Level III The Behavioral Finance Perspective Summary... Traditional Finance Behavioral Finance Investor behavior Traditional finance describes how investors should behave Behavioral fin
Trang 1Level III
The Behavioral Finance Perspective
Summary
Trang 2Traditional Finance Behavioral Finance
Investor
behavior
Traditional finance describes how investors should behave
Behavioral finance tries to explain how investors actually behave
Information Investors have perfect information
and process information in an unbiased manner
Bounded rationality; investors “satisfice”
Cognitive and emotional biases Attitude to risk Investors are risk averse
Reject all gambles with non-positive expected return
Investors are not consistently risk averse People do take gambles with non-positive expected return
Markets Efficient market hypothesis Not entirely efficient; adaptive market
hypothesis Portfolios Mean-variance optimized In layers to satisfy investor goals
Trang 3Traditional Finance and Expected Utility Theory
Traditional finance assumes that individuals:
• are perfectly rational, risk-averse and self-interested
• have perfect information and update probability
calculations using Bayes’ formula
“REM will try to obtain the highest possible economic well-being or utility given budget constraints and the available information about opportunities, and he will base his choices only
on the consideration of his own personal utility.”
Expected utility theory
• Indicates how people “should” make decisions
• Objective is to make an optimal decision
• Individuals maximize expected utility at given level of risk
• Expected utility varies from person to person
• Utility increases at a decreasing rate with increases in wealth
“I have always followed a budget and have been a disciplined saver for decades Even in hard times when
Trang 4BF Perspectives: Attitude to Risk
Individuals are not consistently risk averse; the level of risk
individuals are willing to take depends on circumstances and
level of wealth The curvature of the utility function can
change
People take low probability-high risk payoffs (lottery tickets,
out-of-the-money options) while at the same time insure
against low risks with low payoffs (flight insurance,
earthquake insurance)
Risk-seeking (convex) utility function for gains and a
risk-averse (concave) utility function for losses
Friedman-Savage double inflection utility function: a utility
function that changes based on levels of wealth
Trang 5Prospect Theory
Prospect theory is an alternative to expected utility theory and is
based on how decisions are actually made
• Assigns values to gains and losses (changes in wealth) rather than
to absolute wealth
• People often overweight low probability outcomes and
underweight moderate/high probability outcomes
– risk averse when there is a high probability of gains or a low
probability of losses
– risk seeking when there is a low probability of gains or a high
probability of losses
• Value function is based on deviations from a reference point
– Concave for gains and convex for losses
– Steeper for losses than for gains (loss aversion)
Prospect theory explains why people simultaneously buy
lottery tickets and insurance while investing money
conservatively
“When considering investments, I have always liked using long option positions I like their risk/return tradeoffs My personal estimates of the probability of gains seem to be higher than that implied by the market prices I am not sure how to explain that, but to me long
Trang 6Bounded Rationality
People don’t necessarily optimize because the cost might be too high; also there are limitations to
knowledge and cognitive capacity The bounded rationality theory recognizes that people are not fully rational when making decisions People satisfice (satisfy + suffice)
• Outcomes might not be optimal but are likely to be adequate
• Decisions are based on a limited set of important factors and/or heuristics: mental shortcuts; also called “rules of thumb” Examples:
– A 60 years old invests 60% of his portfolio in fixed income based on the rule of thumb that the allocation to fixed income should equal ones age
– Sticking with my existing asset management company because it meets my basic requirements – Curriculum Example 2: Depositing funds in a checking account at a bank down the street The bank is FDIC insured and offers a competitive rate
– “When new information on a company becomes available, I adjust my expectations for that company’s stock based on past experiences with similar information.”
• Downside: better alternatives might be missed
Trang 7Traditional Behavioral Finance
Markets are efficient
The price is right
There is no free lunch
Markets are not necessarily efficient; anomalies do exist
Example: “While I try to make decisions analytically, I do believe the markets can
be driven by the emotions of others So I have frequently used buy/sell signals when investing Also, my 20 years of experience with managers who actively trade
on such information makes me think they are worth the fees they charge.”
Implications of adaptive market hypothesis (AMH):
1 Risk premiums change over time
2 Active management can add value by exploiting arbitrage opportunities
3 Any particular investment strategy will not be successful on consistent basis
4 Ability to adapt and innovate is critical for survival
5 Survival is the essential objective Traditional and Behavioral Perspective on Market Behavior
Trang 8Traditional and Behavioral Perspective on Portfolio Construction
Traditional Portfolio Theory Behavioral Portfolio Theory (BPT)
A rational economic individual:
uses self-control to pursue
long-term goals rather than short-long-term
satisfaction
considers risk/return objectives
and constraints
uses the mean-variance
optimization (MVO) framework
considers difference sources of
money/wealth to be fungible
“Client exhibits a self-control bias by spending all of her current
salary income and half her bonus income on current consumption, pursuing short term satisfaction to the detriment of long-term
financial security.”
“A BPT investor maximizes expected wealth subject to a safety constraint As a result, the optimal portfolio of a BPT investor is a combination of bonds or riskless assets and highly speculative assets.”
Mental accounting bias: different mental accounts based on source
and/or use of money Portfolio is constructed in layers: current income, currently owned assets (partially spent on current consumption), present value of future income (very little spent on current consumption)
Trang 9Traditional versus Behavioral Portfolio Theory Examples
“My clients like to match their goals with specific investment allocations or
layers of their portfolio.”
“I follow a disciplined approach to investing When a stock has appreciated by
15 percent, I sell it Also, I sell a stock when its price has declined by 25 percent
from my initial purchase price.”
“Overall, I have always been willing to take a small chance of losing up to 8
percent of the portfolio annually I can accept any asset classes to meet my
financial goals if this constraint is considered
An acceptable portfolio will satisfy the following condition:
Expected return – 1.6 × Expected standard deviation ≥ –8%.”
BPT Mental accounting
BPT Loss aversion, prospect theory
Mean-variance optimization