Finele Module 1 & 2 PDF

**Finele Module 1** **BEHAVIORAL FINANCE**   - is an interdisciplinary research area that combines insights from psychology with finance to better understand investors' behavior and asset prices. It has managed to bridge the gap between theory and practice. - Traditional finance...

**Finele Module 1** **BEHAVIORAL FINANCE**   - is an interdisciplinary research area that combines insights from psychology with finance to better understand investors' behavior and asset prices. It has managed to bridge the gap between theory and practice. - Traditional finance (a) has focused on the ideal scenario of thoroughly rational investors in efficient markets. ( b)  individuals rationally search for information and (c ) know all available actions that serve their preferences (d) stable over time and robust to the occurrence of unanticipated events. As a result, rational investors searching for superior returns detect and eliminate any predictability in the asset prices---the market is efficient. ( e ) the market remains efficient even if some investors behave irrationally. Indeed, rational investors will detect any mispricing generated by irrational investors and exploit it with the use of arbitrage strategies, which are assumed to be unlimited. - **B**ehavioral finance is nothing more than a collection of stories about people like that man---irrational people lured by cognitive and emotional errors into foolish behavior, buying fancier houses than they can afford, with larger mortgages than they can bear. - Behavioral finance lacks the unified structure of standard finance. We are asked, What is your theory of portfolio construction? Where is your asset pricing theory? Yet today's standard finance is no longer unified because wide cracks have opened between the theory that it embraces and the evidence. 1. People are normal. 2. People construct portfolios as described by behavioral portfolio theory, where people's portfolio wants to extend beyond high expected returns and low risks, such as wants for social responsibility and social status. 3. People save and spend as described by behavioral life-cycle theory, where impediments, such as weak self-control, make it difficult to save and spend in the right way. 4. Expected returns of investments are accounted for by behavioral asset pricing theory, where differences in expected returns are determined by more than just differences in risk---for example, by levels of social responsibility and social status. 5.  Markets are not efficient in the sense that price always equals the value in them, but they are efficient in the sense that they are hard to beat. **Finele Module 2** In Module 2.1  you are tasked to understand and learn from the discussion on Shortcuts and Errors committed by investors so as to avoid them in the future focusing on Cognitive shortcuts and errors committed by the investors. **COGNITIVE SHORT CUTS AND ERRORS** 1. **FRAMING** Framing is a cognitive shortcut, such as framing money into one or two actual checking accounts or into one or two mental accounts we keep in our minds. Each shortcut involves considerations of utilitarian, expressive,\ and emotional benefits and costs. We use framing shortcuts when we simplify complex problems and substitute solutions to the simplified problems for solutions to the complex problems.\ We use framing shortcuts well when the solutions to the simplified problems are close to the solutions to the complex problems. We commit cognitive errors when the solutions to the simplified problems are far from the solutions to the complex problems.  2. **CONFIRMATION** We use confirmation shortcuts when we examine evidence to confirm or disconfirm beliefs, claims, or hypotheses.\ We use confirmation shortcuts well when we search for disconfirming evidence as vigorously as we search for confirming evidence and assign equal weight to disconfirming and confirming evidence. We commit confirmation errors when we search for confirming evidence while neglecting disconfirming evidence and when we assign less weight to disconfirming evidence than to confirming evidence.  3. **HINDSIGHT** Hindsight shortcuts are always precise when there are one-to-one associations between past events and future events, actions and outcomes, and causes and consequences. Hindsight shortcuts can easily turn into hindsight errors where randomness and luck are prominent, loosening associations between past events and future events, actions and outcomes, and causes and consequences. Hindsight errors might arise from unawareness of the influence of randomness and luck or from a desire to see the world as predictable, devoid of randomness or luck.  4. **ANCHORING AND ADJUSTMENT** We use anchoring and adjustment shortcuts well when we begin with proper anchors and adjust from them properly.\ We begin the process of estimating the appropriate price-to-earnings ratio (P/E) of a privately held company by identifying an anchor, such as the average P/E of public companies in the same industry.\ We adjust our P/E estimate upward to reflect the private company's better growth opportunities and downward to reflect the status of this company as a private, rather than public, company.\ We commit anchoring and adjustment errors when we begin with faulty anchors and adjust from them improperly. The average P/E of public companies in the same industry might be a faulty anchor, for example, if P/Es in this industry are inflated in a bubble.  5. **REPRESENTATIVENESS** We use representativeness shortcuts when we assess the likelihood of events by their similarity to or representativeness of other events.\ We use representativeness shortcuts well when we consider both representativeness information and base-rate information.