Behavioral Finance

What are calendar anomalies?

Calendar anomaly: an irregularity identified when patterns of trading behavior that occur at certain times of the year are considered. January effect.

What are the three types of market anomalies?

Fundamental, Technical, Calendar

What is mental accounting bias?

Mental accounting: an information-processing bias in which people treat one sum of money differently from another equal-sized sum based on which mental account the money is assigned to. Leads to people placing investment in goal-based buckets (e.g. retirement, savings, etc.), without regard for potential correlation among them.

What is a "rational" portfolio, from a traditional perspective?

The portfolio that is mean-variance efficient. Tolerance for risk, investment objectives and constraints and investor circumstances are taken into account to generate an optimal portfolio allocation. However, perfect information and rationality principle may not be valid.

What does risk evaluation depend on?

- risk evaluation is reference-dependent, meaning risk evaluation depends in part on the wealth level and circumstances of the decision maker - it is not necessarily true that an individual's utility function has the same curvature consistently: There may be levels of wealth, for instance, at which an investor is a risk-seeker and levels of wealth where the investor is risk-neutral

What are the important differences between the evaluation process under prospect theory and the expected utility theory?

- values are attached to changes rather than final states - decision weights need not coincide with probabilities - unlike expected utility theory, the prospect theory value function measures gains and losses but not absolute wealth and is reference-dependent

What are the three approaches to analysis of decisions, per Howard Raiffa?

1. Normative analysis: concerned with the rational solution to the problem at hand and defines an ideal that actual decisions should strive to approximate (traditional finance assumptions); 2. Descriptive analysis: concerned with the manner in which real people actually make decisions (behavioral finance explanations); 3. Prescriptive analysis: concerned with practical advice and tools that might help people achieve results more closely approximating those of normative analysis (efforts to use behavioral finance in practice).

What are the three forms of market efficiency (per Fama)?

1. Weak-form: assumes that all past market price and volume data are fully reflected in securities' prices. Technical analysis will not generate excess returns. 2. Semi-strong-form: assumes that all publicly available information, past and present, is fully reflected in securities' prices. Technical and fundamental analysis will not generate excess returns. 3. Strong-form: assumes that all information, public and private, is fully reflected in securities' prices. Even insider information will not generate excess returns.

What is social proof?

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

What is a double inflection utility function?

A utility function that changes based on levels of wealth.

What is the difference between Behavioral Finance Micro (BFMI) and Behavioral Finance Macro (BFMA)?

BFMI: examines behaviors or biases that distinguish individual investors from the rational actors envisioned in neoclassical economic theory - questions perfect rationality and decision-making of individual investors. BFMA: considers market anomalies that distinguish markets from the efficient markets of traditional finance - questions the efficiency of markets.

What is cognitive dissonance? What are belief perseverance biases?

Cognitive dissonance: The mental discomfort that occurs when new information conflicts with previously held beliefs or cognitions. To resolve this dissonance, people may commit the following cognitive errors: - notice only information of interest (selective exposure); - ignore or modify information that conflicts with existing cognitions (selective perception); - remember and consider only information that confirms existing cognitions (selective retention).

What are the two guidelines for identifying a behaviorally modified asset allocation for a client? How to respond to behavioral biases?

Cognitive errors should be moderated, whereas emotional biases should be adapted to. Because cognitive errors stem from faulty reasoning, they can often be corrected through better information, education, and advice. Thus, most cognitive biases can be "moderated." Because emotions can be more difficult to control, it may be possible only to recognize an emotional error and "adapt" to it.

What are cognitive errors vs emotional biases?

Cognitive errors stem from basic statistical, information-processing, or memory errors; cognitive errors may be considered to result from reasoning based on faulty thinking. Emotional biases stem from impulse or intuition; emotional biases may be considered to result from reasoning influenced by feelings. Behavioral biases, cognitive or emotional, may cause decisions to deviate from the rational decisions of traditional finance.

What are cognitive errors vs emotional biases?

Cognitive errors: Behavioral biases resulting from faulty reasoning; cognitive errors stem from basic statistical, information processing, or memory errors. Emotional biases: Behavioral biases resulting from reasoning influenced by feelings; emotional biases stem from impulse or intuition.

What bias can be potentially exhibited by analysis doing research one a stock?

Confirmation bias, a cognitive bias, is the tendency for people to misread evidence as additional support for an initial hypothesis. Confirmation bias is a potential bias for analysts conducting research. It is a form of resolving cognitive dissonance that described the tendency to search for, or interpret, information in a way that confirms the analyst's prior beliefs. The additional information may not be analyzed in a rigorous way, but it can nevertheless appear to make the judgment or forecast more likely by sharing some of its general characteristics.

What is myopic loss aversion?

