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95 Cards in this Set

  • Front
  • Back

Axioms of utility theory

1. Completeness


2. Transitivity


3. Independence


4. Continuity

Bayes' formula

Rational economic man (REM)

Will try to obtain the highest possible economic well-being or utility given budget constraints and the available information about opportunities, and only base his choices on him.


Construct curves of consumption bundles


Assumed to maximize utility

Certainty equivalent

Max sum of money a person would pay to participate or min sum of money would accept not to participate in the opportunity

Indifference curve analysis

May Incorporate budget lines/constraints which represent restrictions on consumption that stem from resource scarcity

Double Inflection Utility Function

Utility function that changes based on level of wealth

Prospect theory

Assigns value to G/L (∆wealth) rather than to final wealth, and probabilities are replaced by decision weights.

Neuro-economics

Attempts to explain investor behavior based on the functioning of the brain.

Traditional finance assumptions

Investors are:


-Rational


-Risk-averse


-Self-interested utility maximizers who process available info in unbiased way



Assume investors hold and construct optimal (mean-reverting) portfolios.


Behavioral finance

Investors are acknowledged to have informational, intellectual, and computational limitations.


May satisfied rather than optimize when making decisions

Decision theory

Assumes decision maker is fully informed and able to make quantities calculations with accuracy. Perfectly rational

Bounded rationality

Recognizes that people aren't fully rational when making decisions, don't necessarily optimize, but rather satisfied when arriving at their decisions. (More cost and time efficient)

Satisfice definition

Combines satisfy & suffice and describes decisions, actions, outcomes that may not be optimal but are adequate.


To find solution in decision-making situation that meets needs of the situation and achieves the goals of the decision maker

Adaptive markets hypothesis (AMH) -definition

Applies principles of evolution (competition, adaptative, natural selection) to fina mkts in attempt to reconcile efficient mkt theories w/behavioral alternatives.


Revised version of EMH that considers bounded rationality, satisfice g, and evolutionary principles.


Individuals act in their own: self-interest, make mistakes, learn and adapt, competition motivates adaptation and innovation, natural selection and evolution determine mkt dynamics

5 implications of AMH

1. Relationship b/w risk&reward ∆over time


2. Active mgmt can add value by exploiting arbitrage opportunities


3. Inv. Strategy won't consistently do well. Periods of good/bad performance


4. Ability to adapt &innovate is critical to survive


5. Survival is the essential objective

Behavioral approach to asset pricing

Includes sentiment such as behavioral stochastic discount factor-based asset pricing model

Sources of cognitive errors

Basic statistical, information-processing, memory errors


Faulty reasoning

Sources of emotional biases

Impulse, intuition


Reasoning influenced by feelings, perceptions, beliefs


Not easily corrected

Cognitive dissonance

Mental discomfort that occurs when new info conflicts w/ previously held beliefs or cognitions.

Cognitive dissonance

Mental discomfort that occurs when new info conflicts w/ previously held beliefs or cognitions.

Cognitive dissonance

Mental discomfort that occurs when new info conflicts w/ previously held beliefs or cognitions.

Conservatism bias

Belief perseverance bias where maintain prior view, forecasts by inadequately incorporating new info


Slow to update info

Confirmation bias

Belief perseverance bias. People tend to look for and notice what confirms their beliefs. Ignore/undervalue what contradicts their beliefs.


Selective exposure, perception, retention, selection bias.

Confirmation bias

Belief perseverance bias. People tend to look for and notice what confirms their beliefs. Ignore/undervalue what contradicts their beliefs.


Selective exposure, perception, retention, selection bias.

Representativeness bias

Tend to classify new info based on past experiences and classifications.


Attempt to derive meaning from their experiences


Best fit

Base-rate neglect

Base rate or probability of the categorization not adequately considered.

Sample-size neglect

Incorrectly assume that small sizes are representative of populations.

Illusion of control bias

People tend to believe that they can control/influence outcomes when they can't


Consequences: trade more than prudent, inadequately diversified portfolios

How to overcome illusion of control

Seek contrary viewpoints


Keep records


Be aware that global capitalism is highly complex and have little control over outcomes

Hindsight bias

Bias w/ selective perception and retention aspects. See past event as having been predictable and reasonable to expect


- false sense of confidence

Anchoring and adjustment bias

Information processing bias. Use of a psychological heuristic influences the way people estimate probabilities.

