Behavioural finance 1.2

The priming effect

When people are exposed to a certain suggestion, they consciously change their behavior judgment and choices

Cognitive ease

When things are going well around us we find ourselves in cognitive ease; there is no need to mobilize system 2

Baseline judgements

Occur without special intent and with little or no effort; done automatically by System 1 and judges whether System 2 needs to be activated to put in more effort

Halo effect (a cognitive attribution bias)

A psychological phenomenon; the tendency to allow one specific trait or our overall impression of the pression to positively influence our judgment of their other related traits

Horn effect

The opposite of the Halo effect, which works in the negative direction

The law of small numbers

People are not adequately sensitive to sample size; system 1 acts as a machine for jumping into conclusions to exaggerate the consistency and coherence

The causes effect relationship

Human beings are pattern seekers that believe that regularities appear not by chance, but as a result of causality or of someone's intent

Magical thinking

Believing that one event happens as a result of another without any plausible link of causation

Innumeracy

People have difficulty with numbers (is it more probable to get 1 2 3 4 than any other four numbers)

Conjunction fallacy

A variant of the representativeness (most probable: win the lottery or win the lottery and be a happy person)

Base rate neglect

The base rate/prior information is considered, but not sufficiently (The lawyer/engineer example, which is more probable)

Hyperbolic discounting

Humans use different discount rates over time; their preferences are not consistent over time “present-biased”-lack self control; promotes immediate gratification and encourages impulsive decisions

Exponentio discounting

Constant discount rate over time

Cognitive errors

Due to deficiencies in mental perception of basic statistical proportions, in information processing or in the way memory functions

Emotional biases

Arise from the impact of the feelings that economic agents experience as well as from intuition

Types of cognitive biases

Belief perseverance biases and information processing biases

The illusion of control bias

A type of behavior in which people believe they are in control or at least can influence the occurrence of certain events and outcomes

Framing bias

Illusions of thought are called cognitive illusions; people may change their risk preferences according to the wording

Outcome bias

The winningness of individuals to perform a certain action, assessing the situation on the basis of past performance

The sunk cost fallacy

The continued injection of resources into loss making investments due to the unwillingness to admit costly failure

Status Quo bias

The lack of inclination in humans to make changes in their present situation

The endowment bias

The position of a commodity increases its value from the point of view of its owner

Regret aversion bias

People refrain from making specific decisions because they fear that the resolutions made may turn out, in hindsight, not to have been the optimal ones

Affinity bias

People invest in certain companies from irrational reasons - just because these companies are for them a benchmark of a high position in society, a way of joining a certain social stratum, a source of ostentation or a means of maintaining an image

Familiarity heuristics/bias

The tendency for individuals to prefer what is familiar and to seek to avoid the unknown

Ambiguity (Uncertainty) aversion

People dislike uncertainty more than they dislike risk

Attentional bias

People to focus their attention on just one or two possible outcomes when making judgments

Distinction bias

People tend to view two options as more dissimilar when assessing them together than when assessing team separately

Choice supportive bias

Tendency of a person to defend his own decision or to rate it better later just because he made it

When can we trust the intuition of an expert

1. An environment that is regular enough to be predictable

2. the opportunity to learn these patterns through continuous practice

Expected utility theory

The principle of decreasing sensitivity to gains the more they increase whoever subjects will be increasingly sensitive to increasing amounts of losses

Market bubble stages

Stealth phase, awareness phase, mania phase, blow off phase

Market bubble

Usually arise due to exogenous shock such as technological innovation, military conflicts

Black swan event

Unpredictable and highly improbable events that are inevitable in our world; the degree of predictability is unknown; Not all crisises are black swans , which are a turning point for the people, no one could foresee scale and scope of the disaster

Bubbles are not black swans , but predictable surprises

The subprime market

The segment of the financial business that relates to loans do individuals or companies that have a higher risk of default due to their poor credit history or limited resources

Subprime housing bubble

Lenders gave risky home loans to people with bad credit; lowinterest rate and large capital inflows from abroad

Securitisation

Packaging a specific pool of assets (mortgage loans, consumer loans, etc.) and issuing securities that are collateralised by the underlying assets and the associated cash flows.

Limits to arbitrage

Even when a mispricing is clear, factors like high transaction fees, restriction on short selling and using borrowed money can make correcting the price too dangerous or costly

Market anomalies

An event that does not conform to the general accepted principles of the efficient market hypothesis

Types of market anomalies

Fundamental, technical and calendar (seasonal) anomalies

Fundamental anomalies

Contradict the efficient market hypothesis in terms of its semi-strong form and the assumption that the current price levels of financial assets take into account all the historic information and all the publicly disclosed information

The value premium

The empirically documented evidence that value stocks achieve higher returns (B/P ratio) than growth stocks over the long term; traditional explanation - differences in the beta coefficients of stocks; behavioral explanation - behavioral biases

The size effect

The empirical evidence that companies with smaller market capitalization have higher returns than public companies with higher market capitalization (January disclosed information)

Post-earnings announcement drift

Stock's price continues to move in the direction of an earnings surprise (higher or lower) for weeks or months after the report, defying the efficient market hypothesis

Technical anomalies

when past price trends and trading rules generate abnormal profit opportunities, defying weak-form market efficiency.

The momentum effect

Past winning stocks keep rising and past losers keep falling over 3-to-12-month periods. (Herd mentality, self attribution, anchor and adjustment, disposition effect)Underreaction and delayed over-reaction

The momentum investment strategy

A long position in the portfolio of the best performing assets and a short position in the worst performing instruments over the same periods

The time series momentum effect

It assigns to the winning portfolio those stocks that have achieved returns over the formation period above a certain threshold percentage

The time series momentum effect

It assigns to the winning portfolio those stocks that have achieved returns over the formation period above a certain threshold percentage

Long-term return reversal

The winner’s portfolio consisting of the best performing stocks in the last 3 years realise relatively low average returns in the next 5 years

The short term reversibility of returns (contrarían effect)

The best (worst) public companies in the previous 12 months tend to realise low or even negative (high and positive) returns in the next 12 months

The contrarian investment strategy

Hold a long position in the portfolio of losing issues and a short position in the portfolio of winning issues

Calendar anomalies

The Monday effect

The tendency for the return on financial assets in the first day of the week to often be negative (exhaustion of the Monday effect)

The national holiday effect

Observe a higher average positive return on the week days before the holiday, than during any other ordinary day

The January (turn of the year) effect

The month of January exhibits the presence of higher raw returns in the financial markets than any other month of the year on average

Turn off the month effect

Better performance of equity securities at the end of each month and at the beginning of the next

The Halloween effect (sell in May and go away)

During the summer months equity securities are lower than average returns than in the period from November to April

The equity premium

The extra return an investor expects to earn from holding stocks instead of safe, risk-free investments like government bonds.

The neoclassical financial model

Includes beliefs that are opposed to equity premium puzzle volatility puzzle and bubbles puzzle

Equitty premium puzzle behavioral explanation

1. Ambiguity aversion (prefer risk to uncertainty)

2. Myopic risk aversion (people are obsessed with short term thinking and ignore the long term consequences)

Other market anomalies

Excess volatility