CFA Level III

Editing Phase

1) Codification 2) Combination 3) Segregation **only when compares two or more proposals*** 4) Cancellation 5) Simplification 6) Detection of dominance

Cognitive Errors: Belief Perseverance

1. Conservatism bias occurs when market participants rationally form an initial view but then fail to change that view as new information becomes available. In Bayesian terminology they overweight the initial probabilities and do not adjust probabilities for the new information. Consequences and implications of conservatism may include market participants who are: •Unwilling or slow to update a view and therefore hold an investment too long. •Hold an investment too long to avoid the mental effort or stress of updating a view. Conservatism detection starts with participants becoming aware of their own biases. The more difficult the thought process or information, the more likely conservatism bias will occur. Conversely easy changes may be made too often because they involve little mental effort. Thus conservatism can lead to either too little or too much change and turnover.

The success of the typical client/adviser relationship can be measured in four areas, and each one is enhanced by incorporating behavioral finance traits

1. The adviser understands the long-term financial goals of the client. Behavioral finance helps the adviser understand the reasons for the client's goals. The client/adviser relationship is enhanced because the client feels the adviser truly understands him and his needs. The adviser maintains a consistent approach with the client. Behavioral finance adds structure and professionalism to the relationship, which helps the adviser understand the client before giving investment advice 3. The adviser acts as the client expects. This is the area that can be most enhanced by incorporating behavioral finance into the client/adviser relationship. Once the adviser thoroughly understands the client and her motivations, the adviser knows what actions to perform, what information to provide, and the frequency of contact required to keep the client happy. 4. Both client and adviser benefit from the relationship. The primary benefit of incorporating behavioral finance into the client/advisor relationship is a closer bond between the two. This results in happier clients and an enhanced practice and career for the adviser.

Bailard, Biehl, and Kaiser (BB&K) five-way model

1.The adventurer has the following traits: •Confident and impetuous (northeast quadrant). •Might hold highly concentrated portfolios. •Willing to take chances. •Likes to make own decisions. •Unwilling to take advice. •Advisors find them difficult to work with 2.The celebrity has the following traits: •Anxious and impetuous (southeast quadrant). •Might have opinions but recognizes limitations. •Seeks and takes advice about investing. 3.The individualist has the following traits: •Confident and careful (northwest quadrant). •Likes to make own decisions after careful analysis. •Good to work with because they listen and process information rationally. 4.The guardian has the following traits: •Anxious and careful (southwest quadrant). •Concerned with the future and protecting assets. •May seek the advice of someone they perceive as more knowledgeable than themselves. 5.The straight arrow has the following traits: •Average investor (intersection of the two dimensions). •Neither overly confident nor anxious. •Neither overly careful nor impetuous. •Willing to take increased risk for increased expected return.

momentum effect

All forms of the EMH assert technical-price-based trading rules should not add value. Yet studies continue to show evidence of correlation in price movement. A pattern of returns that is correlated with the recent past would be classified as a momentum effect. This effect can last up to two years, after which it generally reverses itself and becomes negatively correlated, with returns reverting to the mean. This effect is caused by investors following the lead of others, which at first is not considered to be irrational. The collective sum of those investors trading in the same direction results in irrational behavior, however. There are several forms of momentum that can take place, which are discussed in the following.

illusion of knowledge bias

Analysts are subject to the illusion of knowledge bias when they think they are smarter than they are. This, in turn, makes them think their forecasts are more accurate than the evidence indicates. The illusion of knowledge is fueled when analysts collect a large amount of data. This leads them to think their forecasts are better because they have more and better information than others. Gathering additional information could add to an analyst's overconfidence without necessarily making the forecast more accurate. The illusion of control bias can lead analysts to feel they have all available data and have reduced or eliminated all risk in the forecasting model; hence, the link to overconfidence

Overconfidence

Analysts can be susceptible to overconfidence as a result of undue faith in their own forecasting abilities caused by an inflated opinion of their own knowledge, ability, and access to information. Analysts also tend to remember their previous forecasts as being more accurate than they really were (a form of hindsight bias). As a result, they overestimate their accuracy and understate potential risk. There are several behavioral biases that contribute to overconfidence.

Distinguish between cognitive errors and emotional biases.

Cognitive errors are due primarily to faulty reasoning and could arise from a lack of understanding proper statistical analysis techniques, information processing mistakes, faulty reasoning, or memory errors. Such errors can often be corrected or mitigated with better training or information. In contrast emotional biases are not related to conscious thought and stem from feelings or impulses or intuition. As such they are more difficult to overcome and may have to be accommodated. Despite the distinction in grouping biases as either cognitive or emotional, a bias may have elements of both cognition and emotion. When trying to overcome or mitigate biases that are both emotional and cognitive, success is more likely by focusing on the cognitive issues.

Behaviorally Modified Asset Allocation (BMAA)

BMAA is another approach to asset allocation that incorporates the client's behavioral biases. A worst case scenario for many clients is to abandon an investment strategy during adverse periods. The outcome can be very detrimental because the change is likely to occur at a low point, right before a recovery for the strategy begins. Determining in advance a strategy the client can adhere to during adverse periods would be a better outcome. BMAA considers whether it is better to moderate or adapt to the client's biases in order to construct a portfolio the client can stick with. BMAA starts with identifying an optimal strategic asset allocation consistent with traditional finance. It then considers the relative wealth of the client and the emotional versus cognitive nature of the client's biases to adjust that allocation.•A high level of wealth versus lifestyle and what the client considers essential needs would be a low standard of living risk (SLR). With a low SLR the client can afford to deviate from an optimal portfolio. The rich can afford to be eccentric.•Biases that are primarily cognitive in nature are easier to moderate. Working with the client can accomplish this and allow for less deviation from a traditionally efficient portfolio mix.•In contrast emotionally based biases are generally harder to moderate and may have to be adapted to, resulting in a less efficient portfolio.•Finally the amount of deviation to accept from a traditional optimal allocation should be established. Typically this would be done by setting a range in which an asset class can deviate from optimal before it must be adjusted back. For example suppose an optimal allocation would call for 60% equity for the client.

