• Shuffle
    Toggle On
    Toggle Off
  • Alphabetize
    Toggle On
    Toggle Off
  • Front First
    Toggle On
    Toggle Off
  • Both Sides
    Toggle On
    Toggle Off
  • Read
    Toggle On
    Toggle Off
Reading...
Front

Card Range To Study

through

image

Play button

image

Play button

image

Progress

1/43

Click to flip

Use LEFT and RIGHT arrow keys to navigate between flashcards;

Use UP and DOWN arrow keys to flip the card;

H to show hint;

A reads text to speech;

43 Cards in this Set

  • Front
  • Back
Behavioural Finance

Heuristic-Driven Bias
(4 bullets)
1. Representativeness
2. Overconfidence
3. Anchoring and Adjustment
4. Aversion to Ambiguity
Behavioural Finance

Frame Dependence
(4 bullets)
1. Loss aversion (meaning that you hold onto deteriorating investment positions)
2. Self-control
3. Regret minimalization
4. Money illusion
Behavioural Finance

Inefficient Markets
(4 bullets)
Impact on markets of
1. Representativeness
2. Conservatism
3. Frame dependence
4. Investor overconfidence
Heuristics
(SS3)

Representativeness
Back-of-envelope calculations that might be right, but are often biased.
1. Judgments based on stereotypes
2. Winner-loser effect relates to this. Extreme past losers in the last 3 yrs do much better than extreme past winners. 'Mean-reverting'
3. Analysts are much more optimistic about recent winners than about recent losers. This is related to 'gambler's fallacy' where after 6 tosses of Heads, you think toss 7 is more likely to be a tail ('it's due'), when there is equal chance.
4. People misinterpret the law of averages "law of large numbers"
Heuristics
(SS3)

Overconfidence
1. Not well calibrated when it comes to guessing/ predicting the future.
2. When they are overconfident, they set too narrow bands on their guess.
Heuristics
(SS3)

Anchoring-and-Adjustment, Conservatism
1. People under-react to earnings announcements to reflect new information. They don't revise earnings estimates enough to reflect new information.
2. Remember the trick with the bags of black poker chips. 45% first question, 96% next question (after you have drawn 8b4w)
3. Negative earnings surprises lead to more negative ones and positive surprises lead to more positive ones (based on this heuristic)
Heuristics
(SS3)

Aversion to Ambiguity
1. A sure $1000 (based on a bag 50/50), or a gamble at $0 or $2000. About 40 % take the gamble.
2. If bag has 100 chips, but proportions are unknown, people opt for the sure $1,000 because they have an aversion to ambiguity and 'fear of the unknown'.
Heuristics
(SS3)

Emotion and Cognition
1. People worry for 20 years after a crash. Emotion is tied to how people respond to events in the future.
Frame Dependence
(SS3)

Loss Aversion
1. Decision making in the face of risk and adversity. Talks about the "role of loss". Accepting a sure loss of $7,500 or taking a 75% chance of losing $10,000 and a 25% chance of losing nothing. Both work out to an expected loss of $7,500. Why?
Because people hate to lose.
= LOSS AVERSION
2. "get-evenitis" disease brought down Barings Bank.
Frame Dependence
(SS3)

Concurrent Decisions
1. sure gain of $2,400 or 25% of $10,000
2. sure loss of $7,500 or 75% $10,000. Most choose the chance to get even.
This package of problems gets separated into separate "mental accounts"
Frame Dependence
(SS3)

Hedonic Editing (Mental Accounts)
1. "Transfer your assets" as opposed to sell at a loss. This way you make the client transfer from one mental account to another, instead of closing one account at a loss.

2. People are not uniform in their tolerance for risk. It depends on the situation. Some tolerate more risk when they are facing a loss.
3. If people have just won, they are more likely to take risk and savour the wins separately.
4. If people have a win, then a loss, then they combine the outcomes.
5. If they have a loss first, then they don't risk it again because they are hurt even more if a second loss occurs.
6. Hedonic editing - prefer some "frames" to others (e.g. after the loss, after a win)
Frame Dependence
(SS3)

Cognitive and Emotional Aspects
1. "Frame dependence" is where people behave differently depending on the way their problems are framed.
2. Keep money in your right pocket instead of your left. Some people prefer an income stream in terms of getting a dividend.
Frame Dependence
(SS3)

Self-Control
1. Dividends are income - old people have no problem spending the income from their investments.
2, Capital is separate
Don't dip into capital
Don't kill the goose that lays the golden eggs
Frame Dependence
(SS3)

Regret
1. The emotion attached to not making the right decision. It's not just the pain of the loss, it's the responsibility for making the loss.
2. Regret minimisation leads some investors to use dividends instead of selling stock to finance expenditure.
Frame Dependence
(SS3)

Money Illusion
1. Way it relates to inflation
Even if you are better off in real terms, people react to nominal values.
e.g. If you get a 2% raise and inflation is 2% then you are even, but if you get a 1% raise and inflation is 0, you are better off, but pissed that you didn't get 2% raise and you'll look for another job.
Inefficient Markets
(SS3)

