Behavioral Finance

Question 1

definition of behavioral finance

Answer 1

explain observed investor and market behavior;

investors are not rational; markets are not efficient

Question 2

definition of traditional finance

Answer 2

theory about how investors and markets behave

Investors are rational and markets are efficient

Question 3

explain Raiffa Decision Analysis

Answer 3

3 types:
Normative
Descriptive
Prescriptive

Question 4

explain Normative Analysis

Answer 4

rational solution is the “ideal “ that actual decision makers should strive for (assumption of traditional finance: Expected Utility & Decision Theory)

Question 5

explain Descriptive Analysis

Answer 5

describes the way real people actually make decisions (i.e., behavioral finance: Prospect Theory; Bounded Rationality)

Question 6

explain Prescriptive Analysis

Answer 6

practical advice and tools that help achieve results of normative analysis (use of behavioral finance in practice)

Question 7

describe a rational investor

Answer 7

risk-avers, self-interested, utility maximizer

Question 8

describe an efficient market

Answer 8

all information is priced into market prices and changes

Question 9

describe behavioral finance micro (BFMI)

Answer 9

focuses on differences between actual investor and the rational investor

Question 10

describe behavioral finance macro (BFMA)

Answer 10

focuses on differences between actual markets and efficient markets

Question 11

what kinds of behavioral biases does BFMI suggest impact the financial decisions of individual investors?

Answer 11

cognitive errors; emotional biases

Question 12

Utility Theory is…

Answer 12

people maximize the present value of utility, subject to a present value budget constraint, such that utility is the level of relative satisfaction received from consumption of goods and services

Question 13

What are the axioms of Utility Theory?

Answer 13

completeness
transitivity
independence
continuity

Question 14

What is Bayes’ formula

Answer 14

P(A given B) = P(A) * P(B given A)/P(B)

explains how existing probability beliefs should be changed given new information

Question 15

Rational Decision Making

Answer 15

1. Adhere to axioms of utility theory
2. Assign a probability measure to possible events
3. incorporate new information according to Bayes’ formula
4. Choose action that maximizes utility function subject to budget constraints with respect to conditional probability measure

Question 16

Explain Rational Economic Man (REM)

Answer 16

REM will try to obtain highest possible economic well-being or utility given budget constraints and available info. will base choices on consideration of own personal utility, not that of others except if it impacts his own

Question 17

Utility function of risk-neutral individuals

Answer 17

risk-neutral individuals have linear utility functions

Question 18

utility function of risk-averse individuals

Answer 18

risk-averse individuals have concave utility functions (arch) - diminishing marginal utility of wealth [rational investor]

Question 19

utility function of risk-seeking individuals

Answer 19

risk-seeking individuals have convex utility functions (bowl) - increasing marginal utility of wealth)

Question 20

Describe Bounded Rationality

Answer 20

Bounded rationality assumes that individuals’ choices are rational but subject to limitations of knowledge and cognitive capacity
- decision maker may violate a commonly accepted precept of rational behavior but acts in a manner consistent with pursuit of set of goals

Question 21

Describe Prospect Theory

Answer 21

Prospect Theory assigns values to gains and losses rather than to final wealth, and probabilities are replaced by decision weights. Shape of decision maker’s value function is assumed to differ between the domain of gains and the domain of losses: (reference dependent). Loss-Averse investor

Stage 1: Framing/Editing
Stage 2: Evaluate

Question 22

Describe Decision Theory

Answer 22

assumes decision maker is fully information, is able to make quantitative calculations with accuracy and is perfectly rational

Question 23

Describe Mental Accounting

Answer 23

people classify wealth into different accounts to accommodate the competing goals of short-term gratification and long-term benefits

Question 24

describe Behavioral Stochastic Discount Factor Model (SDF)

Answer 24

market sentiment causes asset prices to deviate from values determined using traditional finance

Question 25

describe 5 factors of Behavioral Portfolio Theory (BPT)

Answer 25

1. Layers of risk are assigned allocations depending on goals 2. allocation of funds within each layer will depend on goal of layer 3. number of assets depends on utility function (risk-averse investors will have more securities) 4. concentration may occur from belief in information advantages 5. loss-aversion causes investors to hold cash or other certain securities

Question 26

describe Adaptive Markets Hypothesis (AMH)

Answer 26

markets are influences by competition for scarce resources and adaptability of participants: - risk premiums change over time - active mgmt adds value - particular strategies will not always do well - ability to adapt and innovate is key to survival - survival is essential objective

Question 27

What are the guidelines for determining a behaviorally modified portfolio?

Answer 27

1. Moderate the less wealthy and adapt to the more wealthy. | 2. Moderate cognitive biases and adapt to emotional biases.

Question 28

What is Standard of Living Risk (SLR)?

Answer 28

the risk that a current or a specified acceptable lifestyle may not be sustainable.