3. Behavioral portfolio theory (BPT):

Based on empirical evidence and observation, rather than hold a well-diversified portfolio as prescribed by traditional finance, individuals construct a portfolio by layers. Each layer reflects a different expected return and risk. BPT further asserts that individuals tend to concentrate their holdings in nearly risk-free or much riskier assets. Allocation of funds to an investment of each layer depends on: • The importance of each goal to the investor. If a high return for the goal is important, funds will be allocated to the high-return (high-risk) layer. If low risk is crucial to the goal, funds will be allocated to the low-risk (low-return) layer.•Asset selection will be done by layer and based on the goal for that layer. If high return is the goal, then higher-risk, more-speculative assets will be selected.•The number of assets in a layer will reflect the investor's risk aversion. Risk-averse investors with a concave utility function will hold larger numbers of assets in each layer.•If an investor believes they hold an information advantage (have information others do not have), more concentrated positions will be held.•If an investor is loss-averse, the investor will hold larger cash positions to avoid the possible need to sell assets at a loss to meet liquidity needs. The resulting overall portfolio may appear to be diversified but is likely to be sub-optimal because the layers were constructed without regard to their correlation with each other. Such layering can explain:•The irrational holding of both insurance, a low risk asset, and high-risk lottery tickets by the same individual.•Holding excess cash and low-risk bonds in the low-risk layer and excessively risky assets in the high-risk layer. (This also includes not holding more moderate-risk assets.)

Complex Risk Functions

Behavioral finance observes that individuals sometimes exhibit risk-seeking as well as risk-averse behavior. Many people simultaneously purchase low-payoff, low-risk insurance policies (risk-averse behavior) and low-probability, high-payoff lottery tickets (risk-seeking behavior). Combinations of risk seeking and risk aversion may result in a complex double inflection utility function.

Bounded Rationality vs. Prospect Theory

Bounded rationality relaxes the assumptions of perfect information and maximizing expected utility. Prospect theory further relaxes the assumption of risk aversion and instead proposes loss aversion. Prospect theory is suited to analyzing investment decisions and risk. It focuses on the framing of decisions as either gains or losses and weighting uncertain outcomes. While utility theory assumes risk aversion, prospect theory assumes loss aversion

Codification

Codification codes the proposal as a gain or loss of value and assigns a probability to each possible outcome. To do this, the reference point must be selected.

Combination

Combination simplifies the outcomes by combining those with identical values. For example, an investor might probability weight expected returns of a stock (codification) and then combine identical outcomes

Decision Theory

Decision theory is focused on making the ideal decision when the decision maker is fully informed, mathematically able, and rational. The theory has evolved over time. •Initial analysis focused on selecting the highest probability-weighted payoff.•Later evolution separated expected value, which is just the market price of an item paid by anyone versus expected utility. Expected utility is subjective and depends on the unique preferences of individuals and their unique rate of diminishing marginal utility and substitution. •Risk is defined as a random variable due to the one outcome that will occur from any probability-weighted analysis. For example, a stock has an expected return denoted E(R) of 10% but returns 12%. Risk can be incorporated into analysis by maximizing expected utility. •In contrast, uncertainty is unknowable outcomes and probabilities. It is, by definition, immeasurable and not amenable to traditional utility maximization analysis. •Subjective analysis extends decision theory to situations where probability cannot be objectively measured but is subjective.

isolation effect

Editing choices can sometimes lead to the preference anomaly known as the isolation effect, where investors focus on one factor or outcome while consciously eliminating or subconsciously ignoring others. It is referred to as an anomaly because the sequence of the editing can lead to different decisions.

representativeness

Exhibiting representativeness, an analyst judges the probability of a forecast being correct on how well the available data represent (i.e., fit) the outcome. The analyst incorrectly combines two probabilities: (1) the probability that the information fits a certain information category, and (2) the probability that the category of information fits the conclusion. An analyst exhibits the availability bias when he gives undue weight to more recent, readily recalled data. Being able to quickly recall information makes the analyst more likely to "fit" it with new information and conclusions. The representativeness and availability biases are commonly exhibited in reactions to rare events.

There are several actions analysts can take to minimize (mitigate) overconfidence in their forecasts

For example, they can self-calibrate better. Self-calibration is the process of remembering their previous forecasts more accurately in relation to how close the forecast was to the actual outcome. Getting prompt and immediate feedback through self evaluations, colleagues, and superiors, combined with a structure that rewards accuracy, should lead to better self-calibration. Analysts' forecasts should be unambiguous and detailed, which will help reduce hindsight bias.

3. Framing bias

Framing bias occurs when decisions are affected by the way in which the question or data is "framed." In other words, the way the question is framed affects how the information is processed leading to the answer given. For instance, if a stock is priced at GBP20 and that is compared to a cost basis of GBP 15, the holder is more likely to sell (and experience the pleasure of realizing a gain). But if the price of GBP20 is compared to a previous close of GBP25, the holder is less likely to sell (and experience the pain of a loss). If only one or two reference points are considered (as above), it could be called narrow framing. Consequences and implications of framing bias may include market participants who:•Fail to properly assess risk and end up overly risk-averse or risk-seeking.•Choose suboptimal risk for their portfolio or assets based on the way a presentation is made.•Become overly concerned with short term price movement and trade too often. Framing could be detected by asking a question such as "Is my decision based on realizing a gain or a loss?" Instead a more appropriate analysis might compare current price to intrinsic value analysis.