Considered as explanation for equity premium puzzle - the anomalously higher historical real returns of stocks over bonds. Investors presented with annual return data for stocks and bonds tend to adopt more conservative strategies (lower allocation to equities) than those presented with longer-term return data, such as 30-year compound returns. Investors are more concerned with the potential for short-term losses than with planning for the relevant time horizon and focusing on long-term results. The overemphasis on short-term losses results in a higher than theoretically justified equity risk premium.

What is decision theory?

Decision theory is concerned with identifying values, probabilities, and other uncertainties relevant to a given decision and using that information to arrive at a theoretically optimal decision. - normative: identifies ideal decision - assumes full information, ability to make quantitative calculations with accuracy and perfect rationality - application is prescriptive

What is framing bias?

Framing bias: an information-processing bias (cognitive error) in which a person answers a question differently based on the way in which it is asked (framed).

What is hindsight bias?

Hindsight bias: a bias (cognitive error), where people may see past events as having been predictable and reasonable to expect. This is based on the obvious fact that outcomes that did occur are more readily evident than outcomes that did not occur. May lead to overestimating the degree to which an investor predicted an investment outcome, giving them false sense of confidence.

What is a rational economic man (REM)?

Traditional finance assumes that after gathering information and analyzing it according to Bayes' formula, individuals will make decisions consistent with the decisions of homo economicus or rational economic man (REM). REM ignores social values unless adhering to them will give him pleasure (i.e., provide utility) or failing to adhere to them will cause him pain (i.e., create disutility). Principles of perfect rationality, perfect self-interest, and perfect information govern REM's economic decisions. REM will: - try to obtain the highest possible economic well-being or utility given budget constraints and the available information about opportunities; - base his choices only on the consideration of his own personal utility, not considering the well-being of others except to the extent this impacts REM's utility; - construct curves of consumption bundles amongst which he is indifferent because each bundle gives the same utility; - make a consumption decision that will fall on the indifference curve that is within budget constraints and furthest from the origin (i.e. that produces the highest utility).

In the framework of prospect theory, what is experimental evidence of human behavior in a situation with low probability of gains and high probability of loss?

- People are risk-seeking when there is a low probability of gains or a high probability of losses. - Deviations in decision making result in overweighting low-probability outcomes. Ex.: Choosing between losing $12,000 with 100% certainty, or accepting a gamble that offers a 50% probability of winning $6,000 and a 50% probability of losing $24,000 Most people would accept the gamble over a sure loss.

List all cognitive errors.

- conservatism bias - confirmation bias - representativeness bias (base-rate neglect, sample-size neglect) - illusion of control - hindsight bias - anchoring and adjustment - mental accounting - framing - availability bias

How to mitigate availability bias (and some other biases)?

- develop an appropriate investment policy strategy, with a focus on appropriate goals (short- and long-term) - have a disciplined approach to investment decision making

What are some of the behavioral factors affecting portfolio construction?

- inertia (failure to change allocations over time) - naive diversification (e.g. allocating funds equally to portfolio investments) - familiar investing (e.g. investing in stocks of the company where investor is employed) - excessive trading - home bias (investing in country of one's residence) - fear of regret (investing equally in investments regardless of composition since one is not sure which one will outperform)

What is behavioral portfolio theory?

- layered portfolio construction, with varying returns and risk expectations - 5 factors that affect portfolio construction: investor goals and importance of each; goal set for the layer; shape of investor's utility function; belief of having an informational advantage resulting in concentrated positions; risk averse investors may hold higher amounts of cash and be reluctant to sell underperforming securities to avoid realization of losses - essentially a portfolio equivalent to an insurance policy and a lottery ticket: the optimal portfolio is a combination of bonds (riskless assets) and highly speculative assets - in the first layer, investor seeks safety to insure his aspirational level of wealth with a small chance of failure; in the second layer, investor is willing to take risk with residual wealth

List all emotional biases.

- loss aversion (disposition effect) - myopic loss aversion - overconfidence bias (illusion of knowledge) - self-control bias - status quo bias - endowment bias - regret-aversion bias

What do the main deviations in decision making result from, when we compare prospect theory to the rational decisions of traditional finance?

- overweighting low probability outcomes and underweighting moderate and high probability outcomes - having a value function for changes in wealth (gains and losses) that is in general concave for gains, convex for losses and steeper for losses than for gains

According to prospect theory, when are people risk averse vs risk seeking?

- people are risk averse when there is a moderate to high probability of gains or a low probability of losses - people are risk seeking when there is a low probability of gains or a high probability of losses - e.g. people buying simultaneously a lottery ticket and insurance while investing money conservatively

What is Grossman-Stiglitz paradox?

- 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 - in equilibrium, if markets are to be efficient, a return should accrue to information acquisition - a market is inefficient if, after deducting such costs, active investing can earn excess returns

What is the behavioral approach to consumption and savings?

- self control bias: people may focus on short-term satisfaction to the detriment of long term goals - mental accounting: people treat one sum of money differently from another sum of money even though money is interchangeable - framing bias: different responses based on how questions are asked (framed) 3 basic mental accounts: current income, currently owned assets, PV of future income. People are most likely to first spend out of current income, then assets, then future income. Saving results in mental reclassification into assets of PV of future income, thus allowing to accommodate the competing goals of short-term gratification and long-term benefits.

What is self control bias?

A bias where people fail to act in pursuit of their long-term goals because of a lack of self-discipline (instant gratification).

What is indifference curve analysis?

A decision-making approach whereby curves of consumption bundles, among which the decision-maker is indifferent, are constructed to identify and choose the curve within budget constraints that generates the highest utility.

What is adaptive market hypothesis?

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. Implications: 1. Relationship between risk and reward varies over time, because of changes in risk preferences and changes in the competitive environment; 2. Active mgmt can add value by exploiting arbitrage opportunities; 3. Any investment strategy will not consistently do well but 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: the survivors will be those who successfully learn and adapt to changes.

Discuss specifics of advising Active Accumulators.

Active Accumulator (AA): - basic type: active - risk tolerance: high - primary biases: emotional The most aggressive behavioral investor type. Entrepreneurial and often the first generation to create wealth. At high wealth levels, AAs often have controlled the outcomes of non-investment activities and believe they can do the same with investing. Overconfidence in investing. High portfolio turnover, high risk, often do not follow diversification and allocation rules. Want to be "hands on". Like control, emotional, irrationally optimistic. Adviser must be able to take control and prove to AA that they have the ability to make wise, objective, long-term decisions.

What is status quo bias?

An emotional bias where people do nothing (maintain "status quo") instead of making a change, because they are unwilling to step out of their comfort zone.

What is a regret-aversion bias?

An emotional bias where people tend to avoid making decisions that will result in action out of fear that the decision will turn out poorly. Two types: - error of commission: regret from an action taken - error of omission: regret from an action not taken

What is endowment bias?

An emotional bias where people value an asset more when they hold rights to it than when they do not.

What is self-control bias?

An emotional bias, expressed in lack of self-discipline to delay gratification in pursuit of long term goals. In individuals, it is displayed as reckless spending and inability to save/invest for the long term. In institutional investors, self-control bias occurs when investors deviate from their long-term goals, e.g., the investment policy statement, due to a lack of self-discipline. For instance, when an investor is not adhering to the strategy which has been successful in the past.

What is overconfidence bias?

An emotional bias, in which people demonstrate unwarranted faith in their own intuitive reasoning, judgements and cognitive abilities. - illusion of knowledge bias: prediction overconfidence (too narrow confidence intervals) and certainty overconfidence (too high probabilities assigned to outcomes) - self-attribution bias: taking credit for successes and assigning responsibility for failures (through self-enhancing and self-protecting)

What is a loss-aversion bias?

An emotional bias, in which people tend to strongly prefer avoiding losses as opposed to achieving gain. Disposition effect: the holding (not selling) of investments that have experiences losses (losers) too long, and the selling (not holding) of investments that have experienced gains (winners) too quickly.

What is the investment preference of someone with a mental accounting bias?

An individual with mental accounting bias likely compartmentalizes his portfolio into discrete layers of low-risk assets versus risky assets without regard to the correlations among the assets. Ex.: suppose an individual is presented with two options, Portfolio 1 (100% in global balanced fund that is mean-variance optimized) and Portfolio 2 (25% in CDs, 25% in global bond index fund, 35% in a global equity index fund, and 15% in a high risk, actively manager, micro cap equity fund). Both portfolios provide the same level of income and expected return and have the same Sharpe ratio. Portfolio 2 is constructed with discrete layers for each objective, while Portfolio 1 is constructed to be mean-variance optimized. As a result, the individual would most likely select Portfolio 2, particularly because it has the same income, expected return, and Sharpe ratio as Portfolio 1.

What is an anchoring and adjustment bias?

Anchoring and adjustment bias: an information-processing bias (cognitive error), in which the use of an "anchor", a psychological heuristic, influences the way people estimate probabilities. Anchoring bias is the tendency to give disproportionate weight to the first (or early) information received on a topic (initial impressions, estimates, or data "anchor" subsequent judgements). When required to estimate a value with unknown magnitude, people begin by envisioning some initial default number, which they then adjust up or down.

What is availability bias?

Availability bias: an information-processing bias (cognitive error) in which people take a heuristic approach to estimating the probability of an outcome based on how easily the outcome comes to mind. Four sources of availability bias: - Retrievability: If an answer or idea comes to mind more quickly than another answer or idea, the first answer or idea will likely be chosen as correct even if it is not the reality. - Categorization: if a search set is small, then naturally it will be harder for individual to recall relevant subjects within it, which will lead to an incorrect estimated probability of an event within that search set (e.g. coming up with a list of famous baseball vs soccer players) - Narrow range of experience: occurs when a person with a narrow range of experience uses too narrow a frame of reference based upon that experience when making an estimate. - Resonance: people are often biased by how closely a situation parallels their own personal situation.

What is Barnewall Two Way Model?

Barnewall divided investors into two types: active and passive. "Passive investors" are defined as those investors who have become wealthy passively—for example, by inheritance or by risking the capital of others rather than risking their own capital. Passive investors have a greater need for security than they have tolerance for risk. "Active investors" are individuals who have been actively involved in wealth creation through investment, and they have risked their own capital in achieving their wealth objectives. Active investors have a higher tolerance for risk than they have need for security. Related to their high risk tolerance is the fact that active investors prefer to maintain control of their own investments. Their tolerance for risk is high because they believe in themselves.

What is Bayes' formula?

Bayes' formula is a mathematical rule explaining how existing probability beliefs should be changed given new information. In other words, Bayes' formula expects people to update old beliefs in a certain manner when given new information. P(A|B) = [ P(B|A) / P(B) ] P(A) where: P(A|B) = conditional probability of event A given B. It is the updated probability of A given the new information B. P(B|A) = conditional probability of B given A. It is the probability of the new information B given event A. P(B) = prior (unconditional) probability of information B. P(A) = prior probability of event A, without new information B. This is the base rate or base probability of event A

What is the behavioral approach to asset pricing?

Behavioral Stochastic Discount Factor-based asset pricing models - investors do not make investments in an unbiased way SDF-based equation uses a discount rate that captures time value of money, fundamental risk and sentiment risk. Sentiment = erroneous, subjectively determined beliefs. Discount rate = risk free rate + fundamental premiums + sentiment premium (the traditional DR does not have the sentiment component)

What is the principle difference between traditional and behavioral finance?

Behavioral finance focuses on and attempts to explain how investors and markets behave in practice ("normal"), while traditional finance focuses on how investors in markets should behave (how they behave in theory, "rational").

What is completeness axiom?

Completeness assumes that an individual has well-defined preferences and can decide between any two alternatives. Axiom (Completeness): Given choices A and B, the individual either prefers A to B, prefers B to A, or is indifferent between A and B.

What are axioms of utility theory?

Completeness, transitivity, independence, and continuity. If the individual's decision making satisfies the four axioms, the individual is said to be rational. Put another way, if an individual is to maximize utility, he or she will choose one alternative over another if and only if the expected utility of one alternative exceeds the expected utility of the other alternative.

What is confirmation bias?

Confirmation bias: a belief perseverance bias (cognitive error) in which people tend to look for and notice what confirms their beliefs, and to ignore or undervalue what contradicts their beliefs. Aka selection bias.

What is a conservatism bias?

Conservatism bias: a belief perseverance bias (cognitive error) in which people maintain their prior views or forecasts by inadequately incorporating new information. Academic studies have demonstrated that conservatism causes individuals to overweight initial beliefs about probabilities and outcomes and under-react to new information. This is because of cognitive cost: the effort involved in processing information. The higher the cost, the less likely the info will be processed. Individuals may overreact to information that is easily processed and underweight information that is abstract and statistical. As a result, investors may: - be slow to update a forecast even when presented with new information; - opt to maintain a prior belief rather than deal with the mental stress of updating beliefs given complex data.

What is continuity axiom?

Continuity assumes there are continuous (unbroken) indifference curves such that an individual is indifferent between all points, representing combinations of choices, on a single indifference curve. Axiom (Continuity): When there are three lotteries (A, B, and C) and the individual prefers A to B and B to C, then there should be a possible combination of A and C such that the individual is indifferent between this combination and the lottery B. The end result is continuous indifference curves.

What is disposition effect?

Disposition effect is related to loss aversion. It is an anomaly discovered in behavioral finance that relates to the tendency of investors to sell assets that have increased in value, while keeping assets that have dropped in value. This is because individuals dislike losing significantly more than they enjoy winning. The origins of disposition effects are traced to prospect theory which proposes that when an individual is presented with two equal choices, one having possible gains and the other with possible losses, the individual is more likely to opt for the former choice even though both would yield the same economic result.

How does behavioral finance assist in client retention?

Factors such as previous adviser being solely focused on outperforming the S&P 500, and not understanding client's financial objectives, are what may lead to the inclusion of behavioral factors in the IPS. Including these may aid in client retention because factors other than investment results may be considered when clients seek new advisers. Practitioners may lose clients because clients do not feel as though their advisers understand them and/or their financial objectives. The primary benefit behavioral finance offers is the ability to develop a stronger bond between clients and advisers. The adviser can help the client better understand why a portfolio is designed the way it is and why it is appropriate for him or her, regardless of what happens day-to-day in the markets.

Discuss specifics of advising Friendly Followers.

