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What is completeness?
The individual is aware of all choices, can value and assign preferences and prefers one over the other or is indifferent.
What are the four axioms of utility?
- 1. Completeness
- 2. Transitivity
- 3. Independence
- 4. Continuity
What is transitivity?
X>Y, Y>Z : X>Z
What is independence?
If X>Y; (X+Z)>(Y+Z) and (X+nZ)>(Y+nZ)
What is continuity?
If L>M>N, then (aL + bN) = M
What is Baye's Formula?
What are the 3 types of investors, and what are their utility functions?
- 1. Risk Averse - Concave (rainbow)
- 2. Risk Neutral - Linear
- 3. Risk Seeking - Convex (bowl)
What is prospect theory?
Investors analyze risk with regards to gains and losses as opposed to returns. ie. Change in wealth is more important than returns. Also, loss is more important than gain.
What are the two phases in which investors make decisions in prospect theory?
Editing and evaluation
What are the 6 steps in the editing phase?
- 1. Codification
- 2. Combination
- 3. Segregation
- 4. Cancellation
- 5. Simplification
- 6. Detection of dominance
What is Codification?
Investors identify and "code" outcomes as gains or losses and assign a probability.
What is combination?
The investor combines outcomes with identical values. So, a 25% chance of HH, 25% of HT, 25% of TH and 25% of TT results in 50% chance of getting one H and one T
What is segeregation?
Certain and uncertain aspects of the outcomes are seperated. (50,50%) and (100,50%) becomes (50,100%) and (0,50%),(50,50%).
What is cancellation?
Identical components of the outcomes cancel each other out. So (1,3,4) VS. (2,4,6) becomes (1,3) VS. (2,6)
What is simplification?
Numbers become simplified. So a 50.5:49.5 becomes 50:50 odds.
What is detection of dominance?
- An investor will eliminate any choce that is strictly dominated by another. So given
- B dominates A
Discuss the subjective probability weighting done by most investors in the evaluation phase.
Most investors put too high a prob on low prob events (winning lotto, end of world etc) and too low a prob on higher prob events (losing all your money in an options only bet)
What is bounded rationality?
Individuals act as rationally as possible while recognizing they are constrained by loack of knowledge and cognitive ability.
What is satisfice?
Investors gather what tehy consider to be an adequate amount of info and apply heuristics to analyze and shape the information into an acceptable decision.
What is "The Price is Right"?
The idea that asset prices reflect all avaialable information and adjust instantaneously to fully and accurately incorporate the value of new information.
What is "No Free Lunch"?
The idea that no manager should be able to generate excess returns (alpha) consistently.
What is weak form efficient market hypothesis?
Current prices incorporate all past price and volume data. Managers can not consistently beat market using technical analysis.
What is semi-strong form efficient market hypothesis?
Current prices reflect all past price and volume info as well as all public info. Managers can not beat market using technical or fundamental analysis.
What is strong form efficient market hypothesis?
Current prices reflect all past price and volume info as well as all public and private info. Managers can not beat market using any analysis.
What are fundamental anomalies?
Anomolies based on fundamental characteristics of a firm. Like, small cap, or value vs. growth.
What are technical anomalies?
Anomolies based on technical information. Trading strategies based on moving averages and resistance & support levels are technical anomolies.
What are calendar anomalies?
Excess returns based on calendar data. The January effect (markets earn higher returns in January). Turn of the month
What are the four behavaioral finance models?
- 1. Consumption and Savings
- 2. Behavioral Asset Pricing
- 3. Behavioral Portfolio Theory
- 4. Adaptive Markets Hypothesis
What are the 3 behaviors that an individual may exhibit according to the consumption and savings model?
- Self Control
- Mental accounting
What is Framing?
Refers to the way a question or statement is asked. The company will match 100% of five percent of your contributions going forward vs. The company is lowering the match rate from 6% to 5% going forward.
What is self control and self control bias?
- Self control refers to the ability to think rationally when making consumption/savings decisions.
- Self control bias refers to a persons tendancy to put more value on current consumption than on future goals.
What is mental accounting?
Segregating goals and assets to meet those goals while ignoring the fact that wealth is fungible.
What is classifying wealth?
Part of the behavioral life-cycle model that assumes people classify their wealth as current income, currently owned assets, or present value of future income. Think of 401K, cash tips, bonus, inheritance, tax refund, or salary.
What is behavioral asset pricing?
A model that adds sentiment premium to the discount rate of the CAPM model.
What is the sentiment premium?
A premium that can be estimated by considering y analysts' forecasts. The greater the dispersion , the greater the sentiment premium. Higher sentiment premium can result in large misprices.
What is behavioral portfolio theory?
The idea that investors create layered goals which are determined by the 5 factors.
What are the 5 factors in Behavioral Portfolio theory?
- The importance of goals
- Required return
- The investors utility function
- Access to information
- Loss aversion
What is the importance of goals in BPT?
The more important the goal, the less risky the assets used to achieve the goal. Treasuries etc to meet critical goals like planned medical expenses vs. goals to acquire a sports car)
What is required return in BPT?
The risk of assets in any layeer depends on the return required to mee the goals in the layer.
What is the investors utility function?
The marginal utility of each additional security will decrease as you increase more. You will get more utility out of 2 than 1 and out of 3 than 2. The more concave the utility function, the more securities you will use.
What is access to information in BPT?
When an investor perceives that he has an information advantage, the layer could be concentrated in one or a few securities. ( hot tips on a tech stock etc. )
What is loss aversion in BPT?
Investor holds too much cash for fear of losing nominal value. Alternatively, an investor may hold on to a security that has lost value for fear of recognizing and locking in the lost. (SLV).
What is adaptive markets hypothesis?
Investors apply heuristics until they no longer work and then adjust. Darwinian adjustments. Assumes investors satsifice rather the maximize utility.
What are the 5 important conclusions that adaptive market hypothesis leads to?
- Investors satisfice
- Investors must survive to adapt
- No investment strategy can continually outperform
- Risk premiums will vary depending on perceptions. Increased competition in teh market can lead to lower perception and aversion to risk
- Because investors satisfice, mispricing can exist and active management can capture alpha.