Influence by Company Management

Framing refers to a person's inclination to interpret the same information differently depending on how it is presented. We know, for example, that simply changing the order in which information is presented can change the recipient's interpretation of the information. In the case of company information, analysts should be aware that a typical management report presents accomplishments first. Anchoring and adjustment refers to being "anchored" to a previous data point. Being influenced by (anchored to) the previous forecast, analysts are not able to fully incorporate or make an appropriate adjustment in their forecast to fully incorporate the effect of new information. The way the information is framed (presenting the company's accomplishments first), combined with anchoring (being overly influenced by the first information received), can lead to overemphasis of positive outcomes in forecasts.

Goals-Based Investing (GBI)

GBI starts with establishing the relative importance to the client of each of the client's goals. •Essential needs and obligations should be identified and quantified first. These would include essential living expenses and should be met with low risk investments as the base layer of the portfolio assets.•Next might come desired outcomes such as annual giving to charity which can be met with a layer of moderate risk investments.•Finally low priority aspirations such as increasing the value of the portfolio to leave it to a foundation at death could be met with higher risk investments. GBI is consistent with the concept of loss-aversion in prospect theory. The client can see that more important goals are exposed to less risky assets and less potential loss. It is better suited to wealth preservation than to wealth accumulation. By utilizing the mental accounting of layers to meet goals, the client can better understand the construction of the portfolio.

Herding

Herding is when investors trade in the same direction or in the same securities, and possibly even trade contrary to the information they have available to them. Herding sometimes makes investors feel more comfortable because they are trading with the consensus of a group. Two behavioral biases associated with herding are the availability bias (a.k.a. the recency bias or recency effect) and fear of regret. In the availability bias, recent information is given more importance because it is most vividly remembered. It is also referred to as the availability bias because it is based on data that are readily available, including small data samples or data that do not provide a complete picture. In the context of herding, the recent data or trend is extrapolated by investors into a forecast. Regret is the feeling that an opportunity has passed by and is a hindsight bias. The investor looks back thinking they should have bought or sold a particular investment (note that in the availability bias, the investor most easily recalls the recent positive performance). Regret can lead investors to buy investments they wish they had purchased, which in turn fuels a trend-chasing effect. Chasing trends can lead to excessive trading, which in turn creates short-term trends.

Hindsight bias

Hindsight bias is another ego defense mechanism. In effect, the analyst selectively recalls details of the forecast or reshapes it in such a way that it fits the outcome. In this way, the forecast, even though it technically was off target, serves to fuel the analyst's overconfidence. Hindsight bias then leads to future failures. By making their prior forecasts fit outcomes, analysts fail to properly recalibrate their models

Excessive trading of holdings is evident in the brokerage account holdings of individuals even though individuals show status quo in retirement funds. This could be due to overconfidence as the individuals think they have superior stock selection skills or self selection as trading-oriented investors put their money in brokerage accounts and others put money in retirement portfolios at their company. Investors also show a disposition effect in selling stocks that appreciate (e.g., winners) but holding on to stocks that depreciate (e.g., losers).

Home bias is seen in under diversification and failing to invest outside the investor's home country

Traditional finance generally assumes individuals are risk-averse and prefer greater certainty to less certainty

In contrast, behavioral finance assumes that individuals may be risk-averse, risk-neutral, risk-seeking, or any combination of the three; the way something is presented can affect decision making

The Evaluation Phase

In the evaluation phase, investors place values on alternatives in terms of weighted and probability-weighted outcome to determine expected utility. A quantitative illustration is complex and specifically stated to be unnecessary to the purpose of the reading (thus, it is not presented here). The equation is shown as: utility = w(p1)v(X1) + w(p2)v(X2) + ... where: p1 and p2 = probability weights of possible outcomes X1 and X2 v = a function that assigns value to an outcome w = a probability weighting function

risk aversion vs. loss aversion

In the second phase, the evaluation phase, investors focus on loss aversion rather than risk aversion. The difference is subtle, but the implication is that investors are more concerned with the change in wealth than they are in the resulting level of wealth, per se. In addition, investors are assumed to place a greater value in change on a loss than on a gain of the same amount. Given a potential loss and gain of equal sizes, the increase in utility associated with the potential gain is smaller than the decrease in utility (i.e., disutility) associated with the potential loss. Investors tend to fear losses and can become risk seeking (assume riskier positions) in an attempt to avoid them

Further Implications of Biases on Investment Policy and Asset Allocation

Investment practitioners who understand behavioral biases have a better chance of constructing and managing portfolios that benefit normal clients. By first acknowledging and then accommodating or modifying biases, more optimal results are likely. This starts with asking the right questions:•What are the biases of the client?•Are they primarily emotional or cognitive?•How do they effect portfolio asset allocation?•Should the biases be moderated or adapted to?•Is a behaviorally modified asset allocation warranted?•What are the appropriate quantifiable modifications?

Satisfice and bounded rationality

Jane Smith has excess funds she can deposit to earn interest. She wants the funds to be backed by the government, so she visits the bank closest to her workplace. The rate seems acceptable, and she makes the deposit after verifying that the deposits are government insured. Is her behavior consistent with a rational economic man? No. Smith is showing bounded rationality and satisfice. The rate was adequate and met the condition of government guarantee, so she accepted it. She did not research all other options or have perfect information (bounded rationality). There is no reason to expect that this particular rate is the optimal solution

1. Loss-aversion bias

Loss-aversion bias has already been well discussed previously. It arises from feeling more pain from a loss than pleasure from an equal gain. Consequences and implications of loss-aversion may include:•Feeling less pleasure in a gain in value for a profit than pain in a decline in value for an equal loss.•To avoid the pain of loss an investment holder will tend to hold on to losers too long but may sell winners too quickly.•Trade too much by selling for small gains which raises transaction costs and lowers returns.•Incurring too much risk by continuing to hold assets that have deteriorated in quality and lost value.•If an initial decline in value occurs, then taking excessive risk in the hope of recovering. Investment managers can be particularly susceptible to this behavior.•Allowing the framing of the reference point to determine if a position is seen as a gain or loss.•Treating money that is made on a trade differently than other funds and taking excess risk with such money.•Myopic loss aversion occurs when the shorter term risk of stocks incorrectly leads to an excessively high equity risk premiums in the market. The excessive risk premium ignores that long-term equity returns are favorable and leads to general underpricing and under-weighting of equity in portfolios. Loss aversion could be overcome by maintaining a disciplined well thought out process based on future prospects of an investment, not perceived gain or loss.

