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CFA Level III > Behavioral Finance > Flashcards

Behavioral Finance Flashcards

(47 cards)

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1
Q

What is Traditional and Behavioral Finance

A

Traditional finance

  • How people should behave
  • Assumes rational, risk-adverse, and selfish

Behavioral finance

  • How people actually behave
  • Can result in biases and markets may not be efficient
  • Could be risk-adverse, neutral, or seeking
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2
Q

Investor Risk Types

A

Risk-Averse - Concave

Risk-Neutral - straight

Risk-Seeking - Convex

Friedman-Savage (Forms an S)

Concave at low/high wealth

Convex at medium wealth

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3
Q

Challenges to Rational Economic Men (REM)

Traditional finance

A
  1. Decision making can be flawed by lack of information
  2. Can have conflicts that prioritize short-term (spending) goals over long-term (saving) goals
  3. Lack of perfect knowledge (most crucial)
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4
Q

Utility Theory (TF)

A
  1. Satisfaction based on level of wealth
  2. Diminishing marginal return: satisfaction increases at a slower rate
  3. Convexed indifference curve: slower rate of substitution
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5
Q

Decision Theory (TF)

A

Making the ideal decision when the decision maker is fully informed, mathematically able, and rational.

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6
Q

Bounded Rationality

A

Have a capiticty on knowledge and nothing is perfect

Accept things that satisfy but are not perfect

Example

I have excess funds. I want the funds to be backed by the government so I went to the bank. The rate seems acceptable, so I move forward. I didn’t do any other research.

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7
Q

Prospect Theory (BF)

A

Definition: Perceived gain/loss drives satisfaction (NOT level)

  1. Depends on starting point
  2. Decisions are made in stages
  3. Decision weights are subjective (NOT rational)

Consequences:

Takes gains quickly, hold onto losses

Low probability events are over-weighted

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8
Q

Prospect Theory Stages (BF)

A

Phase 1: Editing

Proposals are made and ranked
Could lead to isolation effect (presentation and complexity affect decisions)

Phase 2: Evaluation

Focus on loss aversion
Investors place more weight for a loss than a gain (fear)

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9
Q

Prospect Theory Behavior

A
  1. People overreact to small probabilities and underreact to large ones
  2. Results in the S shape
  3. Gains = risk-adverse, losses = risk-seekers
    a. explains why people over-concentrate positions
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10
Q

Traditional Finance and Prospect Theory Assumptions

Knowledge
Utility
Decision Making
Risk
Portfolio Construction

A

Traditional Finance Prospect Theory

Knowledge Perfect Capacity limitations

Utility Maximization Satisfice

Decision Making Full rational Congnitive limits

Risk Risk-adverse Depends on gain/loss

Portfolio Constr. Markets are efficient Alternative theories
Focus on asset allocation

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11
Q

Efficient Market Hypthosesis (EMH)

A

Follows traditional finance

3 types of efficiency

  1. weak-form: prices reflect all past data
    1. cannot use technical analysis
  2. semi-strong: prices reflect all past data and public info
    1. cannot use technical or fundamental analysis
  3. strong-form: prices reflect all past data, public, and non-public
    1. cannot use technical or fundamental analysis or insider trading
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12
Q

EMH Support and Challenges

A

Support

Events can trigger abnormalities. (e.g. stock split) which allows for people to make predictions.

Large cap stocks may be more efficient than others

Challenges

Small and value effects

Anomalies (Fundamental & Calendar)

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13
Q

Behavioral Finance Portfolio Construction Types

A
  1. Consumption & savings - can people have self control and save?
  2. Behavioral asset pricing - adds a sentiment premium (dispersion of analysts forecasts) to CAPM. Wider dispersion = higher discount rate
  3. Behavioral Portfolio Theory (BPT) - Build a portfolio of layers with different types of risks (all built separately and correlation is ignored)
  4. Adaptive Markets Hypothesis (AMH) - Adapt your process or die (satisfice driven). Active managagement works
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14
Q

