Behavioral Finance Concepts Quiz

Behavioral Finance Overview

• Behavioral finance is a field of study that examines how psychological factors influence investment decisions and market behavior. It challenges the assumptions of traditional finance, which assumes investors are rational.

Neoclassical vs. Behavioral Approach

• The neoclassical approach assumes rational investors (homo oeconomicus) who make decisions based on utility maximization, correctly interpret information, and efficiently eliminate irrationality.

• Conversely, the behavioral approach recognizes that investors are influenced by psychological factors like emotions, biases, and cognitive limitations. This can lead to systematic deviations from rational behavior.

Investor Rationality

• Neoclassical theory posits rational investors will display risk aversion only when it leads to potential benefits.

• They will maximize expected utility, where the marginal utility of each additional benefit unit remains positive.

• The behavioral approach argues that risk aversion depends on the decision-making context. Investors may attach greater importance to changes in wealth compared to total wealth.

Axioms of Rationality

• Axiom of Completeness: A rational decision-maker can compare and rank all possible options.

• Axiom of Transitivity: Consistent preferences are necessary; if A is preferred to B, and B is preferred to C, then A must be preferred to C.

• Axiom of Continuity: A rational investor's preferences are continuous—meaning that small changes in options won't drastically change their rankings.

• Axiom of Independence: Two options with similar outcomes are to be evaluated as independent of a third option.

Probability Assessment

• Traditional finance assumes investors correctly estimate probabilities and update beliefs based on new information.

• Behavioral finance suggests investors may struggle with probabilistic reasoning, overreact to vivid or anecdotal information.

Limits to Arbitrage

• Arbitrage aims to profit from price differences in the same or similar assets across markets.

• Behavioral finance argues that arbitrage is limited in practice due to transaction costs, imperfections in information, and psychological factors influencing trades. Behavioral factors like noise traders can create deviations from fundamental values, preventing the automatic correction of prices.

Fundamental Risk in Arbitrage

• Fundamental risk arises when one market reacts differently to news than another.

• This can lead to losses for arbitrageurs who depend on prices moving together.

Noise Trader Risk

• Noise traders are traders whose actions are not based on rational valuations, but on emotions or speculation.

Risk of Synchronization

• The risk of synchronization for arbitrageurs is that they might not be aware of when other arbitrageurs will also seek to take advantage of an arbitrage opportunity. Delaying actions can lead to additional costs and missed gains.

Implementation Costs

• Implementation costs include transaction costs (commissions, bid-ask spreads) and information costs (research, analysis).

• High implementation costs reduce opportunities for arbitrageurs, and potentially hinder the effectiveness of the arbitrage mechanism in aligning prices with fundamentals, leading to market inefficiencies.

Regulatory Barriers

• Legal and regulatory requirements can create obstacles or limitations for arbitrageurs.

Portfolio Theory

• Investors should diversify their portfolios to reduce nonsystemic risk. However, practical implementation issues and behavioral biases can cause these diversified portfolios to be inefficient.

Capital Asset Pricing Model

• The Capital Asset Pricing Model (CAPM) depends on investors being rational, but behavioral biases affect the accuracy of the model's assumptions in real-world applications.

Efficient Market Hypothesis

• The efficient market hypothesis (EMH) proposes that prices reflect all available information, but significant evidence shows that markets can display inefficiencies.

Calendar Anomilies

• Time-based phenomena in stock price movements, like the January effect.

• Often, these are explained by behavioural factors (e.g., tax-loss selling).

Incorrect Market Reaction to Information

• Market participants may not interpret information correctly, overreacting to some kinds of data or under-reacting to others, undermining market efficiency.

Contrarian Investing

• Contrarian investing involves taking opposite positions to the prevailing market sentiment. This can be effective because markets often overreact and make prices deviate from their fundamental values.

Momentum Strategy

• This strategy involves identifying assets which have seen consistent, prior price rises and buying into them.

Forecasting Returns Based on Firm Characteristics

• Strategies based on factors like company size (small-cap effect) or book-to-market ratios. Understanding these factors is important because they reflect firm characteristics, fundamentals, or potential future performance.

Psychological Aspects of Decision Making

• Framing effect: the way information is presented to decision-makers influences their perception.

• Money illusion: people may not accurately account for inflation when considering monetary values.

• Mental accounting: people make different accounts in their mind to different expenses or revenues.

• Overconfidence, optimism and narcissism: people are too sure of their skills, opinions and decisions and do not take enough caution to understand the broader risks of these actions.

Investor Behavior

• Understanding that investors' decisions may deviate from rational economic principles.

Forecasting the Future on the Basis of Past Events

• Discusses the biases that can lead to faulty decision-making, leading to overemphasis of past trends.

Extrapolation Bias

• Investors may overemphasize existing trends in the past, extrapolating them into the future without considering external, potential factors.

Following Trends

• Market players may mistakenly interpret short-term market fluctuations as predictable trends, leading to herd behavior and overreactions.

Minimum & Maximum Prices

• Investors tend to focus on recent lows and highs as reference points, influenced by anchoring bias, rather than fundamental analysis.

Perception of Value and Investment Selection

• Assessing different investment options and understanding how perception and biases can shape investment choices.

Good Company v Good Investment

• Separating assessing a company's general performance, with its current or future investment potential.

Beauty Contest

• Investors may focus on other investors' anticipated future investment decisions rather than the underlying value of the company.

Familiarity & Home Bias

• Investors tend to invest in companies or markets they are familiar with—sometimes overlooking potentially better opportunities in less familiar areas.

Incorrect Perception of Information

• Issues with the communication of information and investor misinterpretation of data,leading to market inefficiencies.

Financial Forecasts

• How analyst forecasts are often optimistic and may be driven by conflicting interests or an attempt to build positive relationships and acquire non-public information.

Portfolio Management

• Deficiencies in diversification strategies and how they can negatively affect investors' portfolios.

Myopia in Asset Allocation

• Investors are quick to react to short-term price fluctuations, affected by mental account biases and reluctance to invest in stocks during periods of perceived loss.

Disposition Effect

• Reluctance to sell losing stocks versus a tendency of investors to keep winning stocks longer.

Asset-Pricing Anomalies & Investment Strategies

• Market inconsistencies which lead to inaccurate or inefficient pricing based on investor reactions.

Violation of the Law of One Price

• Instances where identical assets trade at different prices due to market inefficiencies.

Closed-End Funds Puzzle

• This looks at the situation where investment fund prices do not accurately reflect its net asset value.

Twin Stocks

• Similar issues in company valuation, and how this can lead to pricing conflicts, if a company floats more than one stock, leading to a lack of efficient market.

Pricing of Mother and Daughter Shares

• IPO scenarios and potential biases in the valuation and allocation of shares in separate companies.

Calendar Anomalies (Month-of-Year Effect)

• Seasonality factors affect investor behavior as well as the buying and selling of stocks and companies, (e.g., January effect).

Weekend Effect

• Possible reasons behind Monday's low returns, often due to investor behaviors or announcements of financial news.

Contrarian Investing

• How to take different views to the commonly held view often results in higher potential returns.

Momentum Strategy

• How consistent or previous returns of financial instruments, have a potential for increased return rates.

Small-Size Effect

• How under-priced, or less liquid stocks, sometimes exhibit better returns compared to more liquid or established ones.

Book to Market Equity

• Factors which explain the returns on stocks which are considered "high growth" or established value businesses.