Mental accounting bias

Mental accounting bias arises when money is treated differently depending on how it is categorized. For example a client might mentally treat wages differently from a bonus when determining saving and investment goals. Consequences and implications of mental accounting may include market participants: •Structuring portfolios in layers to meet different priority goals. This may help clients overcome other biases. But it ignores correlation between layers of the portfolio and results can be suboptimal from a traditional perspective. •Failing to lower portfolio risk by adding assets with very low correlation. •Segregating return into arbitrary categories of income, realized gains and losses, or unrealized gains and losses. The result tends to be an overemphasis on income generating assets, resulting in a lower total return. Mental accounting could be detected by examining what the portfolio could have achieved if the entire client assets were examined as one portfolio considering the effects of correlation among all parts of the portfolio. An excessive focus on source of return (i.e., income versus price appreciation) could be detected by analyzing the maximum total return consistent with the investor's risk objective and constraints. If this is considerably better than the existing expected return of the portfolio, too much attention is being placed on source of return. For example, if the portfolio has an expected return of 6.7% and the return is primarily income but another portfolio with the same risk but less income has an expected return of 7.5%, it would appear better to accept the portfolio generating less income.

Pompian behavioral model

Most common emotional biases exhibited:•Passive Preserver: Endowment, loss aversion, status quo, regret aversion.•Friendly Follower: Regret aversion.•Independent Individualist: Overconfidence, self-attribution.•Active Accumulator: Overconfidence, self-control. Most common cognitive biases exhibited:•Passive Preserver: Mental accounting, anchoring and adjustment.•Friendly Follower: Availability, hindsight, framing.•Independent Individualist: Conservatism, availability, confirmation, representativeness.•Active Accumulator: Illusion of control.

Fundamental anomalies would relate future stock returns to stock fundamentals, such as P/E or dividend yield. Fundamental anomalies would be violations of both semi-strong and strong-form efficiency. Numerous studies have shown evidence that value stocks with lower P/E, P/B, and P/S, higher E/P and B/P, and dividend yield outperform growth stocks (which tend to have the opposite fundamental characteristics). Studies show abnormal positive returns for small-cap stocks.

Other studies suggest the abnormal return of value stocks is not evidence of excess return but of higher risk. Fama and French (1995, 2008) propose extending the capital asset pricing model (CAPM) to include market cap and B/P as priced risks. Analysis using these revised risk premiums suggests the apparent excess returns are just a failure to properly adjust (upward) for risk.

Behavioral Investor Types (BITs)

Passive Preserver, characterized as having low risk tolerance, an emotional bias, not willing to risk his own capital, usually not financially sophisticated, and possibly difficult to advise because he is driven by emotion. Friendly Follower would also be considered a passive investor who has low to moderate risk tolerance and suffers mainly from cognitive errors, which are errors resulting from faulty reasoning and not emotional biases. A Friendly Follower tends to overestimate her risk tolerance and wants to be in the most popular investments with little regard to market conditions or how the investment fits into her overall long-term investment plan. Since a Friendly Follower tends to approach investing from a more cognitive (thinking) perspective, the best course of action in advising her is to use more quantitative methods in educating her on the benefits of portfolio diversification. Independent Individualist is an active investor who is willing to risk his own capital and give up security to gain wealth. He has moderate to high risk tolerance and suffers from cognitive biases. He is strong-willed, likes to invest, does his own research, and tends to be a contrarian. The Independent Individualist tends to be difficult to advise but will listen to sound advice. Therefore, the best approach to advising him is regular education on investing concepts relevant to the investor Active Accumulator is an active investor with a high tolerance for risk who approaches investing from an emotional perspective. The Active Accumulator is an aggressive investor who often comes from an entrepreneurial background and likes to get deeply involved in her investing. She is strong-willed, confident, and likes to control her investing, making her the most difficult of all the BITs to advise. Thus, the best course of action for the adviser is to take control of the investment process and not let the investor control the situation.

prospect theory continued

Prospect theory assumes that losses and gains are valued differently, and thus individuals make decisions based on perceived gains instead of perceived losses. Also known as "loss-aversion" theory, the general concept is that if two choices are put before an individual, both equal, with one presented in terms of potential gains and the other in terms of possible losses, the former option will be chosen. Read more: Prospect Theory https://www.investopedia.com/terms/p/prospecttheory.asp#ixzz4yQQzizIR Follow us: Investopedia on Facebook

Segregation

Segregation can be used to separate an expected return into both a risk-free and risky component of return. For example, assume a gamble offers a 75% chance of a $100 payoff and a 25% chance of paying $150. This can be segregated as a 100% risk-free payoff of $100 and a 25% chance of another $50.

Adaptive markets hypothesis (AMH):

The AMH assumes successful market participants apply heuristics until they no longer work and then adjust them accordingly. In other words, success in the market is an evolutionary process. Those who do not or cannot adapt do not survive. Because AMH is based on behavioral finance theory, it assumes investors satisfice rather than maximize utility. Based on an amount of information they feel is sufficient, they make decisions to reach subgoals, steps that advance them toward their desired goal. In this fashion, they do not necessarily make optimal decisions as prescribed by utility theory or act as REM. Through trial and error, these heuristic rules that work come to be adopted by more and more participants until they are reflected in market pricing and then no longer work. The market evolves.

