Behavioral Finance

Question 1

The basic axioms of utility theory

Answer 1

• Completeness
• Transitivity
• Independence
• Continuity

Question 2

Bayes’ formula

Answer 2

Question 3

Bounded rationality

Answer 3

People will satisfice rather than optimize when making decisions

Question 4

Heuristic

Answer 4

Any approach to problem-solving, learning, or discovery that employs a practical method not guaranteed to be optimal or perfect, but sufficient for the immediate goals

Question 5

Rational Economic Man (REM)

Answer 5

Will try to obtain the highest possible economic well-being or utility given a budget constraint

Question 6

Utility theory

Answer 6

People will maximize the present value of utility subject to a present value budget constraint

Question 7

Prospect theory

Answer 7

• People assign value to gains and losses (changes in wealth) rather than to final wealth
• Decision weights replace probabilities
• Loss-aversion replaces risk-aversion

Question 8

Behavioral Portfolio Theory (BPT)

Answer 8

• Investors construct their portfolios in layers
• Expectations of returns and risk vary between the layers
• Uses a probability weighting function rather than the real probability distribution used in Markowitz’s portfolio theory

Question 9

The 2 phases of decision-making in Prospect theory

Answer 9

• Editing (framing) phase
• Evaluation phase

Question 10

Friedman-Savage double-inflection utility function

Answer 10

• At low and high income levels, agents exhibit risk-averse behavior
• At moderate income levels, between the inflection points, agents exhibit risk-seeking behavior

Question 11

Grossman–Stiglitz paradox

Answer 11

Argues that prices must offer a return to information acquisition, otherwise information will not be gathered and processed. If information is not gathered and processed, the market cannot be efficient

Question 12

Fama three forms of market efficiency

Answer 12

• Weak: All past market price and volume data are fully reflected in securities’ prices
• Semi-strong: All publicly available information, past and present, is fully reflected in securities’ prices
• Strong: All information, public and private, is fully reflected in securities’ prices

Question 13

• Value companies
• Growth companies

Answer 13

• Value companies typically have, on a per share basis, lower than average price-to-earnings, price-to-book value, and price-to-sales ratios and higher than average dividend yields
• Growth companies typically have, on a per share basis, higher than average price-to-earnings, price-to-book value, and price-to-sales ratios and lower than average dividend yields

Question 14

Turn of the month anomaly

Answer 14

Hensel and Ziemba (1996) examined returns of the S&P 500 over a 65-year period and found that US large-cap stocks consistently generate higher returns at the turn of the month

Question 15

Adaptive Market Hypothesis (AMH)

Answer 15

Applies principles of evolution to financial markets in an attempt to reconcile efficient market theories with behavioral alternatives

Question 16

The five implications of the AMH

Answer 16

1. The relationship between risk and reward varies over time
2. Active management can add value by exploiting arbitrage opportunities
3. Any particular investment strategy will have periods of superior and inferior performance
4. The ability to adapt and innovate is critical for survival
5. Survival is the essential objective

Question 17

Updating beliefs

Answer 17

Done by using the Bayes’ formula or heuristics

Question 18

Emotional biases

Answer 18

• Loss aversion bias
  
  • Myopic loss aversion
• Overconfidence bias
  
  • Prediction overconfidence
  • Certainty overconfidence
  • Self-enhancing and self-protecting biases
• Self-control bias
• Status quo bias
• Endowment bias
• Regret-aversion bias
  
  • Error of commission or omission

Question 19

Belief Perseverance Biases (cognitive biases)

Answer 19

• Cognitive dissonance
• Conservatism bias
• Confirmation bias
• Representativeness bias
  
  • Base-rate neglect
  • Sample size neglect
• Illusion of control bias
• Hindsight bias

Question 20

Information-Processing Biases (cognitive biases)

Answer 20

• Anchoring and adjustment bias
• Mental accounting bias
• Framing bias
• Availability bias
  
  • Retrievability
  • Categorization
  • Narrow range of experience
  • Resonance

Question 21

Probability estimation with anchoring

Answer 21

Starts with some initial default number—an anchor—which is then adjusted up or down according to new information

Question 22

Value function of loss aversion

Answer 22

Question 23

Disposition effect

Answer 23

Holding losers and selling winners

Question 24

Goals-based investing

Answer 24

A portfolio is evaluated in terms of attaining financial goals and is built in layers

Question 25

Goals-based portfolio construction chart

Answer 25

Question 26

Behaviorally Modified Asset Allocation

Answer 26

An asset allocation that takes into account the bias of the investor in order to build an allocation that he is comfortable with

Question 27

Standard of living risk (SLR)

Answer 27

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

Question 28

Adapt versus moderate visual depiction chart

Answer 28

Question 29

Equity market neutral strategy

Answer 29

Long/short with a beta of zero

Question 30

Representativeness bias

Answer 30

A cognitive bias in which people tend to classify new information based on past experiences and classifications

Question 31

Base-rate neglect

Answer 31

* Is a type of representativeness bias * In base-rate neglect, the base rate or probability of the categorization is not adequately considered * The categorization is based on a stereotype and ignores the base probability of the stereotype actually occurring

Question 32

Sample-size neglect

Answer 32

* Is a type of representativeness bias * In sample-size neglect, someone incorrectly assumes that small sample sizes are representative of populations (or “real” data)

Question 33

Barnewall two-way model

Answer 33

* Passive investors: Became wealthy passively. Have a greater need for security than they have tolerance for risk * Active investors: Became wealthy by being actively involved in wealth creation through investment. Have a higher tolerance for risk than they have need for security

Question 34

Bailard, Biehl and Kaiser five-way model chart (BBK)

Answer 34

Question 35

Behavioral Investor Types (BITs)

Answer 35

Question 36

Behavioral factors

Answer 36

* Inertia and Default * Naïve Diversification * Investing in the Familiar * Excessive Trading * Home Bias * Behavioral Portfolio Theory

Question 37

The gamblers’ fallacy

Answer 37

A misunderstanding of probabilities in which people wrongly project reversal to a long-term mean

Question 38

The conjunction fallacy

Answer 38

The probability of two independent events occurring in conjunction is never greater than the probability of either event occurring alone

Question 39

Social proof

Answer 39

A bias in which individuals are biased to follow the beliefs of a group

Question 40

Halo effect

Answer 40

An emotional bias that extends a favorable evaluation of some characteristics to other characteristics

Question 41

Home bias

Answer 41

An anomaly by which portfolios exhibit a strong bias in favor of domestic securities in the context of global portfolios

Question 42

Passive Preservers

Answer 42

Are investors who place a great deal of emphasis on financial security and preserving wealth rather than taking risks to grow wealth. Many have gained wealth through inheritance or by receiving high compensation at work

Question 43

Friendly Followers

Answer 43

Are passive investors with a low to medium risk tolerance who tend to follow leads from their friends, colleagues, or advisers when making investment decisions

Question 44

Independent Individualists

Answer 44

Are active investors with medium to high-risk tolerance who are strong-willed and independent thinkers

Question 45

Active Accumulators

Answer 45

Are entrepreneurial and often the first generation to create wealth; and they are even more strong-willed and confident than Independent Individualists. At high wealth levels, AAs often have controlled the outcomes of non-investment activities and believe they can do the same with investing

Question 46

Cognitive biases versus emotional biases plan of action

Answer 46

Cognitive errors should be moderated whereas emotional biases should be adapted to