Effects on the market from Representativeness
Creates a winner-loser effect

1. Prices deviate from their fundamental value. Past losers become undervalued and past winners become overvalued.
Therefore past losers outperform past winners going forward.
2. Think about the risk adjusted impact of this (losers are more risky) but even after the returns are risk adjusted past losers outperform winners.
Inefficient Markets
(SS3)

Effects on the market from Conservatism
Cause of post-earnings-announcement drift

1. People don't adjust predictions enough based on good/(bad) earnings announcements
Therefore surprises keep happening. Positive surprises lead to more positive surprises and negative surprises lead to more negative ones.
2. Market is mispriced, average positives outperform 2% and average losers underperform 2%
Inefficient Markets
(SS3)

Effects on the market from Frame Dependence
Mental accounting causes a historical equity premium that has been too high, relative to the underlying fundamentals.

1. Loss aversion kept people away from the market after they'd made a loss and so subsequently stocks make a higher risk adjusted return after a crash.
2. When markets are going up, people feel richer 'house money' and when markets dive people feel poorer.
3. When people own stocks they watch them all the time and then they get 'myopic loss aversion' and sell too quickly. People should only check in with their portfolios once a year.
Inefficient Markets
(SS3)

Departure from fundamental value
1. Heuristics cause more volatility in the market than if stocks were valued on fundamentals alone.
Inefficient Markets
(SS3)

Overconfidence
1. LTCM has many behavioral lessons to offer. Early success from mispricing, but not everything corrects and they were stung when things didn't.
2. How good a driver are you? Most people think that they are above average, but only half are.
3. People OVERTRADE and take bad bets because they don't realise that they are at an informational DISADVANTAGE.

LTCM didn't count on unpredictable sentiment and nonfundamental risk.
Portfolios, Pyramids, Emotions and Biases
(SS3)

Hope and Fear
1. People want a college education, a comfortable retirement, so they invest on the hope that their investments will get them there.
2. Fear causes people to look at a situation and say 'How bad can things get'.
3. Hope gets investors to say 'How good can it get?'

One of these two emotions wins in the end.
Portfolios, Pyramids, Emotions and Biases
(SS3)

Layered Pyramids, with needs
1. Security (CDs and money market investments to provide this)
2. Goals (Bonds for college)
3. Aspirations (Stocks and Real Estate)
4. Speculative potential (Lottery tickets, options, 'applied hoping')

Risk tolerance decides how much you apply to each section.

Ironically, the rich can afford to take more risks, even though the poor need the return more.

This is emotion-based risk assessment versus mean-variance determined risk assessment.
Portfolios, Pyramids, Emotions and Biases
(SS3)

Excessive Optimism and Overconfidence
1. Investors are excessively optimistiv about stocks that they own, but not about the DOW
2. The stock price changes more than they think (so they are overconfident)

Naive Diversification is the 1/n rule. People split their 401(k) equally across all options. 'Rule of Five' is also naive, one will lose, 3 will be the same and one will be a real winner.

Home Bias: US investors invest in US stocks (more than the 45% they make up in a world portfolio)
3. Stock price performance was anchored on past performance
4. People underestimate how much their stocks will move with the market. (Underestimate beta)

People discount diversification (they'd rather now a few good companies well)

i. 20 somethings don't have enough insurance because they are overly optimistic
ii. Overconfidence results in too much trading. People think that they can pick winners and think that they can master the market.
Defined Contribution
(SS3)

DC plan participants construct inefficient portfolios
1. 'Bound to human rationality' limits on time and intelligence means people can't solve problems optimally. This means that they use 'heuristics'.
2. 1/n hypothesis - where participants put an equal amount in each fund (within their fund)
3. High level of investment in own company stock of employees in larger plans. i.e. the anti-diversification because the co. is correlated with the employees future income. People invest even more in their company's stock when things have been going well.
Defined Contribution
(SS3)

How to overcome DC behavioural biases
1. Participant education (currently done by the EBRI). Education is only good if it changes behaviour.
2. Pension scheme design. Having an automatic enrollment makes people save more. If they have to vote in, the rarely do it.
3. In the UK they have a 5% limit on 'self-investment' for firms own stock in their own employee fund.
4. DC plans should have 'safe harbor' rules where there is a minimum of 3 choices, to allow the investor to form a diversified portfolio.
Defined Contribution
(SS3)
1. Maybe investing in the co's stock just adds to morale and raises productivity by giving them a vested interest in success.
2. Employers don't see their stock as risky, there is a perception that it is less risky than diversified stock funds.
3. Investing in the familiar (their company) is much like the home country bias.
4. An employer choose 10 options for the DC and the employee allocates 1/10th to each. This is the "endorsement effect" where employees take the allocation of the employer's contributions as a form of investment advice.
5. Investment decisions at self-directed retirement plans are at odds with investment theory and much is explained by behavioural biases.
Global Equity Strategy
(SS3)