\ We commit representativeness errors when we assign too much weight to representativeness information\ and too little to base-rate information.  6. **AVAILABILITY** We use availability shortcuts when we assess the probability of events by information that is readily available in our minds.\ We use availability shortcuts skillfully when all the information is available in our minds or when we are aware that not all the information is available in our minds.\ We commit availability errors when not all the information is available in our minds but we are not aware of its absence. 7. **CONFIDENCE** Confidence shortcuts and overconfidence errors are of three types, classified by psychologists Don Moore and Paul Healy: estimation, placement, and precision.\ We use confidence shortcuts well in estimation, placement, and precision when we assess them objectively and place the objectively appropriate amount of confidence in them.\ We commit overconfidence errors when we place too much confidence in them, and we commit under confidence errors when we place too little confidence in them.\ Overestimation, overplacement, and overprecision are not different manifestations\ of one underlying type of overconfidence. Instead, they are conceptually and\ empirically distinct.  Mod 2.3 PPT **Finele Mod 3**\ **3.1 Behavioral Portfolio and Risk concepts** Individual willingness to take risks is decisive for financial investments. Financial assets are characterized by a variety of expected revenues along with different risks.\ Portfolio theory predicts that investors who are less risk averse will have higher shares of risky assets, such as stocks, in their portfolios.\ As such, understanding Human behavior in financial or any management endeavors is influenced by risk perception, risk attitude, risk communication, and risk management facets.\ What is the relevance of these socio-psychological processes? **BEHAVIORAL PORTFOLIO AND RISK CONCEPTS** Behavioral portfolios are about life, beyond money.\ They are about wants beyond portfolio returns.\ They are about expressive and emotional benefits, beyond utilitarian benefits.\ And they are about risk as falling short of wants **Risk perception** refers to people\'s judgments and evaluations of hazards they (or their facilities, or environments) are or might be exposed to.\ Such perceptions steer decisions about the acceptability of risks and are a core influence on behaviors before,during and after a disaster.\ People\'s risk appraisals are a complex result of hazard features and personal philosophy. **Risk attitudes** are people\'s intentions to evaluate a risk situation in a favorable or unfavorable way and to act accordingly.\ The underlying traits are risk propensity and risk aversion, i.e. cautiousness. High risk propensity can induce hazards; on the other hand, risk management activities may require some risk propensity.\ However, risk attitudes are neither necessarily stable, nor homogeneous across hazard types.  **Risk communication **is a social process by which people become informed about hazards, are influenced towards behavioral change and can participate in decision making about risk issues in an informed manner.Such activities are part of almost all emergency management efforts.\ For effective risk communication, a sound understanding of risk perceptions and attitudes is indispensable.  **Risk management **are manifold procedures for reducing risks (either the hazard itself or its consequences) to a level deemed tolerable by society; this includes monitoring, control and public communication.\ For people exposed to a hazard (residents, employees, commuters, consumers). **SUMMARY:**\ For behavioral finance, various risk concepts is attributed to the many possible outcomes of an investment decision whereby the risk perception, risk attitude, risk communication and risk management of certain investment vehicle versus the other can be measured depending on how the rational investor deal with it and it varies from one investor to the other. Hence, risk can be measured in terms of low, moderate, High or very high. **Topic 2** **Behavioral Portfolio, Mean Variance Portfolio, Goal Based Portfolio** The mean--variance portfolio theory offered by Markowitz in 1952 prescribes portfolios on mean--variance-efficient frontiers to investors with wants that do not extend past the utilitarian benefits of high expected returns and low risk---where risk is measured by portfolio return variances. In contrast, behavioral portfolio theory describes portfolios on behavioral wants frontiers and prescribes portfolios to investors with wants that extend past the utilitarian benefits of high expected portfolio returns and low risk, as measured by portfolio return variance. Such wants include the expressive and emotional benefits of poverty avoidance, attaining wealth, nurturing children and families, being true to one's values, and reaching high social status. Behavioral-wants frontiers are free of ignorance and cognitive and emotional errors. Behavioral portfolio theory also describes portfolios on behavioral-errors frontiers, guiding investors away from behavioral errors by replacing ignorance with knowledge and distinguishing wants from errors. Beginning in 1959, Markowitz revised his initial 1952 mean--variance portfolio theory by sketching "game-of-life" portfolios. This sketch brings mean--variance portfolio theory closer to behavioral portfolio theory. He wrote that "the simulated family's enjoyment for the period would depend on the size of the family, whether it lives in a large house or small apartment, whether it now has to move because someone has a new job elsewhere, etc. The approach required here is both 'behavioral' and 'rational.' It should be behavioral in that it reflects plausible human choices. **Behavioral Portfolios as Goal-Based Portfolios** Investor wants can