Behavioural Finance Flashcards
(34 cards)
Define behavioural finance
Behaviourla finance is a branch of finance which studies how pyscologocial factors impacts investor/financial decisions and market outcomes.
- Behavioual finaance offers a different view of the market compared to EMH.
Describe how behavioural finance differs/challenges views of traditional finance
+ What are the three key arguments it uses to support
this view?
Traditional finance provides a normative view of finacnail markets indicating how ‘rational’ investors should make decisions/behace.
-Whilst behavioural finance is descriptive indicating how investors/individuals ‘actually’ behave.
-Bheavioural finance aruges investors make freuent systematic errors due to biases pushing prices away from fundemental/intrinsic value.
-behavioural finances key 3 arguments:
-Investors are not fully rational
-Irratioanlity is wide spread and sysmteatic
-Limts to arbitrage prevents efficeint price correction
Define expected utility theory (EUT) and the assumptions
-A theory which is the basis for modern finance which assumes individuals make rational decisions to maximise expected utility.
-Assumes:
-Individuals have complete information and probabilities about possible outcomes.
-Preferences of outcomes can be ranked.
-Individuals make decisions optimally by aiming to maximise utility.
-Individuals are risk averse, but take risks if compensated.
Define prospect theory + example
-Prospect theory is a model developed by Tverksy and Kahneman which explains how individuals make decisions under risk, typically deviating from rationality.
-Prospect theory finds individuals are risk averse with gains and risk seeking with losses (prefer to gamble to prevent sure loss).
-Individuals emotionally value a 10 loss to 10 equilvinat gains. Would rather gamble to prevent a sure loss and are risk averse with sure gains.
Aims of behavioural finance as concept
-Aims to understand why investors make specific decisions due to cognitive bias.
-Aims to supplement the rational theories of finance by incorporating behavioural characteristics into decision making.
- offer alternative view to EMH.
Describe difference betwen utility theory and prospect theory
-EUT is normative, assumes individual make rational decisions to maximise expected utility, with the EUT assumptions.
-Prospect theory is descriptive, describes how people typically behave, deviating from rationality.
-EUT assumes risk aversions. PT shows indviduals are risk averse for gains and risk seeking for losses.
How does behavioural finance link to EMH
-Behavioural finance challenges the traditional view and EUT/EMH by encoproating systematic errors and biasses when making decisions which can cause prices to deviate from fundemental/systematic value.
Describe the value function in prospect theory
-Instead of utility funciton in EUT, replaced by a value function.
-Graph refelcts loss aversion with devision making.Eg) evidence shows losses are felt around twice as strongly as equivilant gain. losing £1 is twice as painful as the pleasure of gaining £1.
-Concave for gains (risk averse), convex for losses (risk seeking). Displays individuals are risk seeking with losses and risk averse with gains.
-Includes a reference point which is the individual’s subjective benchmark used to judge outcomes
Describe how cognitive/behavioural biasses violate the assumptions of traditional finance models/consequences + how its systematic/widespread
Cognitive and behavioral biases violate EUT and EMH (traditional models) because investors typically act irrationally, rely on heuristics, and let emotions influence decisions, leading to inconsistent choices and mispriced markets.
- cause investors to deviate from rationality/utility maximising behaviour resulting in misprising and market inefficeinces (violating the EMH)
-irratiaonl investment decisions (poorer management of risk/return)
-pushing share prices away from fundemental value, contray to EMH predictions,
-rrational behavior is systematic people tend to make the same types of errors in across different situations, not randomly.
widespread because these patterns appear across large groups, cultures, and contexts.
Define Heuristics + exampless
-Heuristics refer to mental shortcuts and rules of thumb which individuals use for problem solving.
-Due to uncertainty with the world heursitics provide a quick an efficent way to make reasobale decisions.
Define familiarity (eg) heuristic / cognitive bias)
-familiarity refers to a cognitive bias when investors tend to select stocks they know or thinks they know
-This heursitc can be efficinet if the investors environment provides useful info but leads to home bias, when investors favour domestic stocks –> overconcetration/less global diversidication.
-Eg) investing in sticks of firms which the investor works for.
Describe gamblers fallacy (eg) heuristic / behavioural bias) + example
-Gamblers fallacy, which is an example of a heuristic, refers to when individuals incorrectly believe deviations from the average will be corrected
-However in reality these are indepdent events and the investors doesnt consider this.
-Eg) investor sees stock have multiple consecutive down days therefore mistanekley beleives a rebound is “due” but each day’s price movements are indepdent events.
