Chapter 3: Stochastic dominance and behavioural finance

Question 1

Absolute dominance

Answer 1

When one investment portfolio provides a higher return than another in all possible circumstances.

Question 2

1st order stochastic dominance (equations)

Answer 2

A will dominate B if:
Fa(x) <= Fb(x) for all x,
and Fa(x) < Fb(x) for some value of x.

Question 3

1st order stochastic dominance (description)

Answer 3

A will dominate B if the probability of portfolio B producing a return below a certain value is never less than the probability of portfolio A producing a return below the same value, and exceeds it for at least some value of X.

Question 4

Second-order stochastic dominance

Answer 4

Condition for A to dominate B is that:
int_a^x F_A(y) <= int_a^x F_B(y)

where a is the lowest return that the portfolios could possibly provide.

Question 5

Behavioural finance

Answer 5

looks at how a variety of mental biases and decision-making errors affect financial decisions.

Question 6

Contrarian fund

Answer 6

one that tends to take the opposite view of the rest of the market.

Question 7

Anchoring

Answer 7

Used to explain how people produce estimates.
They start with an initial idea of the answer (“the anchor”) and then adjust away from this initial anchor to arrive at their final judgement.

Question 8

Anchor value

Answer 8

the original estimate provided

Question 9

pre-anchor estimate

Answer 9

the mean estimate people make before being exposed to an explecit anchor.

Question 10

Prospect theory

Answer 10

Relates to how people make decisions when faced with risk and uncertainty.
It replaces the conventional risk-averse / risk-seeking decreasing marginal utility theory with a concept of value defined in terms of gains and losses relative to a reference point.
This generate utility curves with a point of inflexion at the chosen reference point.

Question 11

Framing

Answer 11

The way in which a choice is presented (“framed”) and, particularly the working of a question in terms of gains and losses, can have an enormous impact on the answer given or the decision made.

Question 12

Myopic loss aversion

Answer 12

Similar to prospect theory but considers repeated choices rather than a single gamble.
Research suggests investors are less risk-averse when faced with a multi-period series of “gambles”, and that the frequency of choice or length of reporting will also be influential.

Question 13

Representative heuristics

Answer 13

People find more probable that which they find easier to imagine.
As the amount of detail increases, its apparent likelihood may increase.

Question 14

Availability

Answer 14

People are influenced by the ease with which something can be brought to mind.
This can lead to biased judgements when examples of one event are inherently more difficult to imagine than examples of another.

Question 15

Hindsight bias

Answer 15

Events that happen will be thought of as having been predictable prior to the event;
Events that do not happen will be thought of as having been unlikely prior to the event.

Question 16

Confirmation bias

Answer 16

People will tend to look for evidence that confirms their point of view.

Question 17

Mental accounting

Answer 17

People show a tendency to seperate related events and decisions and find it difficult to aggregate events.
Rather than netting out all gains and losses, people set up a series of “mental accounts” and view individual decisions as relating to one or another of these accounts.

Question 18

Primary effect

Answer 18

People are more likely to choose the first option presented.

Question 19

Recency effect

Answer 19

In some instances the final option discussed may be preferred.
The gap in time between the presentation of the decision may influence this dichotomy.

Question 20

Status quo bias

Answer 20

people have a marked preference for keeping things as they are.

Question 21

regret aversion

Answer 21

by retaining existing arrangements, people minimise the possibility of regret.

Question 22

Ambiguity aversion

Answer 22

people are prepared to pay a premium for rules.

Question 23

Issues that influence people’s choices (8)

Answer 23

F - Framing
P - Primary effect
R - Recency effect
R - Regret aversion
I - People are more likely to select an intermediate option than one at either end.
S - Status-quo bias
M - More options tend to discourage decision-making.
A - Ambiguity aversion

Question 24

8 Themes of behavioural finance

Answer 24

F - framing (and question wording)
A - anchoring and adjustment
M - myopic loss aversion
E - estimating probabilities

P - prospect theory
O - overconfidence
M - mental accounting
O - effect of options