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95 Cards in this Set
- Front
- Back
Axioms of utility theory |
1. Completeness 2. Transitivity 3. Independence 4. Continuity |
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Bayes' formula |
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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 |
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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 |
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Indifference curve analysis |
May Incorporate budget lines/constraints which represent restrictions on consumption that stem from resource scarcity |
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Double Inflection Utility Function |
Utility function that changes based on level of wealth |
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Prospect theory |
Assigns value to G/L (∆wealth) rather than to final wealth, and probabilities are replaced by decision weights. |
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Neuro-economics |
Attempts to explain investor behavior based on the functioning of the brain. |
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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. |
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Behavioral finance |
Investors are acknowledged to have informational, intellectual, and computational limitations. May satisfied rather than optimize when making decisions |
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Decision theory |
Assumes decision maker is fully informed and able to make quantities calculations with accuracy. Perfectly rational |
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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) |
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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 |
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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 |
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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 |
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Behavioral approach to asset pricing |
Includes sentiment such as behavioral stochastic discount factor-based asset pricing model |
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Sources of cognitive errors |
Basic statistical, information-processing, memory errors Faulty reasoning |
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Sources of emotional biases |
Impulse, intuition Reasoning influenced by feelings, perceptions, beliefs Not easily corrected |
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Cognitive dissonance |
Mental discomfort that occurs when new info conflicts w/ previously held beliefs or cognitions. |
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Cognitive dissonance |
Mental discomfort that occurs when new info conflicts w/ previously held beliefs or cognitions. |
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Cognitive dissonance |
Mental discomfort that occurs when new info conflicts w/ previously held beliefs or cognitions. |
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Conservatism bias |
Belief perseverance bias where maintain prior view, forecasts by inadequately incorporating new info Slow to update info |
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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. |
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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. |
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Representativeness bias |
Tend to classify new info based on past experiences and classifications. Attempt to derive meaning from their experiences Best fit |
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Base-rate neglect |
Base rate or probability of the categorization not adequately considered. |
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Sample-size neglect |
Incorrectly assume that small sizes are representative of populations. |
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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 |
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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 |
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Hindsight bias |
Bias w/ selective perception and retention aspects. See past event as having been predictable and reasonable to expect - false sense of confidence |
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Anchoring and adjustment bias |
Information processing bias. Use of a psychological heuristic influences the way people estimate probabilities. |
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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 |
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Farming bias |
Answer question differently based on way in which it's been asked (framed) |
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Narrow framing bias |
Evaluate info to make a decision based on a narrow frame of reference. Lose sight of the big picture |
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Availability bias |
Info-processing bias. Evaluate probability of outcome on how easily comes to mind |
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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) |
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Consequences of emotional bias |
Can make suboptimal decisions |
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Loss aversion bias |
Strongly prefer avoiding losses as opposed to achieving gains. Won't sell losers |
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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. |
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Overconfidence bias |
People demonstrate unwarranted faith in their own intuitive reasoning, judgments, and/or cognitive abilities |
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Self-attribution bias |
- take credit for success - failures are due to external factors |
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Prediction overconfidence occurs when: |
The confidence intervals that FMPs assign to their investment predictions are too narrow. |
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Certainty overconfidence occurs when: |
The probability that FMPs assign to outcomes are too high because they are certain of their judgments |
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Certainty overconfidence occurs when: |
The probability that FMPs assign to outcomes are too high because they are certain of their judgments |
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Self-enhancing bias |
Describes people's propensity to claim too much credit for their successes |
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Self-enhancing bias |
Describes people's propensity to claim too much credit for their successes |
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Self-enhancing bias |
Describes people's propensity to claim too much credit for their successes |
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Self-protecting bias |
Describes the denial of personal responsibility for failure |
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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 |
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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 |
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Hyperbolic discounting |
Human tendency to prefer small payoffs now compared to larger payoffs in the future |
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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 |
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Endowment bias |
Value asset more when they hold rights to it than when they do not. (Inherited investments) |
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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 |
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Error or commission |
Regret from action taken (regret aversion) |
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Error of omission |
Regret from action not taken (regret aversion) |
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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 |
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Standard of living risk (SLR) |
Risk that current or specified acceptable lifestyle may not be sustained. |
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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 |
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Passive investors |
Became wealthy passively (inheritance) Greater need for security than they have tolerance for risk. |
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Passive investors |
Became wealthy passively (inheritance) Greater need for security than they have tolerance for risk. |
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Active investors |
- actively involved in wealth creation - risk their own capital - higher tolerance for risk than they have need for security |
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BB&K model |
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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 |
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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 |
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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 |
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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 |
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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 |
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Biases associated w/ each behavior investor type |
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Passive preserver characteristics |
Basic type: passive Risk tolerance: low Primary biases: emotional Need to be persuaded about |
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Passive Preserver (PP) characteristics |
Basic type: passive Risk tolerance: low Primary biases: emotional Need to be persuaded about |
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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 |
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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 |
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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 |
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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 |
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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 |
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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 |
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Behavioral portfolio |
Constructed not as a whole, but layers associated with goals COV is overlooked |
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Robustness |
Reflects a model's a to perform well out of sample |
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Collecting too much unstructured info can lead to: |
Illusions of knowledge & control Contributing to overconfidence Expose analysts to the risk of representativeness |
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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. |
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Hot hand fallacy |
People wrongly project continuation of a recent trend. Lack of understanding of statistical independence |
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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 |
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Conjunction fallacy |
Probability of 2 independent events occurring in conjunction is never greater than the probability of either event occuring alone |
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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 |
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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 |
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Anomalies |
Persistent abnormal returns that differ from zero and are predictable in direction |
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Anomalies |
Persistent abnormal returns that differ from zero and are predictable in direction |
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Anomalies can be explained by: |
- small sample involved -Statistical bias in selection or survivorship - data mining |
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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 |
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Regret |
Feeling that an opportunity has been missed. Typically an expression of hindsight bias |
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Disposition effect |
Will encourage investors to hold on to losers, causing an inefficient and gradual adjustment to deterioration in fundamental value Emotional |
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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 |
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Biases in bubbles |
Overconfidence, overtrading, underestimation of risks, failure to diversify, rejection of contradictory info |
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Halo effect |
Extends a favorable evaluation of some characteristics to other characteristics |