Analyst Biases in Research

The confirmation bias (related to confirming evidence) relates to the tendency to view new information as confirmation of an original forecast. It helps the analyst resolve cognitive dissonance by focusing on confirming information, ignoring contradictory information, or interpreting information in such a way that it conforms to the analyst's way of thinking. The confirmation bias can also be seen in analysts' forecasts where they associate a sound company with a safe investment, even though the stock price and the current economic environment would indicate otherwise. The gambler's fallacy, in investing terms, is thinking that there will be a reversal to the long-term mean more frequently than actually happens. A representative bias is one in which the analyst inaccurately extrapolates past data into the future. An example of a representative bias would be classifying a firm as a growth firm based solely on previous high growth without considering other variables affecting the firm's future.

Important Implications of the Evaluation Phase

The important implications are:•w reflects a tendency of individuals to overreact to small probabilities and underreact to large probabilities. •The value function is based on changes and is not level. •The resulting value function is S-shaped and asymmetric. Individuals experience a greater decline in value for a given loss than a rise in value for a corresponding gain. •As a result, most investors are risk averse when presented with gains. Empirical studies show that when given an equal chance of making $100 or losing $70, most individuals will not take the bet. They are risk averse and want a higher expected payoff than $15. •However, most individuals are risk seekers when confronted with likely losses. Offered the choice of a sure loss of $75 or a 50/50 chance of winning $30 or losing $200, they exhibit risk-seeking behavior by taking the bet that has an expected payoff of -$85. The bet is worse than the sure loss of $75. •This could explain why many investors over-concentrate in high-risk and low-risk investments but not medium-risk investments.

Risk-averse

The risk-averse person suffers a greater loss of utility for a given loss of wealth than they gain in utility for the same rise in wealth. Therefore, they would pay less than GBP 150 for an uncertain, but expected, payoff of GBP 150.

Risk-neutral

The risk-neutral person gains or loses the same utility for a given gain or loss of wealth and would be willing to pay GBP 150 for the expected payoff of GBP 150.

Risk seeker

The risk-seeking person gains more in utility for a rise in wealth than they lose in utility for an equivalent fall in wealth. Therefore, they would pay more than GBP 150.

Sentiment Premium

The sentiment premium in the BAPM can be derived from the agreement or disagreement among analysts, not the strengths of their sentiments per se. The more widely dispersed analysts' opinions, the greater the sentiment premium, the higher the discount rate applied to assets' cash flows, and the lower their prices.

Support for the EMH

The weak form of the EMH has been the most studied and supported. If past security prices show strong serial correlation, then past prices could be used to predict subsequent changes. Nevertheless, historical studies show virtually zero serial correlation, which is consistent with weak-form efficiency. Stock price changes appear random. However, the random nature of stock prices does not by itself support the further notion that the price is right and that price correctly reflects intrinsic value. Accepting the price as right when it does not, in fact, reflect intrinsic value could lead to a serious misallocation of portfolio resources.

Cognitive Errors: Information-Processing Biases

These are related more to the processing of information and less to the decision making process.

ego defense mechanisms

To subconsciously protect their overconfidence, analysts utilize ego defense mechanisms. One ego defense mechanism is the self-attribution bias. Analysts take credit for their successes and blame others or external factors for failures. Self-attribution bias is an ego defense mechanism, because analysts use it to avoid the cognitive dissonance associated with having to admit making a mistake. The relationship between self-attribution bias, illusion of knowledge, and overconfidence are fairly obvious. By aligning past successes with personal talent, the analyst adds to the feeling of complete knowledge, which in turns fuels overconfidence.

Behavioral asset pricing:

Traditional asset pricing models (e.g., CAPM) assume market prices are determined through an unbiased analysis of risk and return. The intrinsic value of an asset is its expected cash flows discounted at a required return, based on the risk-free rate and a fundamental risk premium. The behavioral asset pricing model adds a sentiment premium2 to the discount rate; the required return on an asset is the risk-free rate, plus a fundamental risk premium, plus a sentiment premium. The sentiment premium can be estimated by considering the dispersion of analysts' forecasts. A high dispersion suggests a higher sentiment premium. Under the traditional CAPM, the sentiment premium would be unwarranted. If this added, erroneous error is systematic and predictable, it might be possible to exploit it. If it is random, it will be more difficult to exploit.

Traditional Finance (TF)

Traditional finance (TF) focuses on how individuals should behave. It assumes people are rational, risk-averse, and selfish utility maximizers who act in their own self interests without regard to social values—unless such social values directly increase their own personal utility. Such individuals will act as rational economic men, which will lead to efficient markets where prices reflect all available, relevant information. Traditional finance is concerned with normative analysis and determining the rational solution to a problem. It uses prescriptive analysis to look for practical tools and methods to find those rational solutions.

Consumption and savings

Traditional finance assumes investors are able to save and invest in the earlier stages of life to fund later retirement. This requires investors to show self control by delaying short-term spending gratification to meet long-term goals. The consumption and savings approach proposes an alternative behavioral life-cycle model that questions the ability to exercise self control and suggests individuals instead show mental accounting and framing biases. Investors mentally account and frame wealth as current income, assets currently owned, and present value of future income. Traditional finance assumes that all forms of wealth are interchangeable. Behavioral finance presumes the mental accounting for wealth by source makes individuals less likely to spend from current assets and expected future wages. Therefore, individuals will overcome at least some of their lack of self-control to save some of what they will need to meet long-term goals. This also makes them subject to framing bias. For example, if individuals perceive a bonus as current income, they are more likely to spend it. If they perceive it as future income, they are more likely to save it.

