Topic 8 - Foundations of Behavioural Finance

Question 1

Behavioural finance attempts

Answer 1

to understand and explain actual investor and market behaviours versus theories of investor behaviour.

Question 2

traditional (or standard) finance

Answer 2

based on assumptions of how investors and markets should behave.

Question 3

The Efficient Market Hypothesis

Answer 3

contends that in a securities market populated by many well-informed investors, investments will be appropriately priced and will reflect all available information.

Question 4

There are three forms of the EMH:

Answer 4

Weak
Semi-Strong
Stron

Question 5

Weak EMH

Answer 5

contends that all past market prices and data are fully reflected in securities prices; that is, technical analysis is of little or no value.

Question 6

Semi Strong EMH

Answer 6

all publicly available information is fully reflected in securities prices; that is, fundamental analysis is of no value.

Question 7

Strong Form EMH

Answer 7

all information is fully reflected in securities prices; that is, insider information is of no value.

Question 8

key assumption of EMH

Answer 8

relevant information is freely available to all participants.

Question 9

If market is efficient

Answer 9

no amount of information or rigorous analysis can be expected to result in outperformance of a selected benchmark.

Question 10

Market Anomalies

Answer 10

security or group of securities performs contrary to the notion of efficient markets

Question 11

3 Types of Market Anomalies

Answer 11

Fundamental
Technical
Calender

Question 12

Fundamental Anomalies

Answer 12

Anomalies that emerge when a stock’s performance is considered in light of a fundamental assessment of the stock’s value

Question 13

Technical Anomalies

Answer 13

Anomalies which can be observed when using technical analysis techniques that attempt to forecast securities prices by studying past prices

Question 14

Calendar Anomalies

Answer 14

Anomalies that document evidence of systematic abnormal stock returns which appear to be related to the calendar, such as the day of the week, the week of the month, the month of the year, the turn of the month, holidays, and so forth.

Question 15

In reality, markets are neither

Answer 15

perfectly efficient nor completely anomalous.

Question 16

Homo-economicus, or rational economic man

Answer 16

assumes that principles of perfect self-interest, perfect rationality, and perfect information govern economic decisions by individuals.

Question 17

Most criticisms of Homo-economicus or rational economic man proceed by challenging these three underlying assumptions:

Answer 17

Perfect rationality

Perfect self-interest

Perfect information

Question 18

Perfect rationality

Answer 18

When humans are rational, they have the ability to reason and to make beneficial judgments.

Question 19

Perfect self-interest

Answer 19

Many studies have shown that people are not perfectly self-interested.

Question 20

Perfect information

Answer 20

Some people may possess perfect or near-perfect information on certain subjects. It is impossible, however, for every person to enjoy perfect knowledge of every subject.

Question 21

Bounded rationality

Answer 21

in decision-making, rationality of individuals is limited by the information they have, the cognitive limitations of their minds, and the finite amount of time they have to make a decision.

That is, decisions made by people are in many cases suboptimal - constrained by limitations in the human abilities to process information and compute the payoffs from outcomes accurately on a consistent basis.

Question 22

Standard Theory of Finance

Answer 22

Investors (“Homo Economicus”)

• Are perfectly rational beings
• Always behave in their self-interest
• Consider all information and accurately assess its meaning
• Some individuals/agents may behave irrationally or against predictions, but in the aggregate they become irrelevant (semi-strong or weak form)

Markets

• Quickly incorporate all known information
• Represent the true value of all securities

Question 23

But if we always behaved rationally…

Answer 23

• Nobody would ever sell investments in a panic at the first sign of trouble
• Nobody would ever buy investments (or other pseudo-investments) based on hunches, hot tips or media hype
• Nobody would ever keep money in the bank instead of using it to pay off high-interest credit card balances

Question 24

Behavioural Finance

Answer 24

is the study of the influence of psychology on financial decision making and it argues that emotions and information processing errors influence decision making

Question 25

Standard FInance v Behavioural Finance Assumptions

Answer 25

While standard finance grounds its assumptions in idealised financial behaviour, behavioural finance grounds its assumptions in observed financial behaviour

Question 26

Behavioural Finance provides an overlay to the Standard Theory of Finance by stating:

Answer 26

Investors (Behavioural Micro)

• Are not perfectly rational
• Are often not perfectly self-interested
• Often act based on imperfect information
• There are systematic patterns and cognitive errors that do not go away in the aggregate, such that there is a positive probability that the ‘marginal investor’ will exhibit a cognitive bias.

Markets (Behavioural Macro)

• May be difficult to beat in the long term
• In the short term, there are anomalies and excesses

Question 27

System 1

Answer 27

operates automatically, intuitively, involuntary, and effortlessly –
like when we drive, or read an angry facial expression.

Question 28

System 2

Answer 28

requires slowing down, deliberating, solving problems, reasoning, computing, focusing, concentrating, considering other data, and not jumping to quick conclusions
like when we calculate a difficult math problem, or fill out a complicated form.

Question 29

In everyday situations where judgement problems arise

Answer 29

System 1 provides intuitive answers that are rapid and associative.

The quality of these proposals is monitored by System 2, which applies rules and uses deduction to endorse, correct or override them.

Question 30

The problem is that even when we use System 2

Answer 30

System 1 can interfere to derail our decision making.

Question 31

Interplay between System 1 and 2

Answer 31

fundamental to understanding why we suffer from a range of behavioural biases.

Question 32

Heuristics

Answer 32

mental shortcut that allows people to solve problems and make judgments quickly and efficiently (associated with System 1).

