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Overview of Behavioral Finance – SS #3
Reading 7
Reading 6
Reading 5
The Behavioral Finance Perspective
Contrast traditional finance with behavioral finance and how that
impacts investor decision making and portfolio construction
The Behavioral Biases of Individuals
Know each bias and be able to (1) identify these behaviors, (2)
differentiate between them when reading passages in the exam, and
(3) talk about the implications of these biases for decision making as an
investment advisor
Behavioral Finance and Investment Processes
Identifying portfolio strategies that can lead to acceptable (if not
optimal) outcomes. The key is the degree to which an investment
manager can accommodate an individual’s quirks depends on the
degree of financial risk that individual is able and willing to take
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Why does Behavioral Finance Matter?
1. People aren’t robots. To do a good job managing money
you have to be aware of your clients’ unique circumstances,
personality traits, and level of financial knowledge
2. Treating clients as unique individuals helps advisors
create tailored strategic asset allocation plans that get close
to “optimal” while mitigating people’s weird quirks in a way
that the client can live with
3. You still need to know what the optimal model would tell you
to. To understand the deviations behavioral finance suggests
might exist you still need to have a good grounding in
the theory of efficient markets
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How will BF get tested on the exam?
• 10% Weighting. This material is conceptual not quantitative or
technical
• It’s a section of lists. You need to memorize the vocab
• The material is a key part of the morning section of the exam. It
shows up with respect to IPS questions and in constructed
response (identify, justify, compare/contrast style questions)
• It shows up in predictable ways, helps nail risk tolerance IPS
questions, and can be worth a lot of points!!
Select Past Problems
2007: #3
2008: #2
2009: #7
2011: #1
2012: #4
2013: #3
2014: #11
2015: #11
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Organizing the Material
• What is an efficient market
• Behavioral challenges to this efficient market hypothesis
• Identifying the various challenges that people’s emotional and mental
reaction to financial markets creates for managing their portfolios
• Categorizing the different emotional and cognitive biases that
investors (and analysts) can face
• Three frameworks for classifying investors into different behavioral
groups.
We’ll move from big picture, to the individual, to the client-advisor relationship
Reading 5:
The Behavioral Finance
Perspective
Traditional Finance
vs.
Behavioral Finance
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What is Traditional Finance?
Traditional Finance is normative. It tries to prescribe what
investors should do in order to achieve an optimal outcome.
TF is built on the assumptions of:
• Rational individuals (REM)
• Perfect information
• Efficient markets that quickly absorb new information
Think of traditional finance as your neoclassical economic
model. Useful directionally, but probably not completely realistic
in terms of how the real world works
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What is Behavioral Finance?
Behavioral economic theories modify the TF models by relaxing
certain assumptions and acknowledging that people aren’t
economic machines:
• We are weird
• We don’t always act rationally
• We make mistakes in processing things
On top of that, perfect information doesn’t exist.
Because behavioral finance knows people might act in a way that
a model can’t predict it is a descriptive or observational discipline
Efficient Markets & challenges
to the idea of efficient markets
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What is an Efficient Market?
If all individuals base their decisions on perfect information
(including past volume, price, and market/firm data) markets as
a whole will also be efficient.
Efficient here means two things:
• The price is right: In other words, asset prices reflect all
available information and prices adjust instantaneously to
incorporate that information
• There is no free lunch: Since prices adjust immediately it is
not possible to get an informational advantage and therefore
earn above-average returns. In other words no alpha is
consistently possible
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Efficient Market Hypothesis Underpins
Assumptions of the CAPM model
CAPM model
𝑟𝑒 = 𝑟𝑓 + 𝛽 𝑟𝑚 − 𝑟𝑓
Where:
re = The required return on equity
rf = Risk-free rate
rm = The market return
β = The stock market beta
(rm-rf) = The Equity risk Premium (ERP)
Garde Capital gives an excellent recap of the CAPM at
http://www.gardecapital.com/capm.html . The whole article
covers testable material for L3
Testable Tips on CAPM
Key Assumptions
• Investors are risk averse• Investors are utility maximizing• Markets are frictionless – no taxes, transaction costs, i.e. it is free to diversify• All investors have the same single period time horizon• All investors have homogenous expectations for e(r), σ, and correlation• All investments are infinitely divisible• Markets are competitive – Investors take price as given & no investor has the ability to
impact that market price
Basically CAPM is a reflection of the assumptions of an efficient market
The CAPM represents a single efficient market frontier on which investors create their portfolio using expected returns, standard deviations, and co-variances of their investments.
Testable Tips on CAPM
At its core the CAPM models the explicit tradeoff between beta (systematic risk) and expected return.
