Week 8- Behavioural Finance Flashcards
Why is traditional finance normative?
Traditional finance theory is normative because it indicates how
investors should make decisions. By contrast, the behavioural
finance approach is to understand why investors make the
observed decisions.
Why do behavioural finance proponents argue?
Behavioural finance proponents argue that investors frequently
make systematic errors and these errors can push the prices of
shares away from fundamental value for considerable periods.
What is the goal of behavioural finance?
Behavioural finance seeks to understand the market
implications of the psychological factors underlying investor
decisions and offers an alternative view of financial market
activity to the efficient market hypothesis.
What does Expected Utility Theory assume?
- Expected utility theory, which provides the basis for much of
modern finance theory, assumes that:
-people have complete information about possible
outcomes;
-the probability of these outcomes;
-can evaluate their preferences across different expected
options;
-then the optimal choice is determined by finding the highest
possible expected utility.
-people are risk averse, will take on risk if they receive
compensation.
what does Prospect theory: Tversky and Kahneman (1981) state?
- Expected utility theory is a normative model which describe how
people should behave, whereas actual behaviour provides the
basis for prospect theory. - People choose the course of action that satisfies their most
important needs, but the choice may not be optimal. “satisfice,”
rather than “optimize,”. - Optimal decision-making is limited because of cognitive
constraints and information availability. (ie not all investors are smart enough)
What is the utility function replaced by in prospect theory?
- The utility function is replaced by value function, which has a
reference point that is determined by the subjective impression
of the individual. - The value function shows the sharp asymmetry between the
value people put on gains and losses (loss aversion). Empirical
test show that losses are weighted about twice as heavily as
gain (losing £1 is twice as painful as the pleasure of gaining £1).
What is the shape of the value function in prospect theory? What does this show?
The value function is convex in the loss domain but concave for
gains. This reflects the observation that people’s choices reflect
risk taking when their decision involves losses, but risk aversion
for gains.
Why is the curve in the loss domain steeper than in the gain domain for prospect theory?
Loss aversion
How are traditional models in finance formulated?
Traditional models in finance are formulated as if the typical
decision maker is an individual who consider all relevant
information and comes up with the best decision. Anomalies
and their continued existence violate this assumption.
What is a heuristic? Why do they exist/why are they useful?
- Given that individuals face both cognitive and environmental
constraints, a heuristic is a useful rule‐of‐thumb or an intuitive
decision-making procedure that people can use for problem
solving. - The world is full of uncertainty and a person’s time is limited. A
decision needs to be made and a heuristic can promote
appropriate decision‐making under certain conditions, such as
a particular environment.
What are the 4 subsections of heuristics?
- Familiarity
- Representativeness
- Gamblers Fallacy
- Affect and feeling
Describe familiarity as a heuristic, what are the good bits?
- An investor chooses a stock to add to his portfolio from the
opportunity set that he knows or thinks he knows. This
strategy is wise if he is more likely to be familiar with stocks
that will perform well in the future. - Taking advantage of the information in the investor’s
environment can make heuristic‐based decision efficient and
optimal.
List 2 potential negatives of using familiarity as a heuristic:
- Home bias- investors are optimistic about their markets and
tend to favour that which is familiar. - Investing in the stocks of companies in which the investor
works. (ie Lehman brothers) - Both of these could lead to a lack of diversification
Describe representativeness as a heuristic
- People often assume that a particular person, object or outcome
is broadly representative of a larger class. - Judging things by how they appear rather than how statistically
likely they are.
What could be an issue between using representativeness as a heuristic?
People could mis interpret what is representative, ie the Linda Problem. This is called a conjunction fallacy- as people tend to associate the chances of events in conjunction being higher than the chance of a singular event.
When do people commit the Gambler’s Fallacy?
People commit the gambler’s fallacy when they assume that a
departure from what occurs on average, or in the long run, will be
corrected in the short run.
What is the issue with the Gambler’s Fallacy?
- Independent events: the odds of any specific outcome
happening in the next chance remine the same regardless of
what preceded it.
Explain the affects and feeling heuristic. Give an example:
The reliance on instinct instead of analysis in making decisions.
Instinct, intuition, and experience should be viewed as
complements to formal analysis, not substitutes.
Example: Firms with reputations for socially responsible policies or
attractive working conditions may generate higher affect in the
public perception.
List 4 kinds of behavioural biases
- Heuristics
- Framing
- Disposition effect
- Overconfidence
Some stocks seem to exhibit a pattern of short to
medium momentum, along with long-term reversal (see L7). What
might be the behavioural explanation to this?
Representativeness- where investors buy, and then continue to buy as others do, causing a price rise, but then eventually realise they have overreacted and sell, making the price revert back to its intrinsic value.
What does the framing effect refer to?
Framing effect refers to the observation that people’s choices
are inconsistent across different presentations of a choice.
Presentation, according to utility theory, should be irrelevant
given that preferences are assumed to be consistent.
Give an example of the framing effect
Example from Tversky and Kahneman (1981): A disease is
expected to kill 600 people and two alternative programmes
presented to two groups of people:
Group 1:
If Program A is adopted, 200 people will be saved.
If Program B is adopted, a 1/3 probability exists that 600 people
will be saved, and a 2/3 probability that no people will be saved.
Group 2:
If Program C is adopted, 400 people will die.
If Program D is adopted, a 1/3 probability exists that nobody will
die, and a 2/3 probability that 600 people will die.
Group 1 respondents choose A (72%), whereas group 2 choose
D (78%).
- Expected utility theory would predict that a rational economic
decision maker would consistently choose A and C if risk averse
and B and D if risk taking.
- Based on the behavioural finance perspective: when a
problem is presented in terms of gains, the majority is risk
averse but when a problem is presented in terms of losses, the
majority is risk taking.
According to framing, how may an investors perception of a choice change?
An investor’s perception of a choice may change by
manipulating the presentation of information
What is mental accounting?
- Specific form of framing in which people segregate certain
decisions. For example, an investor may take a lot of risk with
one investment account but establish a very conservative
position with another account that is dedicated to his/her child’s
education.
What is the dividend puzzle? What is this an example of?
- Dividend puzzle refers to investors’ irrational preference for
stocks with high cash dividends (why?). - A dividend pound is different to a capital pound because the
investor frames the pounds into two distinct mental accounts: - They feel free to spend dividend but would not dip into
capital.
What does the house money effect refer to?
The house money effect refers to gamblers’ greater willingness
to accept higher risk after winning. They frame the bet as being
made with their “winnings account,” and thus are more willing to
accept risk.
What is the effect of the house money effect on financial markets? Why?
The existence of house money effect in financial markets leads
to greater volatility in stock prices. After a price rise, investors
have a cushion of gains and are less averse to the risks.
What is the disposition effect?
- The disposition effect is the tendency to hold onto losing
investments too long, while selling winners too soon. This is
contrary to tax minimisation strategy. - A possible explanation for the disposition effect, as well as
prospect theory, is investors’ two emotions, regret and pride.
What can happen due to pride and regret? Which effect is usually stronger? Why?
- Fear of regret may underlie the disposition effect if it leads
investors to hold onto losers to avoid having to acknowledge
their loss and experience regret, while at the same time selling
stocks that have performed well and feeling prideful. - Pride and regret are flip sides of each other, but the negative
emotion evokes a stronger reaction, consistent with prospect
theory’s loss aversion.
Describe overconfidence:
Investors tend to exaggerate their talents and underestimate the
likelihood of bad outcomes over which they have no control.
What is the potential negatives of overconfidence?
- Overconfidence by investors would lead to excessive trading.
Barber and Odean (2001) show that men trade far more actively
than women and that high trading activity is highly predictive of
poor investment performance. - Fidelity Investments used recent data in 2020 and documented
that female investor traded only about one-half as frequently as
male, yet their average returns were 0.4% higher. - Such overconfidence may be responsible for the prevalence of
active versus passive investment management.
What is self-attribution bias?
Investors also suffer from self-attribution bias, attributing return
outcomes that are consistent with their predictions to their own
skill, but attributing outcomes that are inconsistent with those
predictions to bad luck. This reinforces their overconfidence.
What is confirmation bias?
Confirmation bias suggests that investor would be more likely to
look for information that supports his/her original idea rather than
seek out information that contradicts it.
Question: What might be the behavioural explanations for the
following?
A: When the news broke out in early 2020 about the potential
pandemic, market initially fell slightly.
B: The price of Bitcoin reached a record $20,000 in December
2017.
A- Confirmation bias, investors ignored all information that it may be a significant pandemic because they did not want to think that way.
B- Representativeness, ie herd behaviour.
Give the 3 ways in which the EMH defends itself against behavioural finance theories:
- Investors are rational and hence value securities rationally.
- Even if some investors are not rational, their irrationality is
random and irrational actions will cancel each other out without
impacting prices. Thus, market efficiency does not require
rational individuals- only countervailing irrationalities - Even if the majority of investors are irrational in similar ways
(not random), there will be rational arbitrageurs who eliminate
the influence of the irrational traders on prices.
What is arbitrage?
Arbitrage is the act of exploiting price differences on the same
security or similar securities by simultaneously selling the
overpriced security and buying the underpriced security.
What are limits to arbitrage?
- Fundamental Risk
- Noise Trader Risk
- Implementation Costs
- Limits to Arbitrage and the Law of One Price
Explain fundamental risk to arbitrage:
- Fundamental risk: exists because of the potential for rational
revaluation as new information arrives. - An arbitrageur believes a particular stock is overvalued in the
market, he/she would naturally short-sell the stock in the
expectation that the price will be lower later when he
purchases the stock to close the position. - New positive information might suddenly arrive, and the
price will rise and a loss will be incurred. - Therefore, an arbitrageur may limit trading because of fear
that the firm could perform unexpectedly well. - While price eventually should converge to intrinsic value, this
may not happen until after the trader’s investment horizon.
Give an example of fundamental risk to arbitrage:
Short squeeze example:
- A number of hedge funds in 2008 decided to sell VW shares
short in the expectation of buying them back at a lower price as
the automobile industry had a gloomy outlook.
- Porsche revealed that it had effectively gained control of 74%
of VW’s shares and 20% was held by the state of Lower
Saxony, 6% left in the market.
- Not enough stock available for the short sellers to buy back,
then in just two days VW share increased from €209 to a high
of €1,005.
The above example shows that prices will diverge even further
before they converge.
Explain Noise Trader Risk:
- Noise is opinion on value unrelated to fundamental information
(i.e., based on misinformation). - “wrong” prices might become even more wrong in the short run,
as price movements are driven by misinformation rather than
information. - Noise-trader risk is systematic, which means that it cannot be
diversified away. - The worsening of a mispricing could force the arbitrageur to
liquidate early and sustain steep losses. ‘Markets can remain
irrational longer than you can remain solvent’, Keynes.
Explain Implementation Cost risk:
short-selling is:
- Expensive: The cost of correcting a mispricing may exceed
the potential gain.
- Difficult or even impossible: lack of availability regardless of
fees.
- Legal factors: many pension or mutual fund managers face
strict limits on their discretion to short securities.
- All of the above will limit the ability of arbitrage activity to force prices
to fair value.
Explain Limits to Arbitrage and the Law of One Price and give examples of where it has failed:
Identical assets should have identical prices. However, this law
seems to have been violated in a number of occasions.
Example:
In 1907 Royal Dutch of the Netherlands and Shell of the UK agreed
to merge their business enterprises and split operating profits on a
60–40 basis.
Royal Dutch should sell for exactly 60/40=1.5 times the price of
Shell, since both companies participated in the same underlying
cash flows.
In 1993, Royal Dutch sells for more than 1.5 times Shell. Why not
buy relatively underpriced Shell and short sell overpriced Royal?
“Smart” investors might be limited in their ability to short-sell Royal,
but why anybody would buy overpriced Royal instead of Shell?
What is a bubble? Why isn’t it spotted as it occurs?
- A bubble is a situation where observed prices soar far higher than
fundamentals and rational analysis would suggest. - Bubbles are a lot easier to identify as such once they are over, while
they are going on, it is not as clear that prices are irrationally
exuberant.
Describe the Dot Com bubble:
- In 1994 we had 10,000 websites, in 1999 we had 9,500,000 active
websites and by 2020 we had 1.5 billion. - Many financial commentators during the dot-com bubble justified
the boom as consistent with glowing forecasts for the “new
economy.” - The FTSE 100 Index in the UK more than doubled in value from
3,000 at the beginning of 1994 to nearly 7,000 at the beginning of
2000. Over the next 3 years the index lost 50 per cent of its value. - In accord with behavioural patterns, investors were increasingly
confident of their investment expertise (overconfidence bias) and
apparently willing to generalise short-term patterns into the distant
future (representativeness bias)
Give advances and theories of behavioural finance:
- Behavioural capital asset pricing model (BAPM): The BAPM
assumes that beta is not a sufficient measure of risk and that risk
is not the only factor that determines returns. Statman (2010)
suggests that other Behavioural variables, such as a firm’s display
of social responsibility or social status derived from an association,
affect pricing. - Shefrin and Statman (2000) use mental accounting as a basis for
their Behavioural Portfolio Theory (BPT). Investors segregate
assets into layers, or mental accounts, depending on their
investment goals.