Question 33

heuristic perceptions sometimes

Answer 33

result in mental mistakes and serious errors of judgement

Question 34

The availability heuristic

Answer 34

people assess the frequency of a probability of an event by which they can remember similar events or occurrences.

information that is recent or well publicised

Examples:
Overestimating the # of deaths caused by shark attacks each year following recent media coverage
Increased risk aversion to investing in equities following the GFC

Question 35

The representativeness heuristic

Answer 35

is the tendency to overgeneralise from a few characteristics or observations.

It is a mental shortcut which helps us make decisions by comparing information to our mental prototypes.

When we rely on representativeness to make judgments, we may judge wrongly because the fact that something is more representative does not actually make it more likely.

Question 36

Anchoring

Answer 36

occurs when an individual lets a specific piece of information control their cognitive decision-making process.

Question 37

Regardless how the initial anchors were chosen, people tend to insufficiently adjust

Answer 37

their estimates and produce approximations that are, consequently, biased

Question 38

For investors, anchoring

Answer 38

is the inclination to have a viewpoint and then apply it as a subjective reference for assessing future decisions.

Question 39

Base Rate Heuristic

Answer 39

Humans fundamentally struggle with understanding statistical information

These challenges can lead us to opt for the shortcuts we have developed—to look for similarity (representativeness) or recency (availability) of events rather than doing calculations

Question 40

Provide a definition of the ‘efficient market hypothesis’ that you might give to an individual or audience without any prior knowledge of finance or investing

Answer 40

The Efficient Market Hypothesis is an investment theory which state share prices accurately reflect all available information, and that new information is quickly incorporated in prices due to competition between informed market participants

Question 41

State the three forms of the EMH and identify the implications of each.

Answer 41

a) The “Weak” form, which contends that all past market prices and data are fully reflected in securities prices; that is, technical analysis is of little or no value.
b) The “Semi-strong” form, which contends that all publicly available information is fully reflected in securities prices; that is, fundamental analysis is of no value.
c) The “Strong” form, which contends that all information is fully reflected in securities prices; that is, insider information is of no value.

Question 42

Identify three types of market anomalies which contradict the EMH.

Answer 42

a) Fundamental Anomalies: Anomalies that emerge when a stock’s performance is considered in light of a fundamental assessment of the stock’s value.
b) Technical Anomalies: Anomalies which can be observed when using technical analysis techniques that attempt to forecast securities prices by studying past prices
c) Calendar Anomalies: Anomalies that document evidence of systematic abnormal stock returns which appear to be related to the calendar, such as the day of the week, the week of the month, the month of the year, the turn of the month, holidays, and so forth.

Question 43

Define the concept of ‘bounded rationality’ and explain how it challenges the notion of human rationality as implied by the concept of homo-economicus.

Answer 43

Bounded rationality is the idea that in decision-making, rationality of individuals is limited by the information they have, the cognitive limitations of their minds, and the finite amount of time they have to make a decision.
That is, bounded rationality challenges the assumptions implied by the concept of homo-economicus and contends that decisions made by people are in many cases suboptimal - constrained by limitations in the human abilities to process information and compute the payoffs from outcomes accurately on a consistent basis.

Question 44

Identify and explain the fundamental theoretical assumptions concerning investor and market behaviour that distinguish behavioural finance from traditional finance theories.

Answer 44

Standard or traditional finance assumes that participants, institutions, and markets are rational and that people consider all information, make unbiased decisions and maximize their self-interests. Markets quickly incorporate all known information, and accurately represent the true value of all securities
Behavioural Finance individuals are not perfectly rational, are often not perfectly self-interested, and often act based on imperfect information

Question 45

Briefly contrast the approach taken by macro behavioural finance versus micro behavioural finance.

Answer 45

Behavioural Finance Micro examines the systematic behaviours or biases of individual investors that distinguish them from the rational actors envisioned in classical economic theory.
Behavioural Finance Macro detects and describe anomalies in financial markets, which are inconsistent with standard theories of finance such as the efficient market hypothesis (EMH)

Question 46

Briefly explain dual process theory in relation to human judgement and decision making.

Answer 46

Dual process theory, describes how thought can arise in two different ways, or as a result of two different processes.
• Fast thinking System 1 operates automatically, intuitively, involuntary, and effortlessly.
• Slow thinking System 2 requires slowing down, solving problems, reasoning, computing, focusing, concentrating, considering other data, and not jumping to quick conclusions.

Question 47

What does ‘representativeness’ mean? Give an examples of empirical research (surveys, questions, experiments, etc.) that demonstrates that people may be subject to ‘representativeness’.

Answer 47

The representativeness heuristic is the tendency to overgeneralise from a few characteristics or observations. It is a mental shortcut which helps us make decisions by comparing information to our mental prototypes.

Question 48

Explain the concept of ‘base rates’ within the context of heuristics and decision making. Provide an example of how failing to consider base rates may lead to inaccurate predictions.

Answer 48

Base rate neglect is the tendency for people to mistakenly judge the likelihood of a situation by not taking into account all relevant data. It is a well-established concept in cognitive science, confirmed through extensive research.

Question 49

Identify common ‘anchors’ which client’s may use as a subjective reference when evaluating investments. What would be a more appropriate benchmark to use as an anchor?

Answer 49

Common investment anchors for comparative use include:
• Investment indices (All Ords, S&P 200)
• Media reports
• Other (financial) advisors
• The investment performance of neighbors, relatives, co-workers, etc.
A more appropriate benchmark may be the client’s financial plan, with investment performance and wealth accumulation evaluated relative to their previously identified personal goals and objectives