Behavioral_finance_and_capital_market_expectations

Behavioral finance perspective

• traditional finance: normative

• behavioral finance: descriptive, prescriptive(预测性)

  understand and explain observed investor and market behaviors

  • cognitive errors

  • emotional biases

Traditional finance perspectives on individaul behavior

Utility theory and Bayes' Formula

rational investors make decisions consistent with utility theory.

Utility theory: maximize the present value of utility subject to a present value budget constraint.

• completeness(完整性): A>B, A<B, A=B

• transitivity: A=B, B=C -> A=C or A>B, B>C -> A>C

• independence: if A > B, then A + xC > B + xC

• continuity: if A > B > C, exists B = m A + n C

Bayes' formula: P(A|B) = [P(B|A)P(A)] / P(B)

Certainty equivalent: the maximum sum of money a person would pay to participate or the minimum sum of money a person would accept to not participate in an opportunity

challenges to traditional finance and the REM

• bounded rationality

• people have difficulty prioritizing short-term spending goals over long-term (spending versus saving) goals and do not behave with perfect self-interest

• absnece of perfect information

• wealth utility functions

• double inflection utility function: a utility function that changes based on levels of wealth

Decision making

Decision theory

expected value

Bounded rationality

Bounded rationality assumes knowledge capacity limits and removes the assumptions of perfect information, fully rational decision making, and consistent utility maximization.

It describes the phenomenon whereby people gather some (but not all) available information.

Prospect theory

The value function is defined by deviations from a reference point and is normally concave for gains (implying risk aversion), convex for losses (risk-seeking), and steeper for losses than for gains (loss aversion).

steeper for losses than for gains

Prospect theory further relaxes the assumption of risk aversion and instead proposes loss aversion.

Most people reject a gmable with even chances to win and lose, unless the possible win is at least twice the size of the possible losses.

People are risk-seeking when there is a low probability of gains or a high probability of losses.

deviations in decision making from the rational decisions of traditional finance result from overweighting low probability outcomes, underweighting moderate and high probability outcomes, and hvaing a value funciton for changes in wealth that is in general concave for gains convex for losses, and steeper for losses than for gains.

1. Editing process

   1. Codification: gain or loss respect to some reference point (gain/loss, probability; ...)

   2. Combination: simplified by combing the probabilities associated with identical gains or losses, i.e., (250, 0.2; 200, 0.25; 200, 0.15; 150, 0.4) -> (250, 0.2; 200, 0.4; 150, 0.4)

   3. Segregation: separate the riskless component from its risky component, i.e., (300, 0.8; 200, 0.2) -> (200, 1.0) + (100, 0.8; 0, 0.2)

   4. Cancellation: discarding common outcome probability pairs between choices

   5. Simplification

   6. Detection of dominance

2. Evaluation phase $U = \sum_i w(p_i)v(x_i)$

   where: w is a probabilitu-weighting function

Traditional finance perspective

• week-form efficient: current prices incorporate all past price and volume data. If markets are weakly efficient, managers cannot consistently generate excess returns using technical analysis.

• semi-strong form: prices reflect all public information. If markets are semi-strong efficient, managers cannot consistently generate excess returns using technical or fundamental analysis.

• strong-form efficiency: price reflects all privileged nonpublic information. No analysis based on inside and/or public information can consistently generate excess returns.

market anomalies

• fundamental anomalies

  to semi-strong and strong-form efficiency

  • size effect: small sized firms tend to outperform large-sized firms (错误定价)

  • value effect: value stocks outperform growth stocks

• technical anomalies

  to all three forms of efficiency

  • moving average

  • trading range break

• calendar anomalies

  to all forms of EMH

  • January effect

Consumption and savings

• framing: 框架依赖

• self-control

• mental accounting

Behavioral asset pricing

discount rate = risk-free rate + fundamental risk premium + sentiment premium

Behavioral portfolio theory (BPT)

In BPT, investors construct their portfolios in layers and expectations of returns and attitudes toward risk vary between the layers.

• importance assigned to each goal

• allocation of funds within a layer

• number of assets chosen for a lyer

Adaptive markets hypothesis (AMH)

AMH: A hypothesis that applies principles of evolution - such as competition, adaption, and natural selection - to financial markets in an attempt to reconcile efficient markt theories with behavioral alternatives.

Success is defined as survival rather than as having maximized expected utility.

It assumes successful market participants apply heuristics until they no longer work and then adjust them accordingly.