Utility Theory and Indifference Curves

Traditional finance is based in utility theory with an assumption of diminishing marginal return. This leads to two consequences. First, the risk-averse utility function is concave. As more and more wealth is added, utility (satisfaction) increases at a diminishing rate. Second, it leads to convex indifference curves due to a diminishing marginal rate of substitution. While indifference curves and utility theory appear rational, they ignore that many individuals are unable to quantify such mathematical trade-offs. Indifference curves also don't explicitly consider risk and the assumption of risk aversion. For example, during recessions when jobs are scarce, the trade-off of W for L would likely change.

Rational Economic Men

Traditional finance is based on neoclassical economics and assumes individuals are risk-averse, have perfect information, and focus on maximizing their personal utility function. Investors who behave this way are then defined as rational, or a rational economic man (REM)

prospect theory

Under prospect theory, choices are made in two phases. In the first phase, the editing phase, proposals are framed or edited using simple heuristics (decision rules) to make a preliminary analysis prior to the second evaluation phase. In the editing phase, economically identical outcomes are grouped and a reference point is established to rank the proposals. The goal of the editing phase is to simplify the number of choices that must be made before making the final evaluation and decision. Doing so addresses the cognitive limitations individuals face in evaluating large amounts of information. The risk is that the selection of the reference point frames the proposal as a gain or loss and affects the subsequent evaluation or decision step. In the second phase, the evaluation phase, investors focus on loss aversion rather than risk aversion. The difference is subtle, but the implication is that investors are more concerned with the change in wealth than they are in the resulting level of wealth, per se. In addition, investors are assumed to place a greater value in change on a loss than on a gain of the same amount. Given a potential loss and gain of equal sizes, the increase in utility associated with the potential gain is smaller than the decrease in utility (i.e., disutility) associated with the potential loss. Investors tend to fear losses and can become risk seeking (assume riskier positions) in an attempt to avoid them.

three uses and three limitations of classifying investors into behavioral types.

Uses of classifying investors into behavioral types include:•Portfolios that are closer to the efficient frontier and more closely resemble ones based on traditional finance theory.•More trusting and satisfied clients.•Clients who are better able to stay on track with their long-term strategic plans.•Better overall working relationships between the client and adviser. Limitations of classifying investors into behavioral types include:•Individuals may display both emotional and cognitive errors at the same time, with either behavior appearing irrational.•The same individual may display traits of more than one behavioral investor type at the same time; therefore, the investment adviser should not try to classify the individual into only one behavioral investor type.•As investors age, they will most likely go through behavioral changes, usually resulting in decreased risk tolerance, along with becoming more emotional about their investing.•Even though two individuals may fall into the same behavioral investor type, each individual would not be treated the same due to their unique circumstances.•Individuals tend to act irrationally at different times, seemingly without predictability.

Cognitive Errors

While cognitive errors arise primarily from statistical or information or reasoning deficiencies or faulty memory, they can also have an emotional element. Market participants may unconsciously tilt away from behavior that causes personal distress or pain while tilting towards behavior that causes pleasure. In general cognitive errors are easier to mitigate or correct with better information, asking the right questions, or seeking qualified advice. Cognitive errors can be divided into 5 "belief perseverance" biases that reflect a desire to stick with a previous decision and 4 "processing errors" where the information analysis process is flawed.

Calendar anomalies

appear to show that stocks (small-cap stocks in particular) have abnormally high returns in January, in the last day of each month, and in the first four days of each month. The January anomaly has been known and studied for more than 25 years but has persisted. It would be a violation of all forms of EMH. Even when an anomaly may appear to violate the EMH, there may be no outperformance when transaction costs and risks are considered. Alternatively, any benefits may be temporary and the anomaly may disappear as investors buy and sell securities to exploit the opportunity. On the other hand, limits to arbitrage activity may allow anomalies to persist

Simplification

applies to very small differences in probabilities or to highly unlikely outcomes. For example, a 49% chance of $500 with a 50% chance of $700 and a 1% chance of $750 might be simplified as an equal chance of $500 or $700.

Passive investors

are those who have not had to risk their own capital to gain wealth. For example they might have gained wealth through long, steady employment and disciplined saving or through inheritance. As a result of accumulating wealth passively, they tend to be more risk averse and have a greater need for security than their "active" counterparts

Naïve diversification

as investors equally divide their funds among whatever group of funds is offered. According to a study, when offered a stock and bond fund, investors allocated 50/50. Then, if offered a stock and balanced fund, investors still allocated 50/50. Others suggest investors follow conditional naïve diversification. They select a smaller number of funds (e.g., three to five), and then allocate equally. In either case some argue this is motivated by seeking to avoid regret. Owning equal amounts of all, investors did not miss the best performer.

Bounded rationality

assumes knowledge capacity limits and removes the assumptions of perfect information, fully rational decision making, and consistent utility maximization. Individuals instead practice satisfice. Outcomes that offer sufficient satisfaction, but not optimal utility, are sufficient.

Bailard, Biehl, and Kaiser (BB&K) five-way model

developed in 1986, classifies investors along two dimensions according to how they approach life in general. The first dimension, confidence, identifies the level of confidence usually displayed when the individual makes decisions. Confidence level can range from confident to anxious. The second dimension, method of action, measures the individual's approach to decision making. Depending on whether the individual is methodical in making decisions or tends to be more spontaneous, method of action can range from careful to impetuous.