Friendly Follower (FF): - basic type: passive - risk tolerance: low to medium - primary biases: cognitive Passive investors that tend to follow leads from their friends, colleagues or advisers when making investment decisions. Often overestimate their risk tolerance. Tend to have mainly cognitive biases. Prone to herding behavior. Hindsight bias - FFs think they "knew it all along" when an investment works out well. Shouldn't offer them too many "hot" ideas. The best course of action is to educate them on benefits of portfolio diversification.

What are fundamental anomalies?

Fundamental anomaly: an irregularity that emerges when one considers a stock's performance based on a fundamental assessment of its value (e.g. small cap vs large cap, value vs growth) Arguments for: Value outperforms growth. Low P/B and P/E are a consistent predictor of future value. Low P/E stocks outperform high P/E stocks and market in general. Low P/S outperforms high P/S and market in general. Arguments against: Studies on value investing do not identify anomalies, but rather are a function of incomplete models of asset pricing (Fama & French). Three-factor model instead of CAPM.

Given two layered portfolio allocations and expected portfolio return distributions, how to determine which one would be optimal? Consider an investor who wants to invest 1M, will accept at most 100K loss (900K portfolio value) and has an aspirational portfolio value of 1.05M with 75% probability. The riskless layer will earn 0.50%, and the probability distribution of the expected return on the speculative layer is shown in Exhibit 2. Allocation 1: 59/41% Riskless/Speculative Allocation 2: 90/10% Riskless/Speculative

Given the expected returns for the riskless and speculative layers, Allocation 1 will result in the following amounts: 10% chance: (59% × $1,000,000) × 1.005 + (41% × $1,000,000) × (1 - 0.25) = $900,450 60% chance: (59% × $1,000,000) × 1.005 + (41% × $1,000,000) × (1.12) = $1,052,150 30% chance: (59% × $1,000,000) × 1.005 + (41% × $1,000,000) × (1.50) = $1,207,950 Given the expected returns for the riskless and speculative layers, Allocation 2 will result in the following amounts: 10% chance: (90% × $1,000,000) × 1.005 + (10% × $1,000,000) × (1 - 0.25) = $979,500 60% chance: (90% × $1,000,000) × 1.005 + (10% × $1,000,000) × (1.12) = $1,016,500 30% chance: (90% × $1,000,000) × 1.005 + (10% × $1,000,000) × (1.50) = $1,054,500 Both portfolio allocations meet the safety objective of $900,000 (minimum value of $900,450 for Allocation 1 and $979,500 for Allocation 2). However, Allocation 1 has a 90% chance of exceeding the aspirational level of $1,050,000, whereas Allocation 2 has only a 30% chance of exceeding it. As a result, only Allocation 1 meets both the safety objective and the 75% probability of reaching the aspirational level.

What is the investment preference of an individual with framing and regret bias?

Given two investment options that would result in identical returns, with the difference that one of them follows naive 1/n diversification, an individual with framing and regret bias would select the naively diversified portfolio. - Framing bias may lead such investor to use a 1/n naïve diversification strategy, dividing contributions equally among available funds regardless of the underlying composition of the funds - As a result of a regret bias, investor is likely to choose a conditional 1/n strategy to minimize any potential future regret from one of her funds outperforming another

What is illusion of control bias?

Illusion of control: a bias (cognitive error) in which people tend to believe they can control or influence outcomes when, in fact, they cannot. An illusion of control is a behavioral bias of someone who believes that he or she can know more than others simply by acquiring information. This may result in collection of too much information. While this data may not add to the accuracy of the forecast, it does reinforce the confidence placed in that forecast. For instance, an analyst's endorsement of the complex valuation model which relies on large amounts of data most likely would give her an illusion of control. Results in asset allocation imbalances and accepting too much risk in the portfolio.

What is experimental evidence on gambles that involve a sure loss?

In a choice between the gamble (even with a larger loss) and the sure loss, the gamble may appear more attractive. Experimental results indicate that risk-seeking preferences are held by a large majority of respondents in choices of this kind.

What are the traditional finance assumptions with regards to an individual's decision making process?

In a perfect world, when people make decisions under uncertainty, they are assumed to do the following: 1. Adhere to the axioms of utility theory. 2. Behave in such a way as to assign a probability measure to possible events. 3. Incorporate new information by conditioning probability measures according to Bayes' formula. 4. Choose an action that maximizes the utility function subject to budget constraints (consistently across different decision problems) with respect to this conditional probability measure.

Describe evaluation phase of prospect theory.

In the evaluation phase of prospect theory, people behave as if they compute a value (utility) function based on the potential outcomes and their respective probabilities and then choose the alternative that has a higher utility, using the formula: U = w(p1)v(x1) + w(p2)v(x2) + ... where xi are potential outcomes and pi their respective probabilities; v is a function that assigns a value to an outcome; w is a probability weighting function. The probability-weighting function expresses the fact that people tend to overreact to small probability events but under react to mid-sized and large probabilities.

