**Reading #6**

The Behavioral Finance Perspective

The Behavioral Finance Perspective

**CFA 2015 Level 3**

**SS 3:**

Behavioral

Finance

Behavioral

Finance

**Reading #7**

The Behavioral Biases of Individuals

The Behavioral Biases of Individuals

**Reading #8**

Behavioral Finance and Investment Process

Behavioral Finance and Investment Process

**Traditional Finance (TF)**

**Behavioral Finance (BF)**

normative: focuses on how individual

should

behave

descriptive: focuses on how individuals

actually

behave

(1) Micro BF:

how & why

individuals

deviate from TF theory

(2) Macro BF:

how & why

markets

deviate from "efficient"

Individual investors are Rational Ecomonic Men

In TF, investors are

REM

(Rational Economic Men) aka "Homo Economicus":

TF assumes that REM investors:

are risk-averse

have perfect information

focus on maximizing their personal utility function

Moreover, in decision making:

REM follows "4 axioms"

REM uses Bayes' formula

As a result, REM behaviour leads to

Efficient Markets

In making utility maximizing decisions, REM investor follows

4 Axioms of Utility

:

Completeness:

Transitivity:

Independence:

Continuity:

individuals know their preferences

if

given choices D,E

=>

preference can be one of D>E, D<E, or D=E

individuals consistently apply rankings

if

D>E and F>D

=>

F>E

rankings are additive and proportional

if

D, F mutually exclusive; D>F; and J additive

=>

D+x(J)>F+x(J)

continuous utility indifference curves

if

F>D>E

=>

exists a and b,

such that aF+bE=D

Given new information, REM investor updates beliefs about probabilities using

Bayes' formla:

where:

P(A) - unconditional prob. of event A

P(B) - unconditional prob. of event B

P(A|B) - conditional prob. of event A, given B occured

P(B|A) - conditional prob. of event B, given A occured

TF assumes REM investors are

risk-averse

, and prefer greater certainty to less certainty

For risk-averse person, utility funciton is concave, meaning for 1 unit fall in Wealth, Utility decreases more than it increases for 1 unit gain in Wealth.

Summary so far

TF Assumes:

Bounded Ratioinality and

Prospect Theory

Assume:

unlimited perfect knowledge

utility maximization

fully rational decision making

risk-aversion

capacity limitations

on knowledge

satsicficing

conitive limits

on decision making

reference dependence and

loss aversion leading to possble

cognitive errors

(

Prospect theory only

)

Rational decision making according to Utility Theory

Efficient markets

**vs**

Individual investors not alway rational and subject to biases

Decision making according to Prospect Theory

Markets are not always efficient

Individual Investors in TF

It is the foundation of TF

People maximize objective:

Expected value of PV(Utility)

,

subject to constraint:

PV(Budget)

Utility

= "level of relative

satisfaction

received from the consumption of goods and services"

Utility Theory assumes "

diminishing marginal return

", meaning:

(1)

utility function is concave

since REM is risk-averse, and;

(2)

indifference curves are convex

due to diminishing marginal return of substitution

UTILITY THEORY (TF)

Challenges to TF and REM

lack of information

and flaws in decision-making process

personal

inner conflicts

lead to poor prioritization (i.e. short-term "spending" goals over long-term "saving" goals)

lack of perfect knowledge

(i.e. can people correctly assess impact of central bank policy?)

wealth utility may not always be concave as assumed by utility theory, as

individuals not always "risk-averse"

Individual Investors in BF

Recognizes that real individual are not like REM

Individuals can be any of:

(1) risk-averse; (2) risk-neutral; (3) risk seeking

Satisfaction from +$100

<

Dissatisfaction from -$100

Satisfaction from +$100

=

Dissatisfaction from -$100

Satisfaction from +$100

<

Dissatisfaction from -$100

Side-note:

Indifference curve

shows points at which REM would be equally satisfied between two substitutes

Convex

shape means that too much of either W or L is not as good as a combination of the two.

Utility Function

shows how much utility REM derives from additional unit of Good (Wealth/Leisure/etc.)

