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Questions and Answers
What is a key characteristic of human decision-making in financial markets according to Behavioral Finance?
What is a key characteristic of human decision-making in financial markets according to Behavioral Finance?
Which of the following concepts does Behavioral Finance challenge?
Which of the following concepts does Behavioral Finance challenge?
Which bias refers to the difficulty in adapting to rapid changes or new information?
Which bias refers to the difficulty in adapting to rapid changes or new information?
What aspect of human cognition is highlighted as an area of weakness regarding financial decisions?
What aspect of human cognition is highlighted as an area of weakness regarding financial decisions?
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What is an outcome of evolutionary selection pressure on human decision-making as it pertains to finance?
What is an outcome of evolutionary selection pressure on human decision-making as it pertains to finance?
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Which of the following best describes the concept of Behavioral Bias in financial decisions?
Which of the following best describes the concept of Behavioral Bias in financial decisions?
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What aspect of human evolution contributes to the biases in assessing probabilities in investment decisions?
What aspect of human evolution contributes to the biases in assessing probabilities in investment decisions?
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What aspect of market behavior is suggested to often influence participants' decisions?
What aspect of market behavior is suggested to often influence participants' decisions?
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What characterizes information relevance in niche markets or small stocks?
What characterizes information relevance in niche markets or small stocks?
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How does the stock price affect the feedback cycle in the market?
How does the stock price affect the feedback cycle in the market?
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What does Prospect Theory primarily address in relation to decision-making?
What does Prospect Theory primarily address in relation to decision-making?
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What statement reflects a commonly held belief about market participants according to the behavioral finance paradigm?
What statement reflects a commonly held belief about market participants according to the behavioral finance paradigm?
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In the context of the utility function, what does concavity indicate?
In the context of the utility function, what does concavity indicate?
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What concept illustrates that individuals may exhibit risk-seeking behavior when facing losses?
What concept illustrates that individuals may exhibit risk-seeking behavior when facing losses?
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What kind of market information might be less recognized by participants?
What kind of market information might be less recognized by participants?
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Which of the following best explains the concept of herd behavior in markets?
Which of the following best explains the concept of herd behavior in markets?
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What does time preference explain in economic terms?
What does time preference explain in economic terms?
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What exemplifies the status quo bias in investment decisions?
What exemplifies the status quo bias in investment decisions?
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How does endowment bias manifest in an individual's asset management?
How does endowment bias manifest in an individual's asset management?
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In the context of fairness bias, how is a price increase perceived compared to eliminating a discount?
In the context of fairness bias, how is a price increase perceived compared to eliminating a discount?
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Which of the following best defines the do-nothing strategy associated with status quo bias?
Which of the following best defines the do-nothing strategy associated with status quo bias?
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What is a primary effect of errors in information processing related to probabilities?
What is a primary effect of errors in information processing related to probabilities?
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What describes the anchoring bias in decision-making?
What describes the anchoring bias in decision-making?
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How does mental accounting affect financial decision-making?
How does mental accounting affect financial decision-making?
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In the scenarios with the camera and calculator, what influences willingness to drive to another store?
In the scenarios with the camera and calculator, what influences willingness to drive to another store?
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What does framing bias imply about investment decision-making?
What does framing bias imply about investment decision-making?
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Which situation exemplifies mental accounting bias according to the scenarios presented?
Which situation exemplifies mental accounting bias according to the scenarios presented?
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What common mistake do individuals make when anchoring their estimates?
What common mistake do individuals make when anchoring their estimates?
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Which of the following is NOT an example of mental accounting?
Which of the following is NOT an example of mental accounting?
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What aspect of information processing errors affects perceptions of future risk?
What aspect of information processing errors affects perceptions of future risk?
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What tendency is involved when a person opts to avoid loss rather than seek gain?
What tendency is involved when a person opts to avoid loss rather than seek gain?
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What is a key characteristic of an investment manager with a preference for bond cash flows?
What is a key characteristic of an investment manager with a preference for bond cash flows?
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What does confirmation bias lead individuals to do with conflicting evidence?
What does confirmation bias lead individuals to do with conflicting evidence?
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In the context of the disjunction effect, what generally happens when individuals are faced with contingent decisions?
In the context of the disjunction effect, what generally happens when individuals are faced with contingent decisions?
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What is a consequence of representativeness bias when judging new information?
What is a consequence of representativeness bias when judging new information?
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How does the illusion of control bias typically manifest in traders?
How does the illusion of control bias typically manifest in traders?
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What tendency is exhibited by people under the hindsight bias?
What tendency is exhibited by people under the hindsight bias?
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What is a primary error associated with the representativeness heuristic?
What is a primary error associated with the representativeness heuristic?
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What does the term 'self-attribution bias' refer to in decision-making?
What does the term 'self-attribution bias' refer to in decision-making?
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What major pitfall is associated with the representativeness bias in investing?
What major pitfall is associated with the representativeness bias in investing?
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Which cognitive error incorrectly leads individuals to see patterns where none exist?
Which cognitive error incorrectly leads individuals to see patterns where none exist?