What is utility and utility theory?

In utility theory, people maximize the present value of utility subject to a present value budget constraint. Utility may be thought of as the level of relative satisfaction received from the consumption of goods and services.

Is implementing behavioral finance meant to necessarily reduce portfolio risk?

Incorporating behavioral finance does not have a direct impact on portfolio risk. In some cases, this approach will help encourage a reduction in portfolio risk, but it may also help other clients to take on more risk as appropriate. Investing as the client expects and improvements to client retention metrics are both benefits of incorporating behavioral finance.

What is independence axiom?

Independence also pertains to well-defined preferences and assumes that the preference order of two choices combined in the same proportion with a third choice maintains the same preference order as the original preference order of the two choices. Axiom (Independence): Let A and B be two mutually exclusive choices, and let C be a third choice that can be combined with A or B. If A is preferred to B and some amount, x, of C is added to A and B, then A plus xC is preferred to B plus xC. This assumption allows for additive utilities. If the utility of A is dependent on how much of C is available, the utilities are not additive.

Discuss specifics of advising Independent Individualists.

Independent Individualist (II): - basic type: active - risk tolerance: medium to high - primary biases: cognitive Strong-willed and independent thinkers. Do research on their own, may make an investment without consulting anyone. Enjoy investing and are comfortable taking risks, but often resist a financial plan. Out of all types, IIs are more likely to be contrarian. Biases are typically cognitive. Usually willing to listen to sound advice when it's presented in a way that respects their intelligence. Education is essential to changing their behavior.

Relationship with what type of investor is more likely to suffer from an excessive reliance on risk tolerance questionnaires?

Investor types involving emotional biases - passive preservers and active accumulators. Because risk analysis is a cognitive process, the risk tolerance questionnaires may fail these investors who are likely to view risk as an emotional process.

What are the implications of availability bias (and also some other biases)?

Investors who exhibit availability bias may limit their investment opportunity set, may choose an investment without doing a thorough analysis of the stock, may fail to diversify, and may not achieve an appropriate asset allocation. The implications of this bias lead the portfolio to be undiversified, and as a result, the portfolio holds assets that may not be appropriate.

What is the main assumption of utility theory?

It is assumed that a rational decision maker follows rules of preference consistent with the axioms and that the utility function of a rational decision maker reflects the axioms. From any set of alternatives, a rational decision maker makes decisions consistent with the axioms of utility theory and chooses the combination of decisions that maximizes expected utility.

What is isolation effect?

Kanneman and Tversky, Prospect Theory: To simplify the choice between alternatives, people frequently disregard components that the alternatives share and instead focus on those that distinguish them. Because different choice problems can be decomposed in different ways, inconsistent preferences can result. Ex.: p. 25 in the book on Behavioral Finance - the gamble example, where how prospects were framed had an effect on the choice.

What is efficient market hypothesis?

Markets fully, accurately, and instantaneously incorporate all available information into market prices. Assumes perfect rationality and perfect information, and also that whenever new relevant information appears, the population updates its expectation (Bayes' Rule).

What is a strength of technical analysis?

Momentum can be partly explained by short-term under-reaction to relevant information, and longer term over-reaction and thus supports a view that the technical analysis department has value.

In the framework of prospect theory, what is experimental evidence of human behavior in a gamble with even chances to win or lose?

Most people reject a gamble with even chances to win and lose unless the possible win is at least twice the size of the possible loss. Ex.: Situation 1 A 50% probability of winning $10,000 and a 50% probability of losing $4,000 Situation 2 A 50% probability of winning $10,000 and a 50% probability of losing $8,000 Most people would accept situation 1 and reject situation 2

What is the difference between loss aversion and myopic loss aversion?

Myopic loss aversion describes the phenomenon whereby investors overestimate the risk of equity, keeping stock prices too low and the equity risk premium too high. The terms are similar in that myopic loss aversion is a consequence of loss aversion. The difference is that loss aversion concerns individual behavior, whereas myopic loss aversion describes the effect on overall markets.

What is neuro-economics?

Neuro-economics is an emerging study that combines neuroscience, psychology, and economics in attempting to explain how humans make economic decisions under conditions of uncertainty. Neuro-economics attempts to bridge the gap between research on decision behavior and economic theory by understanding the brain activity of judgment and making choices.

Which behavioral bias is most often observed during asset bubbles?

Overconfidence. In asset bubbles, investors often exhibit symptoms of overconfidence: overtrading, under-estimation of risks, failure to diversify, and rejection of contradictory information. With overconfidence, investors are more active and trading volume increases, thus lowering their expected profits. Overconfidence and excessive trading are linked to confirmation bias and self-attribution bias, as well as hindsight bias and the illusion of knowledge.