Cognitive Errors vs Emotional Baises

A

Cognitive Errors (Thinking)

Faulty reasoning

Can be corrected

Emotional Biases

Based on impulses or intuition

Must be accomodated

(Someone can have both)

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15
Q

Cognitive Errors Types

Belief Perseverance

A
  1. Representativeness
  2. Illusion of control
  3. Conservatism
  4. Confirmation bias
  5. Hindsight bias
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16
Q

Conservatism

A

Type: Cognitive

Definition: rationally form an initial view but won’t change it

Consequences

Hold investments too long

slow to update view

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17
Q

Confirmation Bias

A

Type: Cognitive

Definition: look for or distort information to support current view

Consequences

Under-diversified

Concentration in employer stock

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18
Q

Representativeness Bias

A

Type: Cognitive

Definition: past classification will persist and new information is based on past experience

Consequences

  • Hold on to or buy recent winners
  • Sell or avoid recent losers
  • Excessive turnover
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19
Q

Illusion of Control Bias

Study These Flashcards
A

Type: Cognitive

Definition: think you can control the outcome (a junior analyst)

Consequences (Not as important)

Fail to diversify

Trade frequently

20
Q

Hindsight Bias

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A

Type: Cognitive

Definition: selectively remember what was done in the past

Consequences

Overestimates ability

Takes on too much risky

21
Q

Cognitive Errors Types

Information-Processing Biases

Study These Flashcards
A
  1. Framing bias
  2. Availability bias
  3. Anchoring and adjustment bias
  4. Mental accounting bias
22
Q

Achoring and Adjustment Bias

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A

Type: Cognitive

Definition: Starting from an old reference point and adjusting

New data should be reviewed objectively and could be completely different

23
Q

Mental Accounting Bias

Study These Flashcards
A

Type: Cognitive

Definition: Money is treated based on category.

(wages are different than bonuses or client wants to only focus on income)