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Study Notes
Portfolio Theory and Behavioral Finance
- The course is on Portfolio Theory and Behavioral Finance, specifically focusing on the topic of behavioral biases.
- The course is offered in the Winter semester of 2024 by Dr. Martin Schnauss and Dr. Jan-Alexander Posth.
- The lecture materials include concepts like prospect theory, framing, cognitive errors, information processing biases, and emotional biases.
Topics
- Prospect Theory Summary
- Prospect Theory and Framing
- Behavioral Biases – Cognitive Errors
- Behavioral Biases – Information Processing Biases
- Behavioral Biases – Emotional Biases
Behavioral Finance: Prospect Theory
- Prospect Theory is a decision-making theory considering gains and losses relative to a reference point.
- Humans rarely evaluate in terms of total wealth but in terms of gains and losses.
Where we Come From... and Where We Need to Be!
- Key historical milestones are linked to the concept of risk: development of hominids, first metallic money, alphabet, trade, abacus, mathematical engines.
The Problem
- Key players in financial markets are human. They do not always act rationally and can be biased in their decisions.
- Reasons for biases include evolutionary selection pressure, need for faster decisions, and value for survival and reproduction success.
- Behavioral finance recognizes the conflict between humans' cognitive abilities and their evaluation of investments.
The Problem, cont'd
- Humans are good at dealing with complexity in known environments, reacting quickly to danger, and recognizing patterns.
- However, they are less adept at engaging with complex, abstract matters like numbers and probabilities, adapting to rapid change, and understanding context free information.
Why do we need a paradigm shift? EMH deconstructed, part 1
- Assumption 1: Markets are not perfectly complete nor efficient.
- Not all relevant information is available to all market participants simultaneously.
- Some information may be exclusive to insiders.
- The relevance of public information may not be entirely understood.
- News coverage can vary depending on the focus of the public.
- Niche market or small stocks with few analysts may lack coverage, impacting market efficiency.
- Price fluctuations and news coverage can create a feedback loop, interacting with market irrationality.
Why do we need a paradigm shift? EMH deconstructed, part 2
- Assumption 2: Market participants are not always rational.
- Behavioral biases influence real world decisions.
- A shift from classical finance to behavioral finance is essential for understanding market behavior.
- Common biases include overconfidence, representativeness, herding, anchoring, and conservatism. (table included)
Why do we need a paradigm shift? EMH deconstructed, part 3
- A focus on the emotional aspects of market behavior.
- People often act in herds and lose rationality in both positive and negative market scenarios.
- Market cycles are based on emotional responses, as shown in a visual cycle diagram.
Remember: Utility as a Function of total Wealth
- The utility function is concave, denoting risk aversion.
- This relationship is important for understanding why investors prefer certainty over risk.
Now: Prospect Theory includes the consideration of losses
- Prospect theory considers changes relative to current wealth and shows risk-seeking behavior when facing losses.
- The graph of the utility function is convex for losses.
From Utility theory to Prospect theory – a necessary paradigm shift
- Prospect theory moves beyond expected utility theory, incorporating value function and weighting function.
- Decision-making is based on considerations of different prospects in relationship to a reference point.
Prospect Theory – why does it work?
- Prospect theory assumes decisions are framed according to gains or losses, relative to a reference point.
- Key aspect: valuation function is steeper in losses, reflecting that losses have a larger emotional impact than gains. Positive gains have less of an effect than negative losses.
Prospect Theory – Value function (Kahnemann, Tversky Original)
- The value function shows different slopes for gains and losses, emphasizing the greater impact of losses.
Prospect Theory: Framing
- Framing describes how different ways of describing a prospect can alter decisions (e.g. highlighting gain or loss compared to a reference point).
- Frames influence people by changing their reference point.
Prospect Theory... leads naturally to Framing!
- Different descriptions of prospects, especially in highlighting gains or losses compared to a reference point, lead to different decisions.
- This illustrates how the valuation function influences human decision-making. The steepness of the function around the reference point shows the effect of loss aversion.
Ready to be Framed? – An example...
- Hypothetical example to illustrating framing effect in decision-making. Different framing of the same event (saving lives or letting people die) can lead to different decisions.
…and another one!
- Another example demonstrating the framing effect. Choice A and B are described differently, leading to differing perception of the same underlying scenario, one described as chance of gains or losses involving monetary gain.
Prospect Theory in a nutshell
- Prospect theory separates prospects into positive and negative based on a status quo reference point.
- Absolute values are not the main driving force for decisions, instead probabilities are weighed by the effect of losses.
Behavioral Finance: Behavioral Biases
- This section provides a general overview of behavioral biases that influence financial decisions.
Behavioral Biases: An overview
- This section gives a concise overview of some cognitive and other biases. The categories include cognitive errors and other biases.
Behavioral Biases – Cognitive Errors: Conservatism
- People tend to overestimate base rates and underweight new information, leading to revisions in beliefs about probabilities and outcomes
Behavioral Biases – Cognitive Errors: Aversion to Ambiguity
- People favor the familiar, certain options over uncertain or unfamiliar ones, in investment decision-making to avoid ambiguity.
Behavioral Biases – Cognitive Errors: Confirmation
- Individuals favor information that reinforces their existing beliefs, dismissing conflicting information.
Behavioral Biases – Cognitive Errors: Disjunction Effect
- Decisions are made difficult by dependence on future information.
Behavioral Biases – Cognitive Errors: Representativeness
- People classify new information based on past experiences or stereotypes and overestimate small samples/observations.
Behavioral Biases – Cognitive Errors: Representativeness Heuristic
- People judge based on similarity to existing types, irrespective of base rate probabilities.
- People misinterpret random fluctuations and patterns as meaningful indicators.
Behavioral Biases – Cognitive Errors: Illusion of Control
- People overestimate their ability to control or influence outcomes, often believing in market signals, trends, and technical analysis.
Behavioral Biases – Cognitive Errors: Hindsight
- People overestimate their ability to predict past events accurately.
Behavioral Biases – Information Processing
- Errors in processing information can lead to misconceptions in estimating probabilities and uncertainty.
Behavioral Biases – Information Processing: Anchoring
- Initial values (anchors) exert an undue influence on subsequent estimates. People adjust their estimates based on an initial estimate.
Behavioral Biases – Information Processing: Mental Accounting
- People assign monetary amounts in different mental accounts, influencing their decisions in an irrational way (e.g. treating money from a lottery differently from earned money).
Behavioral Biases – Information Processing: Mental Accounting
- Financial decision making can be affected by the mental context in which a decision is made.
Behavioral Biases – Information Processing: Framing
- Framing biases affect how people perceive and react to decisions based on gain/loss, or questions based on different frames (e.g minimal, topical, comprehensive). People usually make decisions in relation to different aspects.
Behavioral Biases – Information Processing: Framing
- People base choices mainly on the differences between the local alternatives and not the common aspects of those alternatives.
Behavioral Biases – Information Processing: Framing
- In decision making, people consider choices relative to the context (topical framing)
Behavioral Biases – Information Processing: Overreaction and Availability
- People tend to base choices on easily recalled (available) or readily accessible information, which may be biased or limited
Behavioral Biases – Information Processing: Forecasting Errors
- Individuals overemphasize recent information over prior experience.
Behavioral Biases – Information Processing: Magical Thinking
- Irrational beliefs about events often based on patterns (like superstitious thinking).
Behavioral Biases – Information Processing: Quasi-Magical Thinking
- Illusory beliefs about events, like coin tosses or lottery numbers.
Behavioral Biases – Information Processing: Sunk Cost
- People continue investments (e.g., time, money) due to previous investment regardless of their value proposition.
Behavioral Biases – Emotional Bias: Loss Aversion
- People are more averse to losses than they are attracted to gains. Pain of a loss is often greater than the gain. (stop losses).
Behavioral Biases – Emotional Bias: Overconfidence
- Individuals overestimate their knowledge and skills. This results in overestimation in one's ability to judge/select stocks or judge risks in general.
Behavioral Biases – Emotional Bias: Overconfidence
- Example involves assessing whether the market would rebound from a significant event.
Behavioral Biases – Emotional Bias: Self-Control
- Conflict between short-term and long-term goals (e.g., prioritizing immediate gratification over future goals. People tend to favor the short-term over the long-term.
Behavioral Biases – Emotional Bias: Status Quo Bias
- Individuals lack impetus to change existing situations/investments.
Behavioral Biases – Emotional Bias: Status Quo Bias
- People maintain current portfolio allocations even during changing conditions for fear of re-evaluating and making the wrong choice.
Behavioral Biases – Emotional Bias: Endowment
- People value things they already own more than things they do not own even if both items cost the same amount. Perceived loss will be higher than perceived gain.
Behavioral Biases – Emotional Bias: Fairness
- Perception of fairness varies by the context and whether it describes a loss or a gain. Framing a situation as a discount rather than a surcharge often leads to perceived fairness, which may lead to a greater impact. People tend to react more strongly based on loss as opposed to gain.
Behavioral Biases – Emotional Bias: Regret Aversion
- People avoid decisions to prevent regret if something goes wrong.
Behavioral Biases – Emotional Bias: Naive Diversification
- People diversify their assets equally across different alternatives rather than based on risk/return profiles and overlook the differences between various asset option profiles.
Behavioral Biases – Emotional Bias: Culture and Social Contagion
- Social norms, memory, and cultural factors influence decision-making (e.g., in rates of suicide).
Behavioral Biases – Emotional Bias: Certainty Effects, Probabilistic Insurance
- People value guaranteed results higher or have a bias towards guaranteed results and not probabilistic results, regardless of lower risk.
Behavioral Biases – Other Biases: Gambler's Fallacy
- Belief that previous events affect the likelihood of subsequent events. This notion is often observed in gambling.
Behavioral Biases – Other Biases: Herd Behavior
- People act in groups like animals (herds). They rely on social trends in times of crisis to survive. This is often observed in market panics.
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Description
Explore key concepts and biases in Behavioral Finance through this quiz. Test your understanding of how human cognition, market behavior, and evolutionary aspects influence financial decision-making. Discover how these elements shape the financial markets and investor behavior.