behavioral finance lesson 2

descriptive analysis

concerned with the manner in which real people actually make

decisions.

behavioral finance explanations of behaviors

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

normative analysis

concerned with the rational solution to the problem at hand. It defines an ideal that actual decisions should strive to approximate.

traditional finance assumptions about behavior

traditional finance assumes investors are rational, investors are risk-averse, self- interested utility-maximizers who process available information in an unbiased way.

Individuals are acknowledged to have informational, intellectual, and computational limitations and as a result may satisfice rather than optimize when making decisions.

traditional finance assumes that investors construct and hold optimal portfolios, optimal portfolios are mean–variance efficient.

behavioral portfolio theory suggests that portfolios are constructed in layers to satisfy investor goals rather than to be mean–variance efficient.

traditional finance hypothesizes that markets are efficient, Market prices incorporate and reflect all available and relevant information.

Markets are not always observed to be efficient; anomalous markets are observed.

adaptive markets hypothesis

suggests that the degree of market efficiency is related to environmental factors characterizing market ecology. These factors include the number of competitors in the market, the magnitude of profit opportunities available, and the adaptability of the market participants.

3 main differences of traditional and behavioral finance

1. investor is rational vs. investor has biases, irrational, and emotions play a role in the kind of investments undertaken

2. investors receive unlimited knowledge, data, and info that are perfect that they process for complete rationality vs. investors have bounded rationality, making them not processing all info. they are bound to make an error in judgment

3. market is efficient and represents the financial market’s true value (investors have self control) vs. (investors don’t have perfect self control) market is volatile, so there’s a rising and falling of stock prices. investors need to make rational financial decisions and not use their emotions or urges to make an investment

investor behavior

attempts to understand and explain investor decisions by combining the topics of psychology and investing on a micro level (i.e., the decision process of individuals and groups) and a macro perspective (i.e., the role of financial markets).

The decision-making process of investors incorporates both a quantitative (objective) and qualitative (subjective) aspect that is based on the specific features of the investment product or financial service.

examines the cognitive factors (mental) and affective (emotional)

classical decision theory

assumes that rational decision makers evaluate all possible outcomes, serves as the basis for developing the traditional view in finance. Finance theorists then assume that these rational people are averse to risk, so that investors must receive compensation if they are going to take on risk

People are able to evaluate their preferences over possible outcomes and are also able to associate probabilities with each potential outcome. These preferences satisfy certain conditions if they are rational.

utility

converts alternatives into measurable rankings of preferences. functions assign higher numbers to preferred outcomes and can be used to rank combinations of risky alternatives. When choosing among a set of possible outcomes, the rational person picks the outcome with highest expected ___.

modern portfolio theory

• Harry Markowitz

• “Do not put all your eggs in one basket.”

Capital Asset Pricing Model

provides a measure of risk of a security called beta (β). Beta quantifies the sensitivity of a security’s return to the market.

market beta - 1.0

risk-free asset - 0 (since risk-free nga)

efficient market hypothesis

has 3 versions that argues asset prices fully reflect all available information

weak form efficiency

prices reflect any information in their history. Thus, technical analysis of past price data will not be fruitful.

semi-strong form efficiency

prices reflect any public information in addition to past price data. This form of the EMH suggests that investors cannot generate abnormal returns using information releases such as earnings statements or media reports.

strong form efficiency

prices reflect even private information. Thus, even company insiders cannot devise a strategy to consistently generate abnormal returns.

Behavioral Decision Theory

incorporates evidence on how people actually behave into models of decision-making.

According to Simon, people “satisfice,” rather than “optimize,” meaning that they choose the course of action that satisfies their most important needs, but the choice may not be optimal.

prospect theory

Instead of maximizing expected utility, posits that people maximize value.

people evaluate outcomes based on changes in wealth, rather than final position.

The choices people make reflect a strong aversion to losses, referred to as loss aversion.

First, value is measured in terms of changes in wealth from a reference point. Second, the value function is convex for losses reflecting risk taking and concave for gains reflecting risk aversion. Third, the value function is steeper for losses than for gains due to loss aversion.

framing

refers to how a decision maker views a problem. The perception of a problem depends not only on the presentation but also on the characteristics of the decision maker.

heuristics

mental shortcuts or “rules of thumb” that investors use to simplify complex decision-making. While they reduce cognitive effort, they often lead to systematic biases and errors in judgment, influencing investment choices and market behavior.

overconfidence

People tend to be overconfident about their skills, abilities, and knowledge. In finance, overconfidence has garnered particular attention because researchers show this bias to have an important impact on financial decisions for both investors and managers.

regret theory

A widely documented investor bias is the disposition effect. The disposition effect is the tendency to hold onto losing investments too long, while selling winners too soon.

behavioral portfolio theory

Shefrin and Statman (2000) use mental accounting as a basis for their theory in which some investors segregate assets into layers, or mental accounts, depending on their investment goals.

For example, one investment goal might be to provide for retirement, while another is to try to improve the standard of living (i.e., move to a higher level of wealth).

adaptive markets hypotehesis

argues that financial markets are not always perfectly efficient or irrational, but instead evolve and adapt like ecosystems.