Concave

shape means that less utility is gained from each additional unit of Wealth

(1)

(2)

Challenges to Utility Theory and Indifference Curves

individuals often

unable to quantify

mathematical trade-offs

indifference curves

do not explicitly consider risk

(i.e. during recessions, when jobs are scarce and trade-off between W and L may change)

Utility Functions in BF

In real life, risk evaluation is sometimes reference-dependent (e.g. depends on Wealth), meaning individuals sometimes exhibit

both risk-seeking and risk-averse behavior

, for example:

Friedman-Savage,

Double-Inflection Utility Function

e.g. buying lottery ticket

e.g. buying life insurance

Decision Theory

Theory on how to make ideal decisions for informed / mathematical / rational decision maker.

Decision Theory evolved over time:

initially, selecting

highest prob-weighted payoff

later, separated

expected value

from

expected utility

(later depends on individual preferences)

risk

is defined as RV due to one outcome (measurable)

uncertainty

is unknowable outcomes (immeasurable)

subjective analysis

was added for situations where prob can't be objectively measured

Notion of

Bounded Rationality

Added assumption:

knowledge capacity limits

Relaxed assumptions:

perfrect information

fully rational decision making

consistent utility maximization

, instead, Individuals

satisfice

("satisfy" + "suffice") - outcomes with sufficient satisfaction, but not optimal utility, are sufficient

Prospect Theory

Challenges to Decision Theory

According to TF, all investors are assumed to possess the same information and interpret it accurately and instantly, without bias, in evaluating investments and in making utility-maximizing decision.........this is UNREALISTIC

Takes Bounded Rationality further, by

relaxing key Utility Theory assumption:

risk aversion

, instead proposes

loss aversion

, (i.e. pain of -

$

100 > pleasure of +

$

100, note:

$

not in

%

)

Prospect Theory is suited for analyzing investment decisions and risk. It assumes

choices are made in 2 phases:

Editing

phase

Evaluation

phase

Kahneman and Tversky (1979)

Editing Phase

Evaluation Phase

People simplify number of choices before making final decision

Step 1:

Codification

Select reference point, then list and code proposals as gain or loss + assign probability to each outcome (i.e. E(R))

Step 2:

Combination

Combine probabilities for identical outcomes (E(R))

Step 3:

Segregation

separate each outcome (E(R)) into "risk-free" and "risky" components

Step 4:

Cancellation

remove overlapping outcomes commmon to two proposals (i.e. net probabilities for same outcomes)

Step 5:

Simplification

simplify small differences in probabiliities (i.e. round up or down, etc)

Step 6:

Detection of dominance

discard proposals that are clearly dominated (i.e. have lower max/min/avg)

Steps 4-6: If comparing 2 or more proposals

Steps 1-3: apply to individual proposals

Editing phase can give rise to

preference anomalies

.

One example is

ISOLATION EFFECT

anomaly:

Investors focus on one factor/outcome,but consiously/subconciously ignore others

As a result, different sequence of editing can lead to different decisions

Example:

Scenario 1

A

: 33% chance of $3000

B

: 20% chance of $5500

E(A) = $1000

E(B) = $1100

So, most people pick

B

Scenario 2

First Stage:

67% chance of $0

33% chance of Second Stage

Second Stage:

A

: 100% chance of $3000

B

: 60% chance of $5500

E(A) = $1000

E(B) = $1100

BUT now most people pick

A

!!!

People focus on

loss aversion

and behave as though they compute expected utility by placing values on alternatives for probability-weighted outcomes, and selecting alternative with the highest utility:

Value Function

reflects tendency of individuals to

overreact to small

Prob's and

underreact to large

Prob's

explains why investors

over-concentrate

in high-risk and low-risk investments, but

under-concentrate

in medium-risk investmsnts

NOTE:

(1) value function is based on

changes

, not level of wealth!

(2) it is S-shaped and asymmetric reflecting loss aversion

Most individuals are

risk-seeking

when

losses

are likely:

e.g.:

Between

A

: sure loss $75

B

: 50/50 win $30 or lose $200 (E=-$85)

Most pick

B

Most individuals are

risk-averse

when

gains

are likely:

e.g.:

Between

A

: no bet

B

: 50/50 win $100 or lose $70 (E=$30)

Most pick

A

Markets & Portfolio Construction in TF

Efficient Market Hypthesis (

EMH

):

"Markets fully, accurately, and instanteneously incorporate all available information into market prices."

