Key Financial Concepts and Behavioral Biases

This set of flashcards covers key financial concepts related to investment risks, behavioral biases, and methods of measuring returns on investments.

Correlation

How two assets move in relation to each other, ranging from -1 (perfectly negatively correlated) to 1 (perfectly positively correlated).

• -1 = assets move exactly opposite to each other so max diversification

• 1 = same direction = no diversification

• 0 = ideal

Investment Risks

Risks associated with different investment products, including the various types

Market Risk

risk that overall market movements will cause an investment’s value to decline, regardless of the specific asset

Reinvestment Risk

danger that future cash flows (interest or principal) from an investment must be reinvested at a lower rate of return than the original investment, reducing overall returns

. It commonly impacts bonds, CDs, and dividend stocks during falling interest rate environments.

Political Risk:

risk that government actions or political instability will negatively impact an investment’s value

Interest Rate Risk:

risk that changes in interest rates will affect the value of investments, especially bonds (rates up → bond prices down)

Inflation Risk

risk that rising prices will reduce the purchasing power of an investment’s returns

Systematic Risk

Market-wide risk that cannot be diversified away, affecting all investments (e.g., recessions)

Unsystematic Risk

Company- or industry-specific risk that can be reduced through diversification

Liquidity Risk

risk of not being able to quickly sell an investment at its fair value

Credit Risk

risk that a borrower or issuer will fail to make required payments on a debt investment.

Stages of Change

A framework for understanding changes in behavior in five stages: Pre-contemplation, Contemplation, Preparation, Action, and Maintenance.

Pre-contemplation

The stage where an individual does not recognize there is a problem and has no intention to change.

WAER Formula

1. (Weight of security A (FMV Security A/Total Portfolio Value) Expected Return of security A) + (Weight of security Bexpected return of security B)

Contemplation

The stage where an individual is aware of the problem and is weighing the pros and cons, but is not yet committed to action.

Preparation

The stage where an individual intends to take action soon and may have taken small steps toward change.

Action

The stage where the individual actively makes behavioral changes and has recently changed their behavior.

Maintenance

The stage where an individual sustains the change over time and works to prevent relapse.

Availability Heuristic

A cognitive bias where individuals judge the likelihood of events based on how easily examples come to mind, instead of relying on actual data.

Anchoring

A bias where decision-making is overly influenced by the first piece of information encountered.

Confirmation Bias

The tendency to seek out information that confirms existing beliefs while ignoring contradictory evidence.

Herding

The behavior of following a group and mimicking the actions of a larger crowd.

Cognitive-behavioral

A school of thought that posits behavior is learned, and change occurs through identifying triggers and using rewards and consequences.

Developmental

A school of thought suggesting financial behavior is shaped by past experiences and life stages, particularly during childhood.

Alpha definition

alpha measures how much a stock over or under performed its expected return based on its risk (beta)

Alpha Formula

Actual Return - CAPM Expected Return (rfr + beta * (market return - rfr)

Humanistic

A school of thought focused on personal growth and aligning current feelings with current actions.

Holding Period Return (HPR)

Measures total return on investment over the period it is held, calculated as (Selling Price - Purchase Price +/- Cash Flows) / (Purchase Price).

Weighted Average Expected Return (WAER)

The sum of each security’s weight multiplied by its expected return, used to find the average expected return of a portfolio.

Holding Period Return Example Calculation

For a stock purchased at $48, receiving a $2.40 dividend, and sold for $54, the HPR is calculated as (54 - 48 + 2.4) / 48.

WAER Example Calculation

To find the weighted average expected return for a portfolio of securities, calculate the weight of each security and its expected return.