Points between traditional and behavioral

• Traditional finance assumes that investors are rational: Investors are risk-averse,self-interested utility-maximizers who process available information in an unbiased way.

• Traditional finance assumes that investors construct and hold optimal porfolios; optimal portolios are mean-variance efficient.

• Traditioanl finance hypothesizes that markets are efficient: Market prices incorporate and reflect all available and relevant information.

• Behavioral finance makes different (non-normative) assumptions about investor and market behavior.

• Behavioral finance attempts to understand and explain observed investor and market behaviors; observed behaviors often differ from the idealized behaviors assumed under traditional finance.

• Behavioral biases are observed to affect the financial decisions of individuals;

• Bounded rationality is proposed as an alternative to assuming perfect information and perfect rationality on the part of individuals: Individuals are acknowledged to have informational, intellectual, and computational limitations and as a result may satisfice rather than optimize when making decisions.

• prospect theory is proposed as an alternative to expected utility theory. Within propect theory, loss aversion is proposed as an alternative to risk aversion.

• Markets are not always observed to be efficient; anomalous markets are observed.

• Theories and models based on behavioral perspectives have been advanced to explain observed market behavior and portfolio construction.

• One behavioral approach to asset pricing suggests that the discout rate used to value an asset should include a sentiment risk premium.

• Behavioral portfolio theory suggests that portfolios are constructed in layers to satisfy investor goals rather than to be mean-variance efficient.

• The behavioral life-cycle hypothesis suggests that people classify their assets into non-fungible mental accounts and develop spending (current consumption) and savings (future consumption) plans that, althought not optimal, achieve some balance between short-term gratification and long-term goals.

• The adaptive markets hypothesis, based on some principles of evolutionary biology, suggests that the degree of market efficiency is related to environemmntal factors characterizing market available, and the adaptability of the market pariticipants.

• By understanding investor behavior, it may be possible to construct investment solutions that will be closer to the rational solution of traditional finance and, because of adjustments reflecting behavioral insights, easier to accept and remain committed to.

satisfice: suboptimal, but adequate

Traditional Finance assumption	Behavioral finance assumption
perfect information	capacity limitations on knowledge
utility maximization	satisfice
fully rational decision making	bounded rationality.
risk aversion	loss averse

Types	Assumption	Implication
weak-form EMH	market info	technical analysis 无效
semi strong-form EMH	public info	fundamental analysis 无效
strong-form EMH	all info	nobody can win the market

Begavioral Biases of individuals

BFMI: Behavioral Finance Micro, a focus on individual level behavior that examines the behavioral biases that distinguish individual investors from the rational decision makers of traditional finance.

BFMA: Behavioral Finance Macro, a focus on market level behavior that considers market anomalies that distinguish markets from the efficient markets of traditional finance.

Cognitive errors: behavioral biases resulting from faulty reasoning; cognitive errors stem from basic statistical, information processing, or memory errors.

Emotional biases: behavioral biases resulting from reasoning influenced by feeling; emotional biases stem from impulse or intuition.

• Cognitive erros

  • belief perseverance biases (固执己见)

    • conservatism bias: maintain their prior views or forecasts by inadequately incorporating new information. 1. maintain or slow to update a view or a forecast even when presented with new information 2. opt to maintain a prior belief rather than deal with the mental stree of updating beliefs given complex data.

      properly analyzing and weighting new information

    • confirmation bias: tend to look for the notice what confirms their beliefs, and to ignore or undervalue what contradicts their beliefs. 1. consider only the positive information about an existing investment and ignore any negative information. 2. develop screening criteria 3. under-diversify portfolios, leading to excessive exposure to risk 4. hold a disproportionate amount of their investment assets in their employing company's stock

      actively seeking out information that challenge your beliefs.

    • representativeness bias: a belief preseverance bias in which people tend to classify new information based on past experiences and classification.

      • base-rate neglect: a type of representativeness bias in which the base rate or probability of the categorization is not adequately considered.

      • sample-size neglect: small sample sizes are representative of populations

      • adopt a view based almost exclusively on new information or a small sample.

      • update beliefs using simple classifications

      ask questions yourselves

    • illusion of control bias: tend to believe that they can control or influence outcomes when, in fact, they cannot. 1. excessive trading 2. inadequately diversify portfolios

      first to know that successful investing is a probabilistic activity

      seek contrary viewpoints

      keep records

    • hindