Week 8 Behavioural Finance

Question 1

What approach do value investors use to value a firm? What are their characteristics?

Answer 1

Price= NCF/E(R)
- They care most about net cashflows
- Not that concerned by E(R) as it is largely effected by market sentiment

Question 2

What is Neo-classical Finance?

Answer 2

Eugene Farm
A Model of investor behaviour
- Investors look to maximise return whilst minimising risk
- Investors are rational and unbiased in evaluating and acting on information

Question 3

What is behavioural Finance?

Answer 3

Richard Thaler
A model of investor behaviour largely based on psychology and economics
- A descriptively detailed model of investors

Question 4

What is the model paradox?

Answer 4

Simple models work best for complex phenomena
- Its not easy to limit the domain of a model

Question 5

What are the principles of behavioural finance?

Answer 5

1. The brain uses heuristics to cope with limited information and limited capacity
2. The brain creates mental short-cuts that work effectively in normal situations
3. In unfamiliar settings, they can mislead investors
4. Financial markets create lot of unfamiliar settings so the potential for mistakes are large

Question 6

What is the importance of information framing?

Answer 6

Framing refers to the context in which information is presented
It is important because the same information can be framed in different contexts resulting in different outcomes

Question 7

What are the 7 heuristics of behavioural finance?

Answer 7

1. Representative heuristics
2. Preference for familiarity
3. Anchoring & Adjustment Heuristic
4. Illusion of Truth
5. Availability Heuristic
6. Illusion of control
7. Mental accounting

Question 8

What is the representative heuristic?

Answer 8

The representative heuristic is the bias people create when judging the probability of a hypothesis
- Heavily influenced by framing

Question 9

What is the Preference for Familiarity heuristic?

Answer 9

The preference for familiarity heuristic is the bias that people tend to have higher confidence in things they are most familiar with.
- More information creates more confidence even if the information is not relevant
- People tend to refer to the most recent example of the event in question and undermine the probability of earlier outcomes

Question 10

What is the Anchoring and Adjustment Heuristic?

Answer 10

The anchoring and adjustment heuristic is the bias that information can cause a response to be anchored towards the first proposed idea

Question 11

What is the illusion of truth heuristic?

Answer 11

The illusion of truth heuristic is the bais that information that is easy to process is easier to believe
- Recurring presentations of information makes it more believable even if false

Question 12

What is the availability heuristic?

Answer 12

The availability heuristic is the bias that people are most likely to choose an option that is most prevalent in their mind

Question 13

What is the illusion of control heuristic?

Answer 13

The illusion of control heuristic is the tendency for people to overestimate their ability to control an event

Question 14

What is the mental accounting heuristic?

Answer 14

The mental accounting heuristic is the idea that people’s irrational actions may actually be rational given its context.

Question 15

What is the relationship between Investor recognition and stock returns? Which heuristic explains this?

Answer 15

The relationship between investor recognition and stock returns is that:
i) Stock returns are positively related to changes in investor recognition
ii) Future returns are negatively related to changes in investor recognition

• Returns change depending on their coverage by the media, then over time, returns correct as the attention fades
• Explained by the “availability heuristic” because the stock is more prevalent in an investors mind

Question 16

What are the two mechanisms of self-deception? What is an example?

Answer 16

1. People’s confidence intervals estimates are too low - 98% intervals only contain correct quantity 60% of the time
2. People are very bad at estimating possibilities
   Optimistic thinking: Systemic planning Fallacy - poor prediction of how long it takes to write an assignment

Question 17

What are the benefits of self deceptions

Answer 17

• They inflate other people’s views of their ability (illusion of control)
• underestimate the amount of negative feedback they receive
• There is a paradox that emotional over-ride of cost-benefit analysis to undermine risk gives a signal of commitment
  -Loss aversion (disposition effect): can be beneficial as the risk of losing something makes people fight harder to keep it rather than look for an alternative

Question 18

What is the Cassandra learning effect?

Answer 18

• the case of learning about something but you do not believe it or it does not apply to you

Question 19

What are the neo-classical critiques of behavioural finance?

Answer 19

• individual investor decisions are irrelevant as over the whole market, decisions are rational
• smart investors arbitrage away inefficiencies
• There is not unified theory for behavioural finance

Question 20

What are the behavioural finance critques of neo-classical finance?

Answer 20

• often markets are efficient but prices often deviate from fundamental value
• Limits to arbitrage imply that inefficiencies can exist
• Joint hypothesis problem: neo-classic theory is not scientific, rather is reshapes the story to make facts fit in a efficient model