R7 The Behavioral Finance Perspective Flashcards
1
Q
EMH: Anomalies
A
- Fundamental Anomalies. Value and Growth investing - but are they a function of incomplete models of asset pricing?
- Technical Anomalies. Moving averages and Trading Range break (Support and Resistance). Disputed.
- Calendar Anomalies. The January Effect and turn-of-the-month effect.
2
Q
Behavioral Approach to Consumption and Savings
A
- Incorporates self-control, mental accounting, and framing biases
- People classify their sources of wealth into three basic accounts: current income, currently owned assets, and the present value of future income
- Individuals are hypothesized to first spend current income, then to spend based on current assets, and finally to spend based on future income.
3
Q
Behavioral Approach to Asset Pricing
A
- Stochastic discount factor-based (SDF-based) asset pricing model
- Model focuses on market sentiment as a major determinant of asset pricing,
- Sentiment pertains to erroneous, subjectively determined beliefs.
4
Q
Behavioral Portfolio Theory
A
- BPT uses a probability-weighting function rather than the real probability distribution used in Markowitz’s portfolio theory
- Investors construct their portfolios in layers and expectations of returns and attitudes toward risk vary between the layers.
- Construction is primarily a function of five factors:
- Allocation to different layers depends on investor goals and the importance assigned to each goal
- Allocation of funds within a layer to specific assets will depend on the goal set for the layer
- Number of assets chosen for a layer depends on the shape of the investor’s utility function.
- Concentrated positions in some securities may occur if investors believe they have an informational advantage with respect to the securities
- Investors reluctant to realize losses may hold higher amounts of cash so that they do not have to meet liquidity needs by selling assets that may be in a loss position
5
Q
Adaptive Markets Hypothesis
A
(AMH) A hypothesis that applies principles of evolution—such as competition, adaptation, and natural selection—to financial markets in an attempt to reconcile efficient market theories with behavioral alternatives.
- The AMH is a revised version of the EMH that considers bounded rationality, satisficing, and evolutionary principles
- Under the AMH, individuals act in their own self-interest, make mistakes, and learn and adapt; competition motivates adaptation and innovation; and natural selection and evolution determine market dynamics
6
Q
Five implications of the AMH
A
- The relationship between risk and reward varies over time (risk premiums change over time) because of changes in risk preferences and such other factors as changes in the competitive environment
- Active management can add value by exploiting arbitrage opportunities
- Any particular investment strategy will not consistently do well but will have periods of superior and inferior performance
- The ability to adapt and innovate is critical for survival
- Survival is the essential objectiv
7
Q
Bounded Rationality
A
- The notion that people have informational and cognitive limitations when making decisions and do not necessarily optimize when arriving at their decisions.
- The term satisfice combines “satisfy” and “suffice”
- Instead of looking at every alternative, people set constraints as to what will satisfy their needs
- Decision makers may use heuristics to guide their search. An example of heuristics is means-ends analysis.
- Portfolio decisions are based on a limited set of factors, such as economic indicators, deemed most important to the end goal
8
Q
Prospect Theory
A
- Prospect theory considers how prospects (alternatives) are perceived based on their framing, how gains and losses are evaluated, and how uncertain outcomes are weighted.
- Prospect theory assigns value to gains and losses (changes in wealth) rather than to final wealth
- There are two phases to making a choice: an early phase in which prospects are framed (or edited) and a subsequent phase in which prospects are evaluated and chosen
- Depending on the number of prospects, there may be up to six operations in the editing process: codification, combination, segregation, cancellation, simplification, and detection of dominance.
- People are risk-averse when there is a moderate to high probability of gains or a low probability of losses; they are risk-seeking when there is a low probability of gains or a high probability of losses.
9
Q
Rational Economic Man
A
- Traditional Finance Perspective
- Principles of perfect rationality, perfect self-interest, and perfect information govern REM’s economic decisions.
- Those who challenge REM do so by attacking the basic assumptions of perfect information, perfect rationality, and perfect self-interest.
10
Q
Utility Theory
A
- Traditional Finance Perspective
- Generally assumes that individuals are risk-averse
- Theory whereby people maximize the present value of utility subject to a present value budget constraint.
- May be thought of as the level of relative satisfaction received from the consumption of goods and services
- Basic axioms of utility theory: Completeness, Transitivity, Independence , Continuity
- If the individual’s decision making satisfies the four axioms, the individual is said to be rational
- The rational decision maker, given new information, is assumed to update beliefs about probabilities according to Bayes’ formula
11
Q
EMH
A
- Weak Form - All past market price and volume data are fully reflected in securities’ prices. Technical analysis will not generate excess returns
- Semi-Strong Form - all publicly available information, past and present, is fully reflected in securities’ prices. Technical and fundamental analyses will not generate excess returns
- Strong-form - assumes that all information, public and private, is fully reflected in securities’ prices. Even insider information will not generate excess returns.
