Behavioral Finance

Question 1

Investors are Rational

Answer 1

One of the four basic premises of traditional finance. Investor decisions are logical, centered on a clearly defined goal and free from the unsteady influences of emotion or irrationality, and take into account all available information.

Question 2

Markets are Efficient

Answer 2

One of the four basic premises of traditional finance. At any given time, a stock’s share price in the market incorporates and reflects all relevant information about that stock. Stocks are deemed at all times to trade at their fair value on stock exchanges.

Question 3

The Mean-Variance Portfolio Theory Governs

Answer 3

One of the four basic premises of traditional finance. Mean-Variance investors choose portfolios by viewing and evaluating mean returns and variance for their entire portfolios.

Question 4

Returns are Determined by Risk

Answer 4

One of the four basic premises of traditional finance. The CAPM is the basic theory that links return and risk for all assets by combining a risk-free asset with risky assets from an efficient market.

Question 5

Investors Are “Normal”

Answer 5

One of the assumptions of behavioral finance. Normal investors have normal wants and desires, but may commit cognitive errors (through biases or otherwise). Normal investors may be misled by emotions while they are trying to achieve their wants.

Question 6

Markets Are Not Efficient

Answer 6

One of the assumptions of behavioral finance. There can be deviations in price from fundamental value so that there are opportunities to buy at a discount or sell at a premium. As a result, markets can be tough to beat, but they are not efficient.

Question 7

The Behavioral Portfolio Theory Governs

Answer 7

One of the assumptions of behavioral finance. Under this theory, investors segregate their money into various mental accounting layers. This mental process occurs when people “compartmentalize” certain goals to be accomplished in different categories based on risk rather than viewing their entire portfolio as a whole. This may result in having very different risk preferences for the same value depending on the goal or situation.

Question 8

Risk Alone Does Not Determine Returns

Answer 8

One of the assumptions of behavioral finance. The Behavioral Asset Pricing Model determines the expected return of a stock using Beta, book to market ratios, market capitalization ratios, stock “momentum,” the investor’s likes or dislikes about the stock or company, social responsibility factors, status factors, and more.

Question 9

Affect Heuristic

Answer 9

Deals with judging something, whether it is good or bad. Do they like or dislike some company based on non-financial issues.

Question 10

Anchoring

Answer 10

Attaching or anchoring one’s thoughts to a reference point even though there may be no logical relevance or is not pertinent to the issue in question. Anchoring is also known as conservatism or belief perseverance.

Question 11

Availability Heuristic

Answer 11

When a decision-maker relies upon knowledge that is readily available in his or her memory, the cognitive heuristic known as “availability” is invoked. This may cause investors to overweight recent events or patterns while paying little attention to longer-term trends.

Question 12

Bounded rationality

Answer 12

When individuals make decisions, their rationality is limited by the available information, the tractability of the decision problem, the cognitive limitations of their minds, and the time available to make the decision. Decision-makers in this view act as “satisficers”, seeking a satisfactory solution rather than an optimal one. One consequence of this concept is that having additional information does not lead to an improvement in decision-making due to the inability of investors to consider significant amounts of information.

Question 13

Confirmation Bias

Answer 13

A commonly used and popular phrase is that “you do not get a second chance at a first impression.”People tend to filter information and focus on information supporting their opinions.

Question 14

Cognitive Dissonance

Answer 14

The tendency to misinterpret information that is contrary to an existing opinion or only pay attention to information that supports an existing opinion.

Question 15

Disposition Effect

Answer 15

Also known as Regret Avoidance or “faulty framing” where normal investors do not mark their stocks to market prices. Investors create mental accounts when they purchase stocks and continue to mark their value to purchase prices even after market prices have changed.

Question 16

Familiarity Bias

Answer 16

Investors tend to overestimate/underestimate the risk of investments with which they are unfamiliar/familiar.

Question 17

Gambler’s Fallacy

Answer 17

Investors often have incorrect understanding of probabilities which can lead to faulty predictions. Investors may sell stock when it has been successful in consecutive trading sessions because they may not believe the stock is going to continue its upward trend.

Question 18

Herding/Herd Mentality

Answer 18

This cognitive bias is explained just by looking at the word. People tend to follow the masses or the “herd.”

Herd mentality is the process of buying what and when others are buying and selling.

• Herd mentality leads to:
  
  • Buying high
  • Selling low

Question 19

Hindsight Bias

Answer 19

Another potential bias for an investor. Hindsight is looking back after the fact is known and assuming they can predict the future as readily as they can explain the past.

Question 20

Illusion of Control Bias

Answer 20

The tendency for people to overestimate their ability to control events; for example, it occurs when someone feels a sense of control over outcomes that they demonstrably do not influence.

Question 21

Overconfidence Bias

Answer 21

Usually concerns an investor that listens mostly to himself or herself, overconfident investors mostly rely on their skills and capabilities to do their own homework or make their own decisions. This effect causes many investors to overstate their risk tolerance.

Question 22

Overreaction

Answer 22

A common emotion towards the receipt of news or information.

Question 23

Prospect Theory

Answer 23

Provides that people value gains and losses differently and will base their decisions on perceived gains rather than perceived losses. Investors are “loss averse” and have an asymmetric attitude to gains and losses, getting less utility from gaining, say, $100 than they would lose if they lost $100. This explains why investors may avoid higher-risk investments even if they offer strong risk-adjusted returns. It also explains why they over-insure against risks through low deductibles.

Question 24

Recency bias

Answer 24

Giving too much weight to recent observations or stimuli; for example, focusing on short-term past performance. Occurs when priority and attention are given to current occurrences and events as opposed to consideration of long-term trends. Recency bias often causes one of two results; one believes that recent events will continue to repeat themselves or if time has passed, one may believe that the events are unlikely to occur again.

Question 25

Similarity Heuristic

Answer 25

Used when a decision or judgment is made when an apparently similar situation occurs even though the situations may have very different outcomes.

Question 26

Naïve diversification

Answer 26

The process of investing in every option available to the investor.

• This is common with 401(k) or other employer-sponsored retirement plans.
• A plan participant thinks they are adequately diversified if they invest an equal amount in all the funds.
• Also known as 1/n diversification.

Question 27

Representativeness

Answer 27

Thinking that a good company is a good investment without regard to an analysis of the investment.

Question 28

Familiarity

Answer 28

Causes investment in companies that are familiar, such as an employer.

• Clearly, this can cause devastating effects on a portfolio (e.g. Enron).

Question 29

Loss aversion

Answer 29

Suggests investors prefer avoiding losses more than experiencing gains.

• An unwillingness to sell a losing investment, in the hopes it will turn around.
• In other words, investors feel more pain from losses than enjoyment from gains.

Question 30

Socialization

Answer 30

The process of acquiring values, beliefs, and behaviors that are acceptable and or expected by society.

Question 31

Multicultural Psychology

Answer 31

Defined as “an extension of general psychology that recognizes that multiple aspects of identity influence a person’s worldview, including race, ethnicity, language, sexual orientation, gender, age, disability, class status, education, religious or spiritual orientation, and other cultural dimensions, and that both universal and culture-specific phenomena should be taken into consideration when psychologists are helping clients, training students, advocating for social change and justice, and conducting research.

Question 32

Social Consciousness

Answer 32

An awareness of and sense of responsibility for problems or injustices that exist within society.