Question 29

Standard asset allocation program with a client involves

Answer 29

1. Advisers administer a risk tolerance questionnaire 2. Discuss the client's financial goals and constraints 3. Recommend the output of a mean-variance optimization

Question 30

List some cognitive errors that are belief perserverence

Answer 30

``` conservatism bias confirmation bias representativeness bias control bias hindsight bias ```

Question 31

list some cognitive errors that are information processing related

Answer 31

anchoring and adjustment mental accounting bias framing bias availability bias

Question 32

list some emotional biases

Answer 32

``` loss aversion bias overconfidence bias self-control bias status quo bias endowment bias regret-aversion bias ```

Question 33

conservatism bias

Answer 33

maintain prior views or forecasts by inadequately incorporating new information - overweight of initial beliefs

Question 34

confirmation bias

Answer 34

look for and notice what confirms beliefs and ignore or undervalue what contradicts beliefs

Question 35

representativeness bias

Answer 35

classify new information based on past experiences and classifications

Question 36

illusion of control bias

Answer 36

believe they can control or influence outcomes when they can't

Question 37

hindsight bias

Answer 37

selective perception and retention. remember own predictions of the future as more accurate than they actually were because they are biased by the knowledge of what has actually happened

Question 38

anchoring and adjustment bias

Answer 38

use of a psychological heuristic influences the way people estimate probabilities. tend to adjust anchors insufficiently and produce end approximations that are consequently biased

Question 39

mental accounting bias

Answer 39

treat one sum of money differently from another equal-sized sum based on which mental account the money is assigned to

Question 40

framing bias

Answer 40

person answer question differently based on way in which it is asked

Question 41

availability bias

Answer 41

heuristic approach to estimating the probability of an outcome based on how easily the outcome comes to mind. easily recalled outcomes are perceived as being more likely than those that are harder to recall or understand.

Question 42

loss-aversion bias

Answer 42

strongly prefer avoiding losses as opposed to achieving gains

Question 43

overconfidence bias

Answer 43

demonstrate unwarranted faith in intuitive reasoning, judgments, and/or cognitive abilities

Question 44

self-control bias

Answer 44

fail to act in pursuit of long-term overarching goals because of a lack of self-discipline

Question 45

status quo bias

Answer 45

people do nothing instead of making a change

Question 46

endowment bias

Answer 46

people value an asset more when they hold rights to it than when they do not

Question 47

regret-aversion bias

Answer 47

avoid making decisions that will result in action out of fear that the decision will turn out poorly

Question 48

goals-based investing

Answer 48

ID an investor's specific goals and the risk tolerance associated with each goal; investments are chosen considering each goal individually; portfolio is contructed in layers; investors are assumed to be loss-averse, not risk-averse

Question 49

For a client with high wealth and low SLR with emotional biases...

Answer 49

accommodate the biases, deviating 10-15%

Question 50

For a client with high wealth and low SLR with cognitive biases...

Answer 50

moderate and accommodate the biases, deviating 5-10%

Question 51

For a client with low wealth and high SLR with emotional biases...

Answer 51

moderate and accommodate the biases, deviating 5-10%

Question 52

For a client with low wealth and high SLR with cognitive biases...

Answer 52

modify the biases, deviating 0-3%

Question 53

Barnewall two way behavioral model

Answer 53

passive investors have not had to risk their own capital to gain wealth active investors risked own capital to gain wealth and take active role in investing own money

Question 54

Bailard, Biehl, and Kaiser (BB&K) 5-way model

Answer 54

``` two dimension of classification: careful to impetuous anxious to confident - Individualist - Guardian - Adventurer - Celebrity - Straight Arrow ```

Question 55

Individualist (BBK)

Answer 55

Careful & Confident makes own decisions after careful analysis listens and processes info rationally

Question 56

Gaurdian (BBK)

Answer 56

careful & anxious concerned with future and asset protection may seek advice

Question 57

Adventurer (BBK)

Answer 57

confident & impetuous | may hold concentrated portfolios and willing to take chances; likes to make own decisions

Question 58

Celebrity (BBK)

Answer 58

impetuous & anxious may have opinions but recognizes own limitations seeks and takes advice about investing

Question 59

Straight Arrow (BBK)

Answer 59

cross of BBK extremes | average investor who will take increased risk for increased expected return

Question 60

Pompian four behavioral investor types process

Answer 60

1. interview to determine active v passive 2. plot on risk tolerance scale 3. test for behavioral biases 4. classify into one of the BITs

Question 61

Passive Preserver (Pompian)

Answer 61

emotional bias; passive; low risk tolerance; not financially sophisticated

Question 62

Friendly Follower (Pompian)

Answer 62

cognitive bias; passive; overestimates risk tolerance; likes popular investments

Question 63

Active Accumulator (Pompian)

Answer 63

emotional bias; active; high risk tolerance | entrepreneurial and strong-willed; likes to be involved

Question 64

Independent Individualist (Pompian)

Answer 64

cognitive bias; active; higher risk tolerance; will risk capital to gain wealth; strong willed; does own research and tends to be contrarian