Mental Accounting bias

People treat one sum of money differently from another equal-sized sum. (Buckets)


Correlations b/w invs not taken into account when creating overall portfolio

Farming bias

Answer question differently based on way in which it's been asked (framed)

Narrow framing bias

Evaluate info to make a decision based on a narrow frame of reference. Lose sight of the big picture

Availability bias

Info-processing bias.


Evaluate probability of outcome on how easily comes to mind

Types of availability bias

- retrievability (1st idea more likely to be kept)


- categorization (gather info perceived as relevant)


- narrow range of experience (using too narrow frame of reference)


- resonance (biased by how closely a situation parallels their own personal situation)

Consequences of emotional bias

Can make suboptimal decisions

Loss aversion bias

Strongly prefer avoiding losses as opposed to achieving gains. Won't sell losers

Disposition effect

Holding (not selling) of investments that have experience losses (losers) too long, and the selling (not holding) of investments that have experienced gains (winners) too quickly.


Resulting portfolio may be riskier than the optimal portfolio based on the risk/return objectives of the investor.

Overconfidence bias

People demonstrate unwarranted faith in their own intuitive reasoning, judgments, and/or cognitive abilities

Self-attribution bias

- take credit for success


- failures are due to external factors

Prediction overconfidence occurs when:

The confidence intervals that FMPs assign to their investment predictions are too narrow.

Certainty overconfidence occurs when:

The probability that FMPs assign to outcomes are too high because they are certain of their judgments

Certainty overconfidence occurs when:

The probability that FMPs assign to outcomes are too high because they are certain of their judgments

Self-enhancing bias

Describes people's propensity to claim too much credit for their successes

Self-enhancing bias

Describes people's propensity to claim too much credit for their successes

Self-enhancing bias

Describes people's propensity to claim too much credit for their successes

Self-protecting bias

Describes the denial of personal responsibility for failure

Self-control bias

People fail to act in pursuit of their L-T, overarching goals because of a lack of self-discipline.


May be a function of hyperbolic discounting

Self-control bias

People fail to act in pursuit of their L-T, overarching goals because of a lack of self-discipline.


May be a function of hyperbolic discounting

Hyperbolic discounting

Human tendency to prefer small payoffs now compared to larger payoffs in the future

Status quo bias

Do nothing /inertia



Endowment bias -> ownership imbues an investment w/ intangible value beyond the true value to holder. Preference for no ∆


Regret-aversion bias -> opt for status quo rather than potentially experience regret for selling shares that went up

Endowment bias

Value asset more when they hold rights to it than when they do not.


(Inherited investments)

Regret-aversion bias

Try to avoid pain of regret associated with bad decisions.


Need education


Regret more intense when unfavorable outcomes are the result of error of commission vs error of omission


To overcome: education is essential

Error or commission

Regret from action taken (regret aversion)

Error of omission

Regret from action not taken (regret aversion)

Goals-based investing

Portfolio evaluated in terms of attaining financial goals and risk management focuses on the size and likelihood of potential losses.


Investors assumed to be loss averse, not risk averse

Standard of living risk (SLR)

Risk that current or specified acceptable lifestyle may not be sustained.

Steps in designing standard AA program

1. Administer risk tolerance questionnaire


2. Discuss client's financial goals & constraints


3. Recommend output of a mean-variance optimization

Passive investors

Became wealthy passively (inheritance)


Greater need for security than they have tolerance for risk.

Passive investors

Became wealthy passively (inheritance)


Greater need for security than they have tolerance for risk.

Active investors

- actively involved in wealth creation


- risk their own capital


- higher tolerance for risk than they have need for security

BB&K model

Characteristics of Adventurer

May hold highly undiversified portfolios bc confident and willing to take chances


Confidence leads them to make their own decisions and makes them reluctant to take advice


Challenge for IA

Characteristics of Celebrity

Like to be center of attention


May hold opinions about some things but to a certain extent recognize their limitations & may be willing to seek and take advice about investing

Characteristics about Individualists

Independent and confident, which may be reflected in their choice of employment.


