Part 1

Weak-Form Efficiency

• In a weak-form efficient market, technical trading rules cannot consistently produce excess returns due to prices incorporating all past price and volume data.
• The failure of technical analysis to yield excess returns is evidence of a weak-form efficient market.

Heuristic-Driven Bias

• Heuristic-driven bias emerges when investment principles, shaped by experience, lead to reliance on heuristics (rules of thumb) for decision-making.
• Imperfect heuristics influence investment decisions and cause errors; bad advice is not part of the development of this bias but can contribute to it.

Prospect Theory

• Prospect theory suggests investors prioritize avoiding losses, implying that the risk of loss may be the best risk measure.

Bounded Rationality

• Bounded rationality acknowledges that individuals make the most rational decisions possible, given the limitations of available information and cognitive processing ability.

Heuristic Learning

• Heuristic learning processes involve trial and error, and experimentation, not research.
• Heuristic learners gather information simply from their own experiences or easily accessible sources.

Satisficing

• Satisficing involves gathering an adequate amount of information and applying heuristics to make an acceptable decision rather than seeking an optimal utility-maximizing choice.

Psychological Profiling

• Psychological profiling is important because investors display non-rational psychological traits inconsistent with modern portfolio theory.
• Loss aversion is such a trait, where investors prefer uncertain larger losses over smaller certain losses, conflicting with risk aversion assumed in modern portfolio theory.

Traditional Finance vs Behavioral Finance

• Traditional finance assumes investors are risk averse, rational, and make unbiased utility-maximizing decisions.
• Behavioral finance recognizes the use of psychological biases in investment decisions and explains investor actions.

Semi-Strong Form Efficiency

• In a semi-strong form efficient market, prices already reflect all available public information.
• Consistently generating excess returns using public information indicates the market is not semi-strong form efficient and may be weakly efficient instead.

Codification

• Codification involves classifying outcomes as gains or losses during the editing phase of decision-making.
• Investors code outcomes and assign probabilities, Combining identical values and simplifying probabilities to gain clarity.

Bayes' Theorem

• Bayes' theorem revises expectations based on new information.
• An example is a fundamental analyst changing a stock recommendation due to a revised earnings report.

Risk Neutral Investor

• A risk-neutral investor is indifferent between investments with the same expected return, regardless of differing risk levels (standard deviations).
• Both risk-averse and risk-seeking investors would not be indifferent.

Steps to Achieve Goals

• Satisficing involves taking incremental steps towards desired goals, leveraging heuristics, trial and error, and learned behavior, rather than exhaustively analyzing all available information.

Bayes' Formula

• Bayes' formula incorporates new data into forecasts, aiding investment decisions and improving accuracy.

Framing

• Framing influences choices based on how information is presented, whether highlighting potential gains or losses.
• An investor's selections are affected by how outcome is stated (possible gain versus possible loss).

Loss Aversion

• Choosing riskier investments over less risky ones when facing potential losses demonstrates loss aversion.
• The larger uncertain losses were chosen over smaller losses that are certain.

Isolation in Prospect Theory

• In prospect theory's editing phase, cancellation leads to the isolation effect, where investors focus on and base decisions on specific outcomes.
• Investors using cancellation eliminate and ignore possible outcomes common to choices.

Wealth Fungibility

• Considering wealth fungible means viewing it as interchangeable and creating a single portfolio to meet lifetime consumption needs, rather than dedicating it to specific goals in layered portfolios.

Traditional to Behavioral Finance Shift

• The focus shifts from statistical risk/return measures to lifestyle-based goals when transitioning from traditional to behavioral finance.
• Risk is redefined from dispersion-based measures to the probability of achieving stated goals.

Heuristics

• Using heuristics involves a trial-and-error-based investment style, learning from mistakes.

Pyramiding

• Pyramiding is creating portfolios by matching layers of assets to specific goals; layers are not evaluated within the portfolio context.

Anchoring and Adjustment Bias

• Anchoring and adjustment bias is a cognitive information processing bias.

Base Rate Neglect

• Base rate neglect involves failing to consider the underlying probability of a categorization when making judgments.
• Also, too little weight may be placed on the base rate; conservatism has similar effect.

Behavioral Finance Implications

• Behavioral finance implies investors are loss averse rather than simply risk averse, affecting their willingness to take risks.

Overconfidence Bias

• Overconfidence bias: the best course of action is not to increase the confidence interval of forecasts because this is not as effective at reducing overconfidence as keeping records of trades.
• Overconfident investors hold under-diversified portfolios and trade excessively.

Belief Persistence

• Cognitive errors stem from belief persistence; conservatism, representativeness, and hindsight biases lead to this.

"Representativeness Bias"

• "Representativeness bias" is a cognitive error where investors classify information based on "if-then" heuristics.
• The investor has a tendency to place information into categories.

Conservatism Bias

• Conservatism bias involves ignoring information conflicting with existing beliefs, such as avoiding contrary data.
• The opposite is ignoring and avoiding information that is contrary to beliefs.

Portfolio Pyramid

• Investors construct portfolios like pyramids: less risky assets on the bottom to fund necessities, more risky assets on top for higher goals.

Confirmation Bias-

• The confirmation biases results from the individuals only wanting to notice information that agrees with their perceptions or beliefs.
• The result is putting the recent market activity into the category of a market trend

Asset Allocation: Behavioral Biases

• Modern portfolio construction and risk measurement are NOT a result of incorporating behavioral biases into asset allocation.

Behavioral Finance Retirement Funding

• Behavioral finance predicts using a pyramid approach to fund retirement, with safe investments at the bottom.

Emotional Bias

• Emotional Biases: Status quo and endowment biases are examples of emotional biases.

Basis for Decision Making

• Loss aversion is the basis for decision making; someone is reluctant to accept a loss.

Availability Bias

• Availability bias is when individuals relies on readily recalled information when estimating probabilities.
• It is when new information is associated with an easily recalled past event.

The Availability and Representative Heuristics

• The Availability and Representative Heuristics: Assuming a stock will perform well in the future because good earnings report will result in an overpriced and underperforming stock.

Myopic Loss Aversion

• Myopic loss aversion: a way to address the affect is performing fundamental analysis on the investments to know not to hold onto losers too long and sell winners too soon.
• An explanation of myopic loss aversion includes investors focusing too much on the short term and seeing investments separately instead in portfolio context.

Implications of Loss Aversion

• In loss-averse investors, aversions to experiencing losses results in risk-seeking behavior

Cognitive Errors versus Emotional Bias

• Cognitive errors result from the inability to analyze all information while emotional biases is caused by feelings, impulses, or intuition.

Framing Behavioral Characteristics

• Framing is using information to make decisions; Roberts (example) is placing more weight on the financial publication because it specializes in investments.

Cognitive Errors from Biases

• Cognitive Errors from Biases: Conservatism, hindsight, and framing biases are the biases due to cognitive errors.

Investor Behavioral Bias

• Conservatism bias is when investors hold on to earlier beliefs and fail to fully incorporate new information about a stock into their forecast.