Forecasting
The pointlessness of forecasting
"Those who have knowledge don't predict, those who predict don't have knowledge"
1. Forecasting has a really bad track record.
2. Economists have a bad track record of forecasting the rate of inflation. Inflation forecasts are a function of past rates.
3. Analysts are only good at telling you what has just happened.
Global Equity Strategy
(SS3)

Overconfidence as a driver of poor forecasting
Two most common biases are:
1. Optimism
2. Overconfidence (where people are surprised more than think they'll be) = Not well calibrated. People get far too sure about their ability to predict.
Weatherman are better predictors than doctors. (Doctors are overconfidence when measured confidence vs accuracy) Professionals are too overconfident.
3. Professionals have an illusion of control when it comes to predicting earnings because they believe that they have it researched. The illusion of knowledge drives overconfidence.

ignorance = don't know that overconfidence exits
arrogance = ego defense mechanism
(SS3)

Excuses to defend experts bad forecasts
1. "If only" defense
2. "Ceteris parabis" defense, analysis was correct but something else occured to blow the forecast off course
3. "I was almost right"
4. "It just hasn't happened yet"
5. "Single prediction" where analysis is valid, but the forecast was wrong (so forecasting is useless)
(SS3)

Why use forecasts?
i. People feel like they have to know more than everyone else to outperform. (this matches up with the efficient market hypothesis)
ii. ANCHORING is the reason people continue to forecast. People grab onto the irrelevant in the face of uncertainty. Desperate to know something, anything.
(SS3)

What can be used to debunk forecasts?
i. Stop relying on pointless forecasts.
ii. Use a non-forecast based strategy like value-based investing based on trailing earnings.
iii. analysts are analysts NOT forecasters. they should analyse and let other decide with no price given ( a useless anchor) ps this is never likely to happen.
Alpha Hunters and Beta Grazers
(SS3)

Chronic Market inefficiencies (vs chronic)
i. more ambiguous, more resistant
ii. longer term time horizons to correct

The market can remain irrational far longer than you can hold onto your position - or career.
Alpha Hunters and Beta Grazers
(SS3)

Acute Market inefficiencies (vs chronic)
Acute inefficiencies
i. can be exploited by accessible arbitrages
ii. all the associated uncertainties can be hedged or minimised
iii. correction occurs in the short term time horizon
Alpha Hunters and Beta Grazers
(SS3)

True Active Alpha investing is?
i. Focused on so-called anomalies
ii. These anomalies lead to incremental returns that persist.
iii. Inefficiencies are not always exploitable, because they may correct slowly or never.
Alpha Hunters and Beta Grazers
(SS3)

Convoy Behaviour (Chronic Inefficiency)
1. Herd behaviour of institutional portfolios - they all copy each other.
2. People seek out other opinions that MATCH their own, when they should get a contrarian view and evaluate it
Alpha Hunters and Beta Grazers
(SS3)

Bayesian Rigidity (Chronic Inefficiency)
1. Retaining your OLD views in the face of new information.
2. A way to get around this is to write out in advance what action you are going to take before things go wrong and then you will make fewer mistakes.
Alpha Hunters and Beta Grazers
(SS3)

Price-Target Revisionism (Chronic Inefficiency)
i. Establish the price at the outset is rule 1.
People are always tempted to revise this target up.
Solution for this would be to sell a part of it when it hits this price.
Alpha Hunters and Beta Grazers
(SS3)

The Ebullience Cycle (Chronic Inefficiency)
1. When things are bad "Unopened Envelope"
state of denial, where people don't act when things are going wrong.
2. When things are good, envelope is ripped open and winners are praised as testament to the investors genius.
Alpha Hunters and Beta Grazers
(SS3)

Rebalancing Behaviour (Chronic Inefficiency)
Four types of actors act like this
1. Holders ('unopened envelope' where equity allocation falls)
2. Rebalancers - mostly institution who are 'formulaic rebalancers'
3. Valuators - based on market being 'cheap' or 'rich' and that the market will keep going in its direction. If market goes down, some may buy because it's cheap - the momentum guys think that this is an indication of it going lower, so they sell.
4. Shifters - change in investors situation, not necessarily related to the market, like college etc.
Market Impact of Holders
(SS3)

versus rebalancers, valuators and shifters
i. Holders have little effect on the market, they are out of the game.
ii. New 'holder' money goes to the same allocation as the old 'holder' money.
iii. Most new money comes from holders or rebalancers
Market Impact of Rebalancers
(SS3)

versus holders, valuators and shifters
Rebalancers have a smoothing effect
i. As the market goes down, they buy more
ii. As the market goes up, they sell
iii. Rebalancers buy more of the old allocation assets with any new money.
iv. Most new money comes from holders or rebalancers.
v. The rebalancers themselves may be sources of market inefficiency.
Market Impact of Valuators
(SS3)

versus holders, rebalancers and shifters
Contrarians act as moderators
"Reversionists" will act as moderators
i. Valuators make fresh decisions with new money
Market Impact of Shifters
(SS3)

versus holders, rebalancers and valuators
Momentum traders give the market an exacerbating effect.
i. Shifts become more urgent and widespread in adverse conditions
ii. Any shift that was going to happen is twice as big when momentum traders are there.