional Finance
- Neoclassical Economics
Rational Investors and Efficient Markets
Rational Individuals - Individuals - Risk averse; self-interested utility maximizers
Efficient Market - Incorporates all the relevant and available information
Behavioral Finance
- Psychology
- Understand the investors and markets - assumptions based on observations.
Classification of Behavioral Finance
- Micro (BFMI) & Macro (BFMA)
BFMI
- examines behaviors that distinguish investor from rational investors
- relevant for investment managers/advisers
- behavioral biases effect the financial decisions
BFMA
- factors that differentiate the market from efficient market
- relevant for economist and fund managers
- markets are subject to behavorial effects.
Behavorial biases
- Cognitive Errors or Emotional biases
Cognitive Errors
- statistical, information processing or memory errors.
- based on faulty thinking
Emotional Biases
- impulse or intuition
- reasoning influenced by feelings
Traditional Finance Perspective on Individual Behavior
- Utility Theory and Bayes’ Formula
- Rational Economic Man
- Perfect Rationality, Self-Interest, and Information
- Risk Aversion
Utility Theory
- Max PV(utility) based on present value budget constraint
- Choose between risky and uncertain prospects by comparing their utility value
- Max their utility value - (weighted sum of utility values X expected probabilities)
- Rational decision makes decision as per the axioms of the theory
Utility
- Relative satisfaction from consumption of goods and services
- Based on utility not the price. Varies for individual based on circumstances and preferences
Axioms of Utility theory
- Completeness - can decide between two alternatives
- Transitivity - decides consistently
- Independence -
- Continuity -
Bayes’ Formula
- Probability of the utility outcome changed according to new information is explained by this formula.
Rationale Economic Man
- Will base his choice on his own utility and not well being of others
- Construct Curves of Consumption bundles amongst which he is indifferent (each curve - same utility)
Choses that curve that fits the budget constraint - Perfect rationality, self interest and perfect information
Perfect Rationality, Self - Interest and Information
- Rationality - rational thinker and has the ability to reason and make beneficial judgements
Self Interest - Selfish
In Competitive markets, it is assumed that all relevant info is reflected in prices.
Risk Aversion
Utility function are concave - diminishing marginal utility of wealth
Behavioral Finance Perspective on Individual Investors
Challenges the assumption of Traditional Finance
- Challenges to REM
- Utility maximization and counterpoint
- Attitudes toward risk
Challenges to REM
- Bounded Rationality - Relaxes the assumptions of expected utility theory and perfect information
Rational choices but subject to limitation of knowledge and cognitive capacity.
Utility Maximization and Counterpoint
- Using indifference curve analysis
Attitude towards Risk
- Individuals are not necessairly risk averse Eg: Buying lottery, insurance etc..
- Less income prefer certainty or risk that offers a large gain, Middle income people are more likely to be attracted by fair small gambles.
- Risk depends on indivudal wealth and circumstances
- Double inflection utlity function explains that investors are riskaverse when low income and really high income, in between they are risk seeking
Decision theory
Normative
Neuro-Economics
Neuroscience + Psychology + Economics to understand how people make decision
Bounded rationality
Informational intellectual and cpmputational limitations
People gather some information use heuristics to make the process of analysing information tractable and st when they have arrived at a satisfactory not optimal decision.
Decision that fit within the parameters they seem satisfactory
Satisfice - satisfy + suffice - adequate decisions
Aspirations are set according to past performances and can be upward and downward adjusted
Prospect Theory
- Alternative to utility theory
- describes how individuals make choices when faced with alternatives that involve risk and evaluate gains and losses
Two phases:
1. Editing phase where the prospects are framed
2. Evaluation: where the prospects are evaluated
Phases (Incomplete)
Phase 1 - Identify economically identical outcomes and then establish reference points and rate the prospects
- Use of heuritis effects how evaluation is made in the second stage
- alternatives ranked according to a basic heuristic
Six operations : codification combination segregation cancellation simplification and detection of dominance
Phase 2 - Evaluating the prospects. choosing the one with the highest value
Traditional Perspective on Market behaviour
Efficient Market Hypothesis
- Price is right
- No free lunch
Assumptions of EMH
Assumptions: 1 market participants are rational
2. Relevant information is freely available
Grossman-Stiglitz Paradox
- If the informantion cannot be gathered and processed the markets are not efficient
Forms of EMH
- Weak
- Semi - strong
- Strong
Anomoulus market
- Technical
- Fundamental
- Calendar
Limited Arbitrage
- Extended periods of inefficiency causes investors to withdraw funds resulting in premature closure and no returns.
Traditional Perspective on Portfolio Construction
- Mean Variance efficient
- A portfolio that is theoretically sound may fail to meet the needs because of behavioral circumstances
Behavioral Perspective on Market Behavior and Portfolio Construction
- A behaviorial approach to consumption and saving
- A behavioral approach to Asset Pricing
- Behavioral Portfolio Theory
- Adaptive Market Hypothesis
Behavioral Approach to Consumptions and Saving
- Behavioral Life Cycle: Self Control, Mental Accounting, Framing Biases
- Classify their wealth Current income Currently owned assets and present value of future income
“People lack self control when it comes to current income, saving increases with income.
Self Control
- Pursue short term goals to long term goals
Mental Accounting
- Two sum of money treated differently if they though interchangeable
Framing Biases
Respond differently to same question framed differently
Behavioral Approach to Asset Pricing
- behavioural stochastic discount factor based asset pricing models
- market sentiment major determinant of asset pricing
- discount rate captures the effects of time value of money, fundamental risk and sentiment risk.
Behavioural portfolio theory
- use probability weighing function
- layers and expectation of the of returns and attitude towards risk vary between layers
Factors affecting portfolio construction
- allocation depends on investor goals and importance attached to each goal.
- allocation within layer depends on the goal set for the layer
- number of assets in a layer depends on the investors utility function
- concentrated position in some security if the investor believes they have info advantage with respect to the secrurities
- investors reluctant to realise losses will hold higher amounts of cash
Explanation of BPT
- BPT investor can tolerate failure to achieve at least the aspirational level of wealth but only with a small probability
- bonds risk less assets and highly speculative assets..
Layers of BpT
- layer 1 bonds and risk less assets - seeks safety
Layer 2 willing to take risk with residual wealth
Implication of AMH
- Relationship between risk and reward change over a period of time due to change in risk preferences and such other factors
- Active management can add value by exploiting opportunities if arbitrage
- Any investment strategy will have period of superior and inferior performance
- Abiliti to adapt and innovate is important for survival
- Survival is an essential objective