Discuss specifics of advising Passive Preservers.

Passive Preserver (PP): - basic type: passive - risk tolerance: low - primary biases: emotional Obtained wealth passively, without risking own capital, so not financially sophisticated, not comfortable with change and obsess over short-term performance. Driven by emotion. Passive Preservers may be difficult to advise because they are driven mainly by emotion. PPs are more receptive to "big picture" advice that does not dwell on such details as standard deviations and Sharpe ratios. Because PPs are emotionally biased, providing excessive cognitive detail will lose their attention. PP needs to be convinced of his advisor's general philosophy first and then, as trust is gained, he will respond to advice and take action. Advisers should focus on what the money will accomplish, such as family legacy goals, education, and so on.

Portfolio of what kind of individual would least likely deviate from a mean-variance portfolio?

Portfolio of an individual that has primarily cognitive error biases. Cognitive nature of biases provides for a possibility that, with education, the impact of these biases can be reduced or even eliminated. Because cognitive biases dominate, an advisor should seek to moderate the effect of these biases and adopt a program to reduce or eliminate the bias rather than accept the bias (as would be the case with emotional biases). The result will be a portfolio that is similar to the mean-variance portfolio.

What is prospect theory?

Prospect theory is an alternative to expected utility theory. This theory describes how individuals make choices in situations in which they must decide between alternatives that involve risk and how they evaluate potential losses and gains. Prospect theory considers how alternatives are perceived based on their framing, how gains and losses are evaluated, and how uncertain outcomes are weighted. - people choose to take on risk when evaluating potential losses and avoid risks when evaluating potential gains - prospect theory assigns value to gains and losses (changes in wealth) rather than to final wealth - probabilities are replaced by decision weights - the value function is defined by deviations from a reference point and is normally concave for gains (implying risk aversion), convex for losses (risk-seeking), and steeper for losses than for gains (loss aversion) - reference dependence is a key feature of prospect theory - decision weights are generally lower than the corresponding probabilities, except in the range of low probabilities - 2 stages of decision-making: an early phase in which prospects are framed (or edited) and a subsequent phase where prospects are evaluated and chosen - Depending on number of prospects, there may be up to six operations in the editing process: codification, combination, segregation, cancellation, simplification, and detection of dominance.

Which behavioral biases could explain the presence of momentum?

Regret is a type of hindsight bias that can result in investors purchasing securities after a significant run-up in price because of a fear of not participating. With availability bias, also referred to as the recency effect, the tendency to recall recent events more vividly can result in investors extrapolating recent price gains into the future. Framing bias is a type of cognitive error in which a person answers a question differently based on the way in which it is asked. This behavior is unlikely to explain the persistence of momentum.

What is representativeness bias?

Representativeness bias: a belief perseverance bias (cognitive error) in which people tend to classify new information based on past experiences and classifications, or into a personalized category. An example of that could be an investor relating the certainty about the future or her decision to hold losing positions back to something she has done or experienced in the past. A consequence of representativeness bias is placing an emphasis on short term performance results. Two types: - base-rate neglect: bias where the base rate or probability of categorization is not adequately considered. Involves relying on stereotypes when making investment decisions without adequately incorporating the base probability of the stereotype occurring (e.g. when long-term history suggests that more companies in particular industry do not go out of business - "base rate", but analyst instead relies on a few recent headlines about single cases of bankruptcy). - sample-size neglect: incorrect assumption that small sample sizes are representative of populations. "Law of small numbers".

What is the difference between behaviors that are risk-averse, risk-neutral and risk-seeking?

Risk-averse is someone who prefers to invest to receive an expected value with certainty rather than invest in the uncertain alternative that generates the same expected value. Risk-neutral is someone who is indifferent between two investments. Risk-seeking is someone who prefers to invest in the uncertain alternative. In traditional finance, individuals are assumed to be risk-averse.

What are utility functions of risk-neutral, risk-averse and risk-seeking individuals?

Risk-neutral: linear utility function. Means that utility increases at a constant rate with increases in wealth; the risk-neutral individual has a constant marginal utility of wealth. Risk-averse: concave utility function. Means that utility increases at a decreasing rate with increases in wealth; the risk-averse individual has a diminishing marginal utility of wealth. Risk-seeking: convex utility function. Means that utility increases at an increasing rate with increases in wealth; the risk-seeking individual has an increasing marginal utility of wealth. The degree of risk aversion can be measured by the curvature of the utility function.

What are potential flaws of group decision making / consensus?

Social proof is a belief in which individuals are biased to follow the beliefs of a group. Suppose a committee meets to discuss and debate each security and then votes on which will be approved. Committee members may wrongly favor the judgment of others, often without being fully aware that they are doing so. The process of reaching a consensus will usually narrow the range of views. If a group decision process does not encourage private information held by individual committee members to be shared fully with others before a decision is made, the decision may fail to combine the collective wisdom of the group.