Consequences

Leads to porfolio layers

not looking at correlation

24
Q

Framing Bias

Study These Flashcards
A

Type: Cognitive

Decisions are affected by the presentation of the data and the reference point

Consequences

Select suboptimal assets
Excess short-term trading

25
Availability Bias
AKA - Recency bias **Type:** Cognitive **Definition:** focus on the current information thats easy to get Type: Narrow range of experience (You live in the US so assume US laws apply) **_Consequences (Not as important)_** Decision based on what's familiar (advertising) Under diversification
26
Emotional Biases: Name the 6
1. **L**oss-aversion bias 2. **O**verconfidence bias 3. **S**elf-control bias 4. **S**tatus quo bias 5. **E**ndowment bias 6. **R**egret-aversion bias
27
Loss-aversion bias
**Type:** Emotional 1. **Loss-aversion bias** - feel more pain from a loss **_Consequences_** * Loss not "real" until realized - hold a stock too long * Sell winners too soon * Incur too much risk waiting for stock to come back
28
Myopic bias
**Type:** Emotional loss aversion * Wide spread aversion leads to under ownership of stocks. * Fear of short-run potential of losses * Keeps prices low and risk premium high
29
Overconfidence Bias
**Type:** Emotional 1. **Overconfidence bias** - overestimate own ability **_Consequences_** * Trade a lot and incur high transaction costs * Under-diversified portfolios
30
Self-Control Bias
**Type:** Emotional 1. **Self-control bias** - lack self-discipline. Favor short-term gratification **_Consequences_** Excessive risk save too little
31
Status Quo Bias
**Type:** Emotional 1. **Status quo bias** - too comfortable to make a change **_Consequences_** * Leaves alone even when age, wealth, and risk tolerance changes
32
Endowment Bias
**Type:** Emotional 1. **Endowment bias** - special because you already own it 1. Example: assets that I inherited
33
Regret-aversion Bias
**Type:** Emotional 1. **Regret-aversion bias** - Do nothing due to fear of being wrong **_Consequences_** Too conservative or risky Herding
34
Goals-Based Investing (GBI)
\*\*Starts with importance of each goal\*\* **First:** Essential needs and obligations (living expenses) **Second:** Desired outcomes (gift giving, charity, etc) **Third:** Low priority aspiration (Want to leave $1M to my kids) More important goals have less risky assets
35
Behaviorally Modified Asset Allocation (BMAA)
* Incorporates behavioral biases * Chooses to modify or adapt to the client's baises * Cognitive easier to modify than emotional * Emotional must be accomodated which means a less efficient portfolio * Set up ranges for allowed deviation * based on wealth and standard of living (low SLR can take higher risk)
36
Barnewall two-way behavioral model
**Passive:** didn't risk their own wealth (inheritance, employment) Result: more risk-adverse and want more security **Active:** Risk their own capital for gain Result: more risky and like control
37
Bailard, Biehl, and Kaiser (BB&K) Model
1. **Adventurer:** willing to take chances 2. **Celebrity:** seeks attention, has opinions 3. **Individualist:** seeks info to make decisions 4. **Guardian:** concered with protecting the portfolio 5. **Straight Arrow:** balanced, willing to take appropriate risk for return **Important:** people change over time
38
Pompian Behavioral Model
**_4 Step Process_** 1. Interview to see if passive or active 2. Plot on risk tolerance scale 3. Test for behavioral biases 4. Classify investor * *_4 Types_** 1. Passive Preserver 2. Friendly Follower 3. Independent Individualist 4. Active Accumulator
39
Risk Tolerance Questionnaire
* Only doing a risk-tolerance questionnaire isn't enough * Should be done annualy * Better at identifying cognitive issues (institutional investors) than emotional biases (individuals)
40
Uses and Limitations of Classfying Investors into Behavioral Types
**_Uses_** * More efficient portfolios * More trusting and satisifed cients * Clients who will stick to long-term goals * Better overall relationship with advisor/client **_Limitations_** * Clients may have both emotional and cogitive biases * Advisor shouldn't classify into just one type * Behaviors change over time * Each investor is unique * Can't predict behavior
41
How does behavioral factors influence portfolio construction
**THINK 401(K)** 1. Status quo bias (they accept whatever the default it) 2. Naive diversification (they will put money into any asset class offered 3. Concentration in employer stock 4. Home country bias 5. Excessive trading (brokerage)
42
Analyst Forecast Biases
1. Overconfidence 1. illusion of knowledge &control 2. self-attribution 3. Representativess 4. Hindsight 2. Influence from management 1. Be careful of framing, excessive optimisn 3. Biased research 1. Collecting too much info 2. Can suffer from confirmation and gamblers fallacy
43
Mitigating Forecast Biases
1. Be aware of biases 2. Consider counter arguements 3. Seek feedback 4. Review accuracy of past decisions
44
Investment Committee Recommendation/Challenges
Recommendations; * Establish and stick to an agenda * Document decisions * Members who are not afraid to express their opinions * A committee chair who encourages members to speak out * A mutual respect for all members of the group Challenges: * members go along with the group * member turnover inhibits feedback and reviewing past
45
Traditional Finance Characteristics that Cannot be Explained
* **Value vs Growth** * **​**Stock beaten down tend to outperform * Growth stocks look good but may have * overconfidence, halo effect, home bias * **Momentum** - things going up continue to go up * herding - trading with the group * Trend chasing * **Financial Bubbles and Crashes** * _Herding and trend chasing_ * Achoring/adjustment, availability, and hindsight biases * Bubble: 2 STD from mean, Crash: 30% drop
46
Utility Theory vs Loss Aversion
**_Utility Loss Aversion_** Satisfaction Level of wealth perceived gain/loss Risk Risk adverse risk aversion for gains risk seeking for lossing Focus Total value Each individual position gain/loss
47
Client/Advisor Relationship How Behavioral Finance Helps
1. Long-term goals - Advisor understands 1. BF helps understand reasons 2. Invests as client expects 3. Consistenct approach 1. BF adds structure and professionalism 4. Both client and advisor benefit from relationship 1. BF creates a closer bond

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