Describe how effects and feelings are a cognitive bias (eg) heuristic)
-This example of a cognitive bias (leading to deviations from rationallity) is when investors rely on emotion or instic rather than analysis. Intuition/instint should be used in complement with analysis not to replace it.
Eg)Investors may favour firms with strong reputations for social responsibility/positive brand image, neglecting financial analysis.
Describe framing (eg of cognitive bias) + violates eut
-Framing refers to when individuals choices change dependent on how they are presented, even if outcomes are equivalent.
-Framing violates EUT, which assumes consistent prefernces with presentation being irrelevant.
Describe mental accounting (eg of framing/cognitive bias) + div puzzle example
-Mental accounting is a form of framing where individuals treat money differently depending on source or use.
-Eg) For example, an investor might take high risks in one account but be very conservative.
eg) dividend puzzle, where investors have an irrational preference for stocks with high dividends. Divdends may be viewed as ‘spendable’, sepearting dividend/cap gains into different mental accounts, whereas capital is viewed as untouchable.
Describe house money (eg). framing)
House money is an example of framing (cognitive bias) where investors treat winnings/profits as “free money” therefore more willingness to take risks.Leads to greater volatility in prices.
-“Only investing with winnings, not really a loss”, irrational behaviorur
Describe overconfidence (eg) cognitive bias) + study
self arrritvution bias and conformation bias
-refers to the attribute of investors overestimates their skillset and underestimates risks.
-leads to excessive trading volume and drives active investing over passive.
- self arrritvution bias: investors credit skill for good returns and blames bad luck for poor outcomes, which reinforces overconfidence.
-Overconfidence can lead to conformation bias where Investors seek info that supports their beliefs and ignore contradictory evidence.
-Fidelity found 2020
that female investors traded only about one-half as frequently as
male, yet their average returns were 0.4% higher. Men trade more frequently.
Describe the disposition effect (Eg) cognitive bias)
-The disposition effect s the tendancy to hold on to losing investments for too long and sell winning investments too early, contrary to tax minimisation strategy.
-Disposition effect is driven by emotions, proud of selling for profit, regretful for an investment decision and being unwilling to take the loss.
-Consistent with loss aversion, regret over losses influences decisions stronger than prive over gains.
Describe an example of framing Tversky & Kahneman flashcard in person
Tversky & Kahneman (1981) experimented decision making using the following scenario..
-disease expected to kill 600 people, split people up into two groups to present the info differnet.y
-Group 1: Option A (gain frame): 200 saved guaranteed, Option B: 1/3 chance all saved. around 72% chose A, rise averse.
-Group 2 (loss frame): Option A: 400 will die, option B: 1/3 chance no one will die. around 78% chose D.
-Therefore when choices are framed as gains –> risk averse (guarenteed saved 200). When options framed as losses, more risk seeking (risk seeking to save more/reduce losses.)
describe representativeness eg) heuristic / cognitive bias) + eg
-A heurstic bias where individuals judge the probability of an outcome based on how similar it is to a typical represenative case, ignoring actual probaiblites.
-When investors disregard sample size (how small or large) when forming views about the future from past data.
Eg) An investor sees a small group of 10 tech stocks all performing well and assumes all small tech stocks will do great, ignoring that the small sample size isn’t enough to predict whole market behaviour
Question: What might be the behavioural explanations for the
following?
A: news broke out in early 2020 about the potential
pandemic, market initially fell slightly.
B: The price of Bitcoin reached a record $20,000 in December
2017
-Herding behaviour
-Represenativeness
-Overconfiendece, not specifcally just investor skill but gov ability to manage situation.
-Conservatism bias
-FOMO (crypto), gamblers falacy and house money. Represenativeness etc,
-explain what each is and link to question.
Define herding bheaviour and conservatism bias(cognitive bias)
-Herding behaviour occurs when investors follow the actions of others (whats popualr/fomo) rather than making independent decisions- leading to market bubbles or crashes.
- conservatism bias refers to investors tendency to undereact to new information/news, sticking to existing beleifs and slow to update beleifs –> irrationalty in decision making. Not incorprating enw information.
How do EMH advocates defend market efficiency against investor irrationality?
-believe investors are rational thus value securities rationally.
-Believe irrational behaviour ‘cancels out’ as it is random, leaving effcient prices unaffected.
-The existence of rational arbitrages correct prices even if widespread investors behave irrationally.
Why does behavioural finance argue there are limits to arbitrage/EMH
-Arbitrage is not always effective due to costs, risks and delays when emlinatiting security mispricing.
-Even rational, well funded traders may avoid arbitrage (due to fundemental, nose trader risk etc.)
-These limitations to arbitrage are seen as a weekness to EMH.