Illusion of control bias

exists when market participants think they can control or affect outcomes when they cannot. It is often associated with emotional biases: illusion of knowledge (belief you know things you do not know), self-attribution (belief you personally caused something to happen), and overconfidence biases (an unwarranted belief you are correct). Consequences and implications of illusion of control may include market participants who: •Trade more than is appropriate as they mistakenly believe they can control the outcome of a trade or are overconfident in their analysis. •Fail to adequately diversify. Illusion of control detection starts with realizing investment results are probabilistic. Participants should seek out opposing viewpoints to consider alternative outcomes. Keeping good records to document the thinking behind ideas and reviewing results to see if there are patterns behind which ideas work, which don't, and the actual past probability of being right is essential

4. Hindsight bias

is a selective memory of past events, actions, or what was knowable in the past. Participants tend to remember their correct views and forget the errors. They also overestimate what could have been known. Consequences and implications of hindsight may include market participants who: •Overestimate the rate at which they correctly predicted events which could reinforce an emotional overconfidence bias. •Become overly critical of the performance of others. For example they might criticize the stock selections of an analyst whose recommendations underperformed the market when the recommendations outperformed the market groups for which the analyst was responsible. Hindsight detection starts with asking questions like "Do I really remember what I predicted and recommended?" Participants should also maintain and review complete records to determine past errors as well as successes. They should remember there will be periods when strategies are in or out of favor and review success relative to appropriate benchmarks.

3. Representativeness

is based on a belief the past will persist and new information is classified based on past experience or classification. While this may be efficient, the new information can be misunderstood if is classified based on a superficial resemblance to the past or a classification. Two forms of representativeness include: •Base rate neglect, where the base rate (probability) of the initial classification is not adequately considered. Essentially the classification is taken as being 100% correct with no consideration that it could be wrong. A stock could be classified as a value stock and new information about the stock analyzed based on that classification. In reality, it may not be a value stock. •Sample-size neglect makes the initial classification based on an overly small and potentially unrealistic sample of data. For example, the initial classification of the stock could be based on dividend yield without considering any of the other typical characteristics of a value stock.

Behavioral finance (BF)

is descriptive, which focuses on describing how individuals behave and make decisions. It draws on concepts of traditional finance, psychology, and neuroeconomics. Neuroeconomics has been used to look at decision making under uncertainty, drawing on studies of brain chemistry to understand how decision making utilizes both rational and emotional areas of the brain. Behavioral finance recognizes that the way information is presented can affect decision making, leading to both emotional and cognitive biases. Individuals are normal and may or may not act in a risk-averse utility maximization manner. Their resulting decisions may be suboptimal from a rational (traditional finance) perspective. This can result in markets that temporarily or persistently deviate from efficiency. Behavioral finance can be divided into two general categories: micro and macro. Micro behavioral finance is concerned with describing the decision-making processes of individuals. It attempts to explain why individuals deviate from traditional finance theory. Macro behavioral finance focuses on explaining how and why markets deviate from what we would term efficient in traditional finance.

5. Endowment bias

occurs when an asset is felt to be special and more valuable simply because it is already owned. For example, when one spouse holds on to the securities their deceased spouse purchased for some reason like sentiment that is unrelated to the current merits of the securities. In studies individuals have been asked to state their minimum sale price for an asset they own (say $25) and their maximum purchase price (say $23). The fact that they will sell it at a price higher than they would pay has been explained as endowment. Once they own it, they act as if it is worth more than they would pay. Endowment is common with inherited assets and might be detected or mitigated by asking a question such as "Would you make this same investment with new money today?" If inherited assets are significant holdings in the portfolio it may be essential to address the bias. Starting a disciplined diversification program could be a way to ease the discomfort of sales.

Status quo bias

occurs when comfort with the existing situation leads to an unwillingness to make changes. If investment choices include the option to maintain existing choices, or if a choice will happen unless the participant opts out; status quo choices become more likely.

Self-control bias

occurs when individuals lack self-discipline and favor immediate gratification over long-term goals Consequences and implications of self-control may include:•Insufficient savings accumulation to fund retirement needs.•Taking excessive risk in the portfolio to try and compensate for insufficient savings accumulation.•An overemphasis on income producing assets to meet shorter term distribution needs

Regret-aversion bias

occurs when market participants do nothing out of excess fear that actions could be wrong. They attach undue weight to actions of commission (doing something) and don't consider actions of omission (doing nothing). Their sense of regret and pain is stronger for acts of commission.

2. Confirmation bias

occurs when market participants look for new information or distort new information to support an existing view. It is a kind of selection bias. Client's who get involved with the portfolio process by researching some of their portfolio holdings may become overly attached to some holdings and only bring up information favorable to the holding. This would be confirmation bias. Consequences and implications of confirmation may include market participants who:•Consider positive but ignore negative information and therefore hold investments too long. •Set up the decision process or data screens incorrectly to find what they want to see. •Under diversify as they become overly convinced their ideas are correct. •Over concentrate in the stock of their employer believing they have an information advantage in to that security. Confirmation detection starts with seeking out contrary views and information. For example if an analyst focuses on bottom up fundamental financial statement analysis then the analyst could consult with a top down economic forecaster to gain an alternative view.

2. Overconfidence bias

occurs when market participants overestimate their own intuitive ability or reasoning. It can show up as illusion of knowledge where they think they do a better job of predicting than they actually do. Combined with self-attribution bias, individuals will take personal credit when things go right (self-enhancing) but blame others or circumstances for failure (self-protecting). While it is both cognitive and emotional, it is more emotional in nature because it is difficult for most individuals to correct and is rooted in the desire to feel good. Overconfidence arising from an illusion of knowledge is based a general feeling that the individual will be right. Prediction overconfidence leads individuals to underestimate uncertainty and standard deviation of their predictions while certainty overconfidence occurs when they overstate the probability they will be right.