be described as investor goals, and behavioral portfolios can be described as goal-based portfolios. Behavioral portfolios resemble layered pyramids, where each layer is dedicated to satisfying a want, often specified as a goal. Goals are more specific than wants, as many investors have wants with no specific goals. Investors may have wants for riches, but they do not necessarily have specific dollar amounts of riches as goals. The story of Mavis Wanczyk, the 53-year-old winner of a \$758 million Powerball jackpot in 2017, illustrates a two-layer goal-based pyramid portfolio. Wanczyk's protection-from-poverty goal was a pension from Mercy Medical Center, where she had worked as a nurse for 32 years. Reaching that goal would have required 12 more years of work. Wanczyk's prospects-forriches goal was to retire early from her work, and her means to that goal were lottery tickets she bought regularly. "I had a pipe dream," she said, "and my pipe dream finally came true." Wanczyk chuckled as she described calling Mercy Medical Center to say that she would not be coming back to work. **Topic 3** **Nine Features of Behavioral Portfolio** In discussing the 9 features of behavioral finance, let us look that story as stated below:\ In late 2018, Colin O'Brady, a 33-year-old American, and Louis Rudd, a 49-year-old Englishman, competed with each other to become the first person ever to ski alone across Antarctica with no support from anyone. Previously, only two men had ever tried it: One gave up after 52 days, and the other died. The stories of O'Brady, Rudd, and those who preceded them illustrate nine features of behavioral portfolios.  **First, behavioral portfolios** are about life, including stocks, bonds, real estate, and commodities, but going much beyond them. O'Brady's and Rudd's behavioral portfolios are about their lives. **Second, behavioral portfolios** are built on a foundation of wants. Wants for respect and high social status are prominent among the wants of O'Brady and Rudd. O'Brady's and Rudd's choices may well place them below the mean--variance-efficient frontier, bearing high risk for low financial returns, but these choices may well place them on the behavioral-wants frontier. **Third, satisfying wants in behavioral portfolios **is about gaining utilitarian, expressive, and emotional benefits and avoiding their costs. The utilitarian benefits O'Brady and Rudd will derive by being first include income from advertising deals and speaking engagements, the expressive benefits include reputations as pioneers, and the emotional benefits include pride. **Fourth, circumstances matter in behavioral portfolios**. Circumstances relevant to O'Brady and Rudd include access to resources in money, knowledge, time, and physical fitness, necessary for the quest to satisfy wants. Circumstances also include culture, such as one where being first to ski across Antarctica solo with no support is valued as an accomplishment, rather than denigrated as foolishness greater than eating the most hot dogs in 12 minutes. **Fifth, behavioral portfolios** account for ignorance and cognitive and emotional errors on the way to satisfying wants. The ignorance and cognitive and emotional errors of O'Brady and Rudd include possibly erroneous extrapolation from past experiences to future successes. Rudd's experiences include skiing more than 2,500 Antarctic miles, and O'Brady's experiences include a speed record for scaling the highest points in all 50 states. Cognitive and emotional errors also include misperception of benefits and costs, perhaps caused by the desire to satisfy wants. O'Brady and Rudd might overestimate the likely utilitarian, expressive, and emotional benefits of their venture and underestimate their costs. **Sixth, risk in behavioral portfolios** is the probability of falling short of satisfying wants, not variance of portfolio returns. The risk facing O'Brady and Rudd is the probability of falling short of their want to be the first person to ski across Antarctica solo without any support. **Seventh, satisfying wants is the destination in behavioral portfolios**, and risk is fuel for the vehicles we drive there. The vehicle for satisfying O'Brady's and Rudd's wants includes the right knowledge, equipment, and supply of food and other provisions, and its fuel includes high risk tolerance. **Eighth, behavioral portfolios** resemble layered pyramids, where each layer is a mental account dedicated to satisfying a want. In a simple two-layer pyramid, the mental account in the bottom layer is the protection-from-poverty layer, whereas the top layer is the prospects-for-riches layer. The protection-from-poverty layer of Rudd, at age 49, is probably composed of a military pension, such assets as a house and personal savings, and a good amount of human capital, perhaps as a guide in expeditions. The protection-from-poverty layer of O'Brady, at age 33, does not include a pension but includes even more human capital. The prospects-for-riches layers of both men include prospects for riches from advertising deals and speaking engagements that would accrue to the first person to ski across Antarctica solo with no support. **Ninth, investors rebalance behavioral portfolios** when current portfolios are no longer best at satisfying wants, not when current portfolios depart from fixed proportions, such as 60% stocks and 40% bonds. The central features of behavioral portfolio theory, reflected in portfolio construction, include investors' wants, portfolios as pyramids of wants, risk as shortfalls relative to wants, and avoidance of cognitive and emotional errors in pursuit of satisfying wants. Good portfolio construction practices also include features shared bystandard and behavioral portfolio theory---for example, diversification, low costs, and simplicity.