What are technical anomalies?

Technical anomaly: an irregularity that emerges when one considers past prices and volume levels. Technical analysis uses techniques to forecast prices by studying past prices and volumes: relative strength, moving averages, support and resistance. Moving averages: buy and sell signals are generated by the crossing of a short moving average with a long moving average - when short is above (below), the signal is to buy (sell). Trading range break (support and resistance): a buy signal is generated when price penetrates the resistance level, and a sell signal is generated when the price penetrates the support level. Validity of technical analysis is a hotly debated topic.

What is the Five Way Model?

The Adventurer: Adventurers may hold highly undiversified portfolios because they are confident and willing to take chances. Their confidence leads them to make their own decisions and makes them reluctant to take advice. This presents a challenge for an investment adviser. The Celebrity: Celebrities like to be the center of attention. They may hold opinions about some things but to a certain extent recognize their limitations and may be willing to seek and take advice about investing. The Individualist: Individualists are independent and confident, which may be reflected in their choice of employment. They like to make their own decisions but only after careful analysis. They are pleasant to advise because they will listen and process information rationally. The Guardian: Guardians are cautious and concerned about the future. As people age and approach retirement, they may become guardians. They are concerned about protecting their assets and may seek advice from those they perceive as being more knowledgeable than themselves. The Straight Arrow: Straight arrows are sensible and secure. They fall near the center of the graph. They are willing to take on some risk in the expectation of earning a commensurate return.

What is theory of bounded rationality?

The notion that people have informational and cognitive limitations when making decisions and do not necessarily optimize when arriving at their decisions. People are not fully rational when making decisions and do not necessarily optimize but rather satisfice when arriving at their decisions. Satisfice is a combination of "satisfy" and "suffice" describing decisions, actions, and outcomes that may not be optimal, but are adequate. Cost and time of finding the optimal solution can be very high. So people instead set constraints as to what will satisfy their needs - aspiration levels. Aspiration levels are set based on experiences and on comparisons with what other individuals have achieved. People tend to aspire for a future that is better than the past. When aspirations are reached, people tend to adjust the aspirations upward; when aspirations are not reached, people tend to adjust downward.

How does behavioral finance challenge the traditional Rational Economic Man theory?

- attacking basic assumptions of perfect information, perfect rationality and perfect self-interest - bounded rationality: assumes that individuals' choices are rational but are subject to limitations of knowledge and cognitive capacity - REM does not account for inner conflicts that humans face (e.g. spending vs saving, societal values etc.) - not all financial markets participants have the same level of financial/economic understanding to act rationally (e.g. while anyone can access central bank data, not all know the role of central banks and what the data mean)

What are the biases that contribute to defined contribution plan participants?

- naive diversification - status quo - framing (when holding company stock) - familiarity bias (when holding company stock) Status quo bias is when an investor sticks with the default investment option and default contribution rate in a company retirement plan. Conditional naïve diversification is when an investor allocates equally among a select number of investment choices in their company retirement plan Framing refers to the misconception that by matching the employee's contribution with company stock the sponsor is implicitly endorsing it as a good investment. Familiarity bias refers to investors selecting stocks with which they are comfortable with or have a proximity to. If company stock is offered as an investment option in a defined contribution plan, participants may feel a sense of control or allegiance to the firm and hold more company stock than is sensible, which is an effect of familiarity.

What is experimental evidence on gambles with even chances to win or lose?

Evidence shows that most people reject a gamble with even chances to win and lose, unless the possible win is at least twice the size of the possible loss.

What is halo effect?

Halo effect is the tendency for positive impressions of a person, company, brand or product in one area to positively influence one's opinion or feelings in other areas. It is a type of cognitive bias and is the opposite of the horn effect, where one's perception of another is unduly influenced by a single negative trait.

Placing an emphasis on short-term performance is a consequence of which bias?

Representativeness bias

What is the certainty equivalent?

The certainty equivalent is the maximum sum of money a person would pay to participate or the minimum sum of money a person would accept to not participate in the opportunity. The difference between the certainty equivalent and the expected value is called the risk premium.

What is transitivity axiom?

Transitivity assumes that, as an individual decides according to the completeness axiom, an individual decides consistently. Axiom (Transitivity): Transitivity is illustrated by the following examples. Given choices A, B, and C, if an individual prefers A to B and prefers B to C, then the individual prefers A to C; if an individual prefers A to B and is indifferent between B and C, then the individual prefers A to C; or, if an individual is indifferent between A and B and prefers A to C, then the individual prefers B to C.

What is gambler's fallacy?

a misunderstanding of probabilities in which analysts wrongly project reversal to a long-term mean. This bias is caused by a faulty understanding of random events and expecting patterns to repeat.

Limiting the upside by selling winners too soon while holding on to losers is a consequence of which bias?

Loss aversion bias