Two implications:

"Price is right" - prices reflect all available info

"No Free Lunch" - efficient prices reflect intrinsic value, so there are no excess, risk-adjusted returns after transction costs (i.e. no arbitrage)

Three types of efficiencies:

Weak-form efficient

- prices reflect past

prices

and

volume

data

=> implies

technical analysis

is ineffective

Semi-strong form efficient

- prices reflect

all public information

=> implies

fundamental analysis

is inffective

Strong-form efficient

- prices reflect

all information

(insider and public)

=> implies

no analysis

is effective

strong-form is not generally accepted

Tests of Weak-form Efficiency

Historical studies show zero serial correlation, which is consistent with weak-form, so price changes appear random (e.g. Fama, 1965)

Tests of Semi-strong form Efficiency

(1) Event studies

Some event studies show that stock splits are associated with abnormal rise in prices pre split, which is consistent with semi-strong (but not strong)

(2) Manager studies

Several studies of active management showed that

majority have alpha <0%,

also consistent

Challenges to EMH

Some studies found market anomalies contradictory to EMH.

Anomalies can be temporary or can persist due to limits to arbitrage activity or ability of investors to withrdraw funds from managers (i.e. manager must sell and forego arb if investor redeems)

Fundamental Anomalies

(violate both semi & strong forms)

some studies show that

value stocks

(low P/E, P/B, P/S and high E/P, B/P, div yield) outperform

growth stocks

some studies show abnormal returns for small-cap stocks

Technical Anomalies

(violate all three forms of EMH)

studies showed that

ST moving average

(1,2,5 days) moves above

LT moving average

(50,150,200 days) it signals a buy

studies showed that

price rise above resistance

also signals a buy

Calendar Anomalies

(violate all three forms of EMH)

stocks (esp. small-cap) have abnormally high returns in

Jan

, in

last 1 and first 4 days of each month

.

Behavioral Alternatives to EMH

If prices do not correctly reflect intrinsic value, then traditional approach to portfolio management is falwed.

No unified BF theory yet, but BF proposes 4 alternative behavioral models:

Consumption & Savings

Behavioral asset pricing

(BPT) Behavioral Portfolio Theory

(AMH) Adaptive markets hypothesis

TF assumes individuals save early in life to fund retirement later, however, this requires uncommon self-control.

Instead, Consumption & Savings proposes

behavioral life-cycle model

, in which individuals:

lack self-control

(usually only partially overcome)

exhibit mental accounting of wage by source

(less likely to spend from assets currently owned and PV of future income, more likely to spend from current income)

framing bais (e.g. if bonus is framed as "current income", more likely to spend; but if as "future income", les likely to spend)

TF asset pricing models (i.e. CAPM) assume prices determined through unbiased analysis of risk & return.

Behavioral asset pricing model adds a

sentiment premium

to discount rate, thus:

Required return on asset = risk-free rate

+ fundamental risk premium

+

sentiment premium

Sentiment premium can be estimated from dispersion of analysts' forecasts:

high dispersion => high sentiment premium

TF prescribes construction of well-diverified optimal portfolio.

In reality, many individuals construct portfolio by

layers

, where each layer has different expected risk & return:

if high return key for goal => more $ to

high-risk layer

if low risk key for a goal => more $ to

low-risk layer

asset selection done by

risk layer

if investor risk-averse => higher # of assets in a

layer

if investor has info advantage => more concentrated

if investor is loss-avers => larger cash position

As a result individuals tend to concentrate holdings

in low-risk and high-risk assets.

results in sub-optimal portfolio

vs TF optimal portfolio

AMH = EMH + bounded rationality + satisficing + evolution

(efficiency depends on competition/profits/flexibility of participants)

AMH assumes that success in the market is an

evoluitonary process

=> investors use heuristics until they don't work, then adjust. Investors satisfice, not maximize utility. Based on suffiient information, they aim for subgoals to reach goals, making not necessarily optimal decisions. As successful heuristics become widely adopted, they become reflected in market pricing, and no longer work. Markets evolve.

AMH leads to 5 conclusions:

(1) risk & return relationship is not stable => MRP changes

(2) active management can find arbitrage and add value

(3) no strategy should work all the time

(4) innovation essential to continued success

(5) survivors change & adapt