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CFA Level III > Behavioral Finance > Flashcards

Flashcards in Behavioral Finance Deck (48)
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1
Q

Traditional Finance

A

how individuals should behave; efficient markets; utility theory with diminishing marginal returns (convex indiff curves)

REM - risk averse, rational expectations, asset integration

2
Q

Behavioral Finance

A

how individuals actually behave and make decisions to realize lifestyle-based objectives - need to consider loss aversion, biased expectations, asset segregation

  • micro = decisions of individuals
  • macro = why markets deviate from TF expectations
3
Q

Bayes’ Formula

A

Traditional Finance

incorporate new info into previous forecasts, helps the investment decision making process

4
Q

P(A|B)

A

Conditional probablity of A

Probability of A given B

5
Q

Bounded Reality

A

assumes knowledge capactiy limits and doesn’t assume perfect info/ rational decision making/ consistent utility maximization

SATISFICE - invest based on sufficient info to make a satisfactory investment (not necessarily optimal)

6
Q

Prospect Theory

A

framing decisions as either gains or loses and weighting uncertain outcomes

loss aversion: more willing to take uncertain risk of big loss, than more certain risk of small loss

  1. Editing phase
  2. Evaluation phase
7
Q

Evaluation Phase

A

value proposals in terms of weighted and probability-weighted outcomes to find exp utility

risk averse when presented with gains - tendency of indiv to overreact to small prob and underreact to large prob

8
Q

Weak-Form Efficient Market

A

current prices incorporate all past price and volume data

9
Q

Semi-Strong Form Efficient Market

A

prices reflect all public info, including past price and volume data

10
Q

Strong-Form Efficient Market

A

prices reflect all inside info, public info, and past price and volume data

11
Q

EMH Challenges

A

anomolies = inefficiencies in market

  1. Fundamental: returns to stock fundamentals
  2. Technical: past stock price and volume
  3. Calendar: January effect
12
Q

Consumption and Savings Model

A

mentally categorize wealth as income, assets, and present value of future income

end up spending more than saving

13
Q

Conservatism Bias

A

Cognitive Error - Belief

rationally form initial view, fail to include new info; too little/ much turnover

14
Q

Confirmation Bias

A

Cognative Error - Belief

look for into/ distort new info to support existing view

15
Q

Representative Bias

A

Cognitive Error - Belief

attach more importance to recent data than old data

  • base rate neglect (incorrect initial classification)
  • sample-size neglect (sample size too small)
16
Q

Illusion of Control Bias

A

Cognitive Error - Belief

think they can control or affect outcomes when they cannot

17
Q

Hindsight Bias

A

Cognitive Error - Belief

selective memory of when past events were known; only remember being right

self attribution bias: takes credit for successes and blames external events for failures

18
Q

Anchoring and Adjustment Bias

A

Cognitive Error - Info Processing

changes are made in relation to initial view

19
Q

Mental Accounting Bias

A

Cognitive Error - Info Processing

money treated differently based on categorization

20
Q

Framing Bias

A

Cognitive Error - Info Processing

decisions impacted by how data is “framed”

21
Q

Availability Bias

A

Cognitive Error - Info Processing

over emphasis on readily available info

22
Q

Loss-Aversion Bias

A

Emotional Bias

more pain from loss than joy form an equal gain; longer holding periods, less frequent trading

myopic loss aversion: widespread aversion causing marketwide underownership, holding down prices and increasing risk premiums (stocks)

23
Q

Overconfidence Bias

A

Emotional Bias

overestimate ability or reasoning; ego defense mechanisms (self-attribution bias)

24
Q

Self-Control Bias

A

Emotional Bias

lack self-discipline and favor immediate gratification over long-term goals (disposition effect)

25
Q

Status Quo Bias

A

Emotional Bias

content with existing situation, unwilling to make changes to investments

26
Q

Endowment Bias

A

Emotional Bias

asset believed to be worth more because it’s already owned

27
Q

Regret-Aversion Bias

A

Emotional Bias

  • do nothing b/c fear actions could be wrong
  • risk seeking behavior to reverse losses
  • disposition effect: winners are sold too soon and losing stocks are held too long
  • herding
28
Q

GBI

A

Goals Based Investing

investment tiers based on goals and appropriate levels of risk (obligations, low risk; desires, medium risk; aspirations, high risk)

29
Q

BMAA

A

Behaviorally Modified Asset Allocation

incorporate behavior biases in asset allocation; whether or not to moderate or adapt to biases (easier to moderate cognative biases than emotional biases and easier to moderate for clients with greater wealth)

30
Q

Codification

A

Editing Phase

assigns prob to outcomes

31
Q

Combination

A

Editing Phase

similify outcomes, combine identical for same option

32
Q

Segregation

A

Editing Phase

seperate risk free and risky returns

33
Q

Cancellation

A

Editing Phase

remove outcomes common to diff options

34
Q

Simplicifaction

A

Editing Phase

remove unlikely scenarios (1%)

35
Q

Detection of Dominance

A

Editing Phase

remove inherently inferior options

36
Q

Behavioral Asset Pricing Model

A

add sentiment premium to discount rate

  • how widely disputed opinions are for an asset
  • greater disparity = higher sentiment premium = higher interest rate = lower price)
37
Q

Behavioral Portfolio Theory

A

Alternative Behavior Model

layered portfolio; goals based investing

38
Q

Adaptive Markets Hypothesis

A

Alternative Behavior Model

adapt models, survival of the fittest

39
Q

Transitivity

A

Rational Decision Making Assumptions

consistently apply completeness rankings

40
Q

Completeness

A

Rational Decision Making Assumptions

know preferences and use them to chose between mutually exclusive choice

41
Q

Independence

A

Rational Decision Making Assumptions

rankings are additive and proportional

42
Q

Continuity

A

Rational Decision Making Assumptions

indifference curves are continuous

43
Q

Barnewall Two-Way Behavioral Model

A

investors are either

  1. Passive: did not risk own capital to gain wealth
  2. Active: risk own capital to gain wealth
44
Q

BB&K Five-Way Model

A

Bailard Biehl, and Kaiser five-way model

  • Guardian - careful, not confident
  • Individualist - careful, confident
  • Straight Arrow
  • Adventurer - not careful, confident
  • Celebrity - not careful, not confident
45
Q

Pompian Behavioral Model

A

behavioral investor types (BITs) based on active vs passive risk, risk tolerance, and biases

  1. Passive Preserver: passive, low risk, emotional bias
  2. Friendly Follower: passive, moderate risk, cognitive bias
  3. Independent Individualist: active, moderate risk, cognitive bias
  4. Active Accumulator: active, high risk, emotional bias
46
Q

Limitations to Classifying Investors into BITs

A
  1. people have both emotional and cognative biases
  2. hard to put in one category
  3. behaviors change as time passes
  4. people with same type should not always be treated the same
  5. people are do not always act rationally
47
Q

Benefits to Classifying Investors into BITs

A
  1. portfolios closer to the efficient frontier; resemble ones based on traditional finance theory
  2. more trusting and satisfied clients
  3. clients better able to stay on track w/ long-term plans
  4. better relationships between client and manager
48
Q

Bubbles and Crashes

A

unusual returns b/c panic buying and selling not based on economic fundamentals

Bubbly: prices for an asset class two SD from mean

Crash: fall in prices of 30% or more over months