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CFA Level III > Behavioral Finance > Flashcards

Flashcards in Behavioral Finance Deck (47):

What is Traditional and Behavioral Finance

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


Investor Risk Types 

Risk-Averse - Concave

Risk-Neutral - straight

Risk-Seeking - Convex


Friedman-Savage (Forms an S)

Concave at low/high wealth

Convex at medium wealth


Challenges to Rational Economic Men (REM)

Traditional finance

  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)


Utility Theory (TF)

  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


Decision Theory (TF)

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


Bounded Rationality

Have a capiticty on knowledge and nothing is perfect

Accept things that satisfy but are not perfect



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.


Prospect Theory (BF)

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)


Takes gains quickly, hold onto losses

Low probability events are over-weighted


Prospect Theory Stages (BF)

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)


Prospect Theory Behavior

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


Traditional Finance and Prospect Theory Assumptions

Decision Making
Portfolio Construction

                          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


Efficient Market Hypthosesis (EMH)

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


EMH Support and Challenges


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

Large cap stocks may be more efficient than others


Small and value effects

Anomalies (Fundamental & Calendar)


Behavioral Finance Portfolio Construction Types

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


Cognitive Errors vs Emotional Baises

Cognitive Errors (Thinking)

Faulty reasoning

Can be corrected

Emotional Biases

Based on impulses or intuition

Must be accomodated

(Someone can have both)


Cognitive Errors Types

Belief Perseverance

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



Type: Cognitive

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



Hold investments too long

slow to update view


Confirmation Bias

Type: Cognitive

Definition: look for or distort information to support current view




Concentration in employer stock


Representativeness Bias

Type: Cognitive

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


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



Illusion of Control Bias

Type: Cognitive

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


Consequences (Not as important)

Fail to diversify

Trade frequently


Hindsight Bias

Type: Cognitive

Definition: selectively remember what was done in the past


Overestimates ability

Takes on too much risky


Cognitive Errors Types

Information-Processing Biases

  1. Framing bias
  2. Availability bias
  3. Anchoring and adjustment bias
  4. Mental accounting bias


Achoring and Adjustment Bias

Type: Cognitive

Definition: Starting from an old reference point and adjusting

New data should be reviewed objectively and could be completely different



Mental Accounting Bias

Type: Cognitive

Definition: Money is treated based on category.

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


Leads to porfolio layers

not looking at correlation


Framing Bias

Type: Cognitive

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


Select suboptimal assets
Excess short-term trading


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


Emotional Biases: Name the 6

  1. Loss-aversion bias 
  2. Overconfidence bias
  3. Self-control bias
  4. Status quo bias
  5. Endowment bias
  6. Regret-aversion bias


Loss-aversion bias

Type: Emotional

  1. Loss-aversion bias - feel more pain from a loss


  • Loss not "real" until realized - hold a stock too long
  • Sell winners too soon
  • Incur too much risk waiting for stock to come back


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


Overconfidence Bias

Type: Emotional

  1. Overconfidence bias - overestimate own ability


  • Trade a lot and incur high transaction costs
  • Under-diversified portfolios


Self-Control Bias

Type: Emotional

  1. Self-control bias - lack self-discipline. Favor short-term gratification


Excessive risk
save too little


Status Quo Bias

Type: Emotional

  1. Status quo bias - too comfortable to make a change


  • Leaves alone even when age, wealth, and risk tolerance changes


Endowment Bias

Type: Emotional

  1. Endowment bias - special because you already own it
    1. Example: assets that I inherited


Regret-aversion Bias

Type: Emotional

  1. Regret-aversion bias - Do nothing due to fear of being wrong


Too conservative or risky


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


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)


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


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


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


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)


Uses and Limitations of Classfying Investors into Behavioral Types


  • More efficient portfolios
  • More trusting and satisifed cients
  • Clients who will stick to long-term goals
  • Better overall relationship with advisor/client


  • 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


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)


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


Mitigating Forecast Biases

  1. Be aware of biases
  2. Consider counter arguements
  3. Seek feedback
  4. Review accuracy of past decisions


Investment Committee Recommendation/Challenges


  • 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


  • members go along with the group
  • member turnover inhibits feedback and reviewing past



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


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


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