Like to make own decisions but only after careful analysis


Pleasant to advise bc will listen and process info rationally

Characteristics of Guardian

Cautious and concerned about the future


As people age and approach retirement, may become guardians


Concerned about protecting their assets and may seek advice from those they perceive as being more knowledgeable

Chaclracteristics of Straight Arrow

Sensible & secure


Fall near the center of the graph


Willing to take on some risk in expectation of earnings a commensurate rate

Biases associated w/ each behavior investor type

Passive preserver characteristics

Basic type: passive


Risk tolerance: low


Primary biases: emotional


Need to be persuaded about

Passive Preserver (PP) characteristics

Basic type: passive


Risk tolerance: low


Primary biases: emotional


Need to be persuaded about

Friendly Follower (FF) Characteristics

Basic type: passive


Risk tolerance level: low to medium


Primary biases: cognitive


Should be challenged w/ introspective, provide data-backed support for recommendations

Independent Individualist (II) Characteristics

Basic type: Active


Risk tolerance: medium to high


Primary biases: cognitive


Trust their guts, have faith in themselves


Tendency to take contrarian position

Active Accumulator Characteristics

Basic type: Active


Risk tolerance: high


Primary biases: emotional


Entrepreneurs, 1st generation to create wealth


High turnover rates = drag on performance


Quick decision makers


May lack self-control

Active Accumulator Characteristics

Basic type: Active


Risk tolerance: high


Primary biases: emotional


Entrepreneurs, 1st generation to create wealth


High turnover rates = drag on performance


Quick decision makers


May lack self-control

Reasons to invest in employer's stock

- familiarity & overconfidence effects


- naïve extrapolation of past returns


- framing and status quo effect of matching contributions


- loyalty effect


- financial incentives

Mean-variance portfolio

Constructed s a whole, only E(r) and variance of entire portfolio matter.


COV b/w assets crucial in determination of the variance of the portfolio

Behavioral portfolio

Constructed not as a whole, but layers associated with goals


COV is overlooked

Robustness

Reflects a model's a to perform well out of sample

Collecting too much unstructured info can lead to:

Illusions of knowledge & control


Contributing to overconfidence


Expose analysts to the risk of representativeness

Gambler's fallacy

Misunderstanding of the probabilities


Wrongly project reversal to a L-T mean


Faulty understanding about behavior of random events, expecting reversals to occur more frequently than actually happens.

Hot hand fallacy

People wrongly project continuation of a recent trend. Lack of understanding of statistical independence

Tendency of analysts to recommend high-growth and low-yield stocks typically reflects:

Failure to incorporate the base rate or effect of the environment in which company operates.


Representativeness bias

Conjunction fallacy

Probability of 2 independent events occurring in conjunction is never greater than the probability of either event occuring alone

Social proof

Biased to follow the beliefs of a group


Group will typically have more confidence in its decisions after discussion that leads to an overconfidence bias

Social proof

Biased to follow the beliefs of a group


Group will typically have more confidence in its decisions after discussion that leads to an overconfidence bias


Teams diverse in skills, experience, culture may be less prone to social proof bias

Anomalies

Persistent abnormal returns that differ from zero and are predictable in direction

Anomalies

Persistent abnormal returns that differ from zero and are predictable in direction

Anomalies can be explained by:

- small sample involved


-Statistical bias in selection or survivorship


- data mining

Herding

Occurs when a group of investors trade on the same side of the mkt in the same securities, or when investors ignore their own private info and act as other investors do


Low dispersion of opinion


May be a response to cognitive dissonance

Regret

Feeling that an opportunity has been missed. Typically an expression of hindsight bias

Disposition effect

Will encourage investors to hold on to losers, causing an inefficient and gradual adjustment to deterioration in fundamental value


Emotional

Bubbles & crashes

Appear to be panics of buying/selling


Continuous rise in an asset price is fuelled by investor's expectations or further increase; asset prices become decoupled from econ fundamentals

Biases in bubbles

Overconfidence, overtrading, underestimation of risks, failure to diversify, rejection of contradictory info

Halo effect

Extends a favorable evaluation of some characteristics to other characteristics