Anchoring and adjustment bias

occurs when market participants use psychological heuristic experience based trial and error rules to unduly affect probabilities. Changes are made but in relation to the initial view and therefore the changes are inadequate. Generally when individuals are forced to estimate an unknown, they often select an arbitrary initial value and then try to adjust it up or down as they process information. This makes it closely related to conservatism and a reluctance to change as new information is received. New information is not dependent on initial estimates or starting points and the new data should be objectively considered without regard to any initial anchor point Anchoring and adjustment detection starts with asking questions such as "Am I staying with this stock because I originally recommended it at a higher price. In other words am I becoming dependent on that previous price? Or would I recommend it based on an all new analysis if this was the first time I evaluated it?"

Technical anomalies

relate to studies of past stock price and volume. Technical anomalies would be violations of all three forms of efficiency. (Hint: Remember the semi-strong and strong forms encompass the weak form as well.) •Studies have shown that when a short-term (1-, 2-, or 5-day) moving average of price moves above (below) a longer-term (50-, 150-, or 200-day) moving average, it signals a buy (sell). Other studies show that when a stock price rises above a resistance level, it signals a buy; if the stock price moves below a support level, it signals a sell. As such, the signals do provide value.

Cancellation

removes any outcomes common to two proposals. Overlapping outcomes would not affect any decision.

Active investors

risk their own capital to gain wealth and usually take an active role in investing their own money. Active investors are much less risk averse than passive investors and are willing to give up security for control over their own wealth creation

Availability bias

starts with putting undue emphasis on the information that is readily available. It is a mental short cut to focus excessively on what is easy to get. It can include some or all of the following: •Retrievability, which is simply to focus on what is first thought of. •Categorization, which puts excessive emphasis on how an idea is first categorized. For instance a manager assumes a stock is a growth stock and therefore screens it for issues such as P/E and growth rate (failing to consider other issues like leverage ratios) .•Narrow range of experience could occur when the frame of reference is too narrow. For example a CFA Level III candidate prepares for the exam by working all of the old exam questions. The candidate then says it is unfair when other types of questions are asked on the exam. The frame of reference is too narrow, especially when the readings change and old questions and answers may no longer be relevant. •Resonance occurs when individuals assume what interests them is representative of what other people will find important.

Barnewall two-way behavioral model

was developed in 1987 and classifies investors into only two types: passive and active. Passive investors are those who have not had to risk their own capital to gain wealth. For example they might have gained wealth through long, steady employment and disciplined saving or through inheritance. As a result of accumulating wealth passively, they tend to be more risk averse and have a greater need for security than their "active" counterparts. Active investors risk their own capital to gain wealth and usually take an active role in investing their own money. Active investors are much less risk averse than passive investors and are willing to give up security for control over their own wealth creation.

Detection of dominance

would discard from consideration any proposal that is clearly dominated. The previous 50/50 chance of $500 or $700 dominates an equal chance of $400 or $600 in every regard: higher average, higher minimum, and higher maximum.

Consequences and implications of representativeness

•Attach too many importance to new pieces of information and have excessive turnover. •Make decisions based on simple rules of thumb and classification without thorough and more difficult analysis, attaching either too much or too little importance to new information. Representativeness detection starts with a better understanding of the laws of probability and statistical analysis. Helpful questions that might detect the bias include assessing the probability a given investment is properly categorized in a certain group of ideas and not in a different group. By thinking in probabilities, it is more likely risk will be considered and sufficient diversification will occur. In evaluating the performance of a portfolio this would include analyzing: How the performance compares to similar portfolios (rather than to the general market alone)? Have there been changes in the managers of the portfolio? What is the general reputation of the manager? Has the portfolio or manager changed style or investment approach due to changing conditions?

Four self-evident rules of Traditional Finance

•Completeness assumes individuals know their preferences and use them to choose between any two mutually exclusive alternatives. Given a choice between D or E, they could prefer D, E, or be indifferent. •Transitivity assumes individuals consistently apply their completeness rankings. If D is preferred to E and F is preferred to D, then F must be preferred to E. •Independence assumes rankings are also additive and proportional. If D and F are mutually exclusive choices where D is preferred and J is an additional choice that adds positive utility, then D + x(J) will be preferred to F + x(J). In this case, x is some portion of J. •Continuity assumes utility indifference curves are continuous, meaning that unlimited combinations of weightings are possible. If F is preferred to D, which is preferred to E, then there will be a combination of F and E for which the individual will be indifferent to D.

Challenges to Traditional Finance and the Rational Economic Man

•Decision making can be flawed by lack of information or flaws in the decision-making process. •Personal inner conflicts that prioritize short-term (spending) goals over long-term (saving) goals can lead to poor prioritization. •Lack of perfect knowledge is perhaps the most serious challenge to REM. How many individuals can properly assess the impacts of a change in central bank policy on their future wealth? •Wealth utility functions may not always be concave as assumed by utility theory, and individuals can sometimes exhibit risk seeking behavior.

Tests of the semi-strong form have focused on two areas:

•Event studies, such as the announcement of a stock split, look for evidence that such events are predictive of future stock price movement. In itself, a stock split creates no economic value and should not affect the split adjusted price. However, splits are strongly associated with abnormal dividend increases that might reflect rising economic value. Event studies show that stock prices rise abnormally for up to two years before the split and complete an upward adjustment coincident with the split announcement. This is consistent with the semi-strong EMH. Of course, if you knew ahead of time that the split and dividend increases were coming, it would allow you to earn excess returns. The ability to benefit from advance inside information is consistent with semi-strong form but is a rejection of strong-form efficiency. •Other studies focus on the aggregate ability of professional managers to generate positive excess return or alpha. Studies of mutual fund managers show the majority have negative alphas both before and after management fees. This is consistent with semi-strong EMH. This is sometimes referred to as no free lunch, which asserts that it is difficult or impossible to consistently outperform on a risk-adjusted basis.