On the test:• Be able to use the CAPM to calculate expected return or answer whether
securities are over/under valued based on looking at the SML• Explain how the behavioral asset pricing model modifies the traditional CAPM• Modify CAPM for international or country-specific scenarios• Total risk vs. Systematic risk and risk-adjusted return measures
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Rational Economic Man (REM)
Efficient markets are built on the decisions of perfectly rational
economic actors. These “REM”:
• Think more (stuff) is better than less, e.g. is perfectly rational/self-
interested
• Think less risk is better than more risk all else equal, i.e. is risk
averse
• Have perfect information
• Use Bayes’ formula to make probability adjusted decisions, i.e. is a
mathematical genius
An REM will try to obtain the highest possible utility given their
budget constraints.
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Utility
People maximize their utility subject to their personal preferences
and their budget constraint.
The more of either leisure or work you have, the less valuable having a
little bit more of that becomes. Thus utility assumes diminishing marginal
returns.
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Utility 2
The more wealth you have the more the expected return of an
investment must increase to offset risk.
Since you’re already rich you care more about keeping what you have
versus getting more. Each additional dollar is subject to diminishing
returns.
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Utility and Risk Aversion
.
Risk averse investors,
concave utility
function is assumed
by traditional finance
Linear utility function
Constant marginal utilityIncreasing marginal
utility, a convex utility
function
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Satisfice (satisfy + suffice)
. =Satisfice
Bounded Rationality
Satisfice means getting to an
acceptable outcome, even if that
outcome isn’t optimal or return
maximizing.
The idea of bounded rationality
+ satisfice is a key behavioral
finance concept because it
recognizes that people:
• Gather some but not all
available info
• Use heuristics (rules-of-
thumb)
• Have intellectual limits
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Prospect Theory
.
• Relaxes the assumption of
utility maximization and
substitutes it with loss
aversion
• Investors care more about
relative changes to wealth
than about absolute changes
and this depends on whether
in an area in which they are a
risk seeker or risk averse
TESTABLE CONCEPT: loss aversion can lead to investors selling winning stocks too early (to lock in gains) and/or holding on or even doubling down on losers.
Behavioral Finance Frameworks
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The Four Frameworks
Four main behavioral finance models
Seek to explain and offer suggestions for how to adjust a “rational”
asset allocation to account for a client’s unique characteristics, i.e. to
construct a behaviorally modified asset allocation plan.
The real key for the exam is whether investor’s actual financial
situation and behavioral profile means we can/should
accommodate their behavioral quirks or need to educate
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Consumption and Savings Model
• Bucketing
People’s self-control bias leads to different
ways of framing and bucketing current
income, owned assets, and future savings,
where an investor’s marginal propensity to
consume is highest for current income.
• Behavioral Life-Cycle Theory
The way people save, invest, and think
about their money is different depending on
their stage of life. In this case, the
consumption and savings model is almost
like a form of mental accounting,
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Behavioral Asset Pricing Model (BAPM)
BAPM adds a sentiment premium to the CAPM model
𝒓𝒆 = 𝒓𝒇 + 𝜷 𝒓𝒎 − 𝒓𝒇 + 𝒔𝒆𝒏𝒕𝒊𝒎𝒆𝒏𝒕 𝒑𝒓𝒆𝒎𝒊𝒖𝒎
Where:
Rf = The risk free interest rate
Re = The expected rate of return
Sentiment premium = an estimate derived from analyst forecasts
The greater the dispersion of analysts’ predictions, i.e. the
more they disagree, the larger the sentiment premium
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Behavioral Portfolio Theory
How these layers are
grouped together
depends on:
• How important the goal is
• The required return to meet the goal
• The investor’s specific utility function
• The degree of information they have
about the investment (> info >
concentration > risk)
• How loss averse they are
Suboptimal because BPT does not consider correlation
between the layers. Still, can get investors to stick with a
strategy and minimize doing something really stupid
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Adaptive Market Hypothesis (AMH)
AMH refers to using heuristics (rules of thumb) until the markets evolve and you have to
adapt your rules. AMH is basically efficient market theory with the idea of bounded
rationality + satisficing + evolution.
The adaptive market hypothesis offers a few conclusions about how to approach the
market:
• Risk and return relationships are not stable
• Active management CAN generate alpha as the markets take time to adapt to new
strategies
• Markets DO end up evolving. NO strategy works all the time (adapt or die dinosaur!)
• Adaption/Innovation ARE critical to success and surviving in markets
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Key Testable Concepts from Reading 5
• Contrast traditional finance with behavioral finance and
how that impacts investor decision making and portfolio
construction
• Compare and discuss the consequences of Weak, Semi-
strong form, and strong form modifications to EMH
• Describe and compare utility and prospect theory
• Talk about bounded rationality and cognitive limitations
and its impact on investment decision making (satisfice,
AMH)
• Describe the consumption and savings model, BAPM, and
BPT and how they differ from traditional finance
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