# CFA III SS 3 Behavioral Finance

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1. Four Axioms of Utility Theory
• Completeness: given a choice between C or D, person would choose C, D, or be indifferent
• Transitivity: if prefer C over D and D over E, then would prefer C over E
• Independence: if B>C, then B+D>C+D
• Continuity: if C>B>A, then there is a combination of C & A = B
2. Bayes Law
The person is exhibiting both risk seeking (lottery ticket) and risk averse (insurance) behavior

This is explained by the complex risk function
4. Utility Theory vs Prospect Theory

1. Investor Risk Profile
2. Weighting of Outcomes
• 1. All investors are risk averse
• 2. Probability weight all outcomes

• Prospect Theory (Behavioral Finance)
• 1. Value gains and losses differently: risk averse to gains, risk seeking to losses
• 2. Decisions weights applied to outcomes, which leads to lower probability events having higher weights than they should
5. Prospect Theory Decision Making: Six steps in the early/editing phase
• 1. Codification: code outcomes as gains or losses and place probability on each; coding depends on reference point (current price, cost, year end, etc.)
• 2. Combination: combine outcomes with the same value. for example, one out come of +100 at 10% and another has +100 at 5%, combine as +100 at 15%
• 3. Segregation: separate certain and uncertain outcomes
• 4. Cancellation: identical outcomes are eliminated. ex, two stocks both have 15% chance of 100 return
• 5. Simplification: round probabilities. ex, round 13.7% up to 15%
• 6. Determine Dominance: eliminate inferior options
6. Consumption and Savings Model
• Markets are not efficient because individuals do not save rationally
• Behavioral life cycle theory maintains that individuals are subject to framing, mental accounting, and self-control bias
• Individuals classify wealth as current income, current owned assets, and present value of future income
7. Behavioral Asset Pricing Model
• The greater the dispersion of assets, the greater the premium, so the higher the discount rate and lower the perceived value
8. Behavioral Portfolio Theory
• Investors structure their portfolio in layers - a pyramid
• Layers are not fungible, and correlation between layers is not considered
• May appear diversified but not optimal mean-variance
• Evolutionary principles of biology apply to finance
• Evolve and learn, so no strategy works consistently
10. Weak, Semi-Strong, and Strong form efficient
• Weak: Technical analysis will not work
• Semi-Strong: Market reflects all technical analysis and material public information
• Strong: Market reflects all public and private information
11. Cognitive Errors: Belief Perseverance
• Conservatism: Do not change beliefs easily, especially if information is complex
• Confirmation: Seek evidence to support view
• Representativeness: New information viewed in light of old classification. ex. have growth stock, always see new info in context of growth stock. Base rate bias - Base rate is not questioned. Sample size - sample too small.
• Illusion of control: believe can influence results. ex - employee buying stock in own company
• Hindsight: selective memory
12. Cognitive Errors: Information Processing
• Framing: answer depends on data presentation
• Mental Accounting: ignore fungibility and place funds into mental buckets
• Availability: use easily recalled data to make decisions
13. Emotional Biases
• Loss-aversion: more pain from loss than pleasure from gain
• Overconfidence: may result from self-attribution
• Self-control: lacking discipline to delay gratification in pursuit of long-term goals
• Endowment bias: value owned assets more than non-owned assets
• Regret aversion: make no decision due to fear of wrong decision
• Status-quo: comfort with what exists - do nothing
14. Behaviorally Modified Asset Allocation: Actions based on biases and Standard of Living Risk (SLR)
• Low SLR, emotional bias: Accommodate; 10-15% deviation acceptable
• Low SLR, cognitive bias: Accommodate and moderate; 5-10% deviation
• High SLR, emotional bias: Accommodate and moderate; 5-10% deviation
• High SLR, cognitive bias: Moderate; 0-3% devaition
15. Pompian Behavioral Model
1. Process
2. Classifications and Common cognitive and emotional biases for each classification
3. Risk tolerance and decision making for each classification
• 1. Interview to determine active or passive source of wealth; plot risk tolerance; test for biases; classify investor
• 2. Classifications
• Passive Preserver: cog bias - mental acct, a&a; emo bias - endowment, loss aver, status quo
• Friendly Follower: cog bias - availability, hindsight, framing; emo bias - regret aversion
• Independent Individualist: cog bias - conservatism, availability, confirmation; emo bias - overconfidence, self-attribution
• Active Accumulator: cog bias - illusion of control; emo bias - overconfidence, self-control
• 3.
• PP: Low risk tolerance, emotional decision making
• FF: med-low RT, cognitive
• II: med-high RT, cognitive
• AA: high RT, emotional
16. Bailard, Biehl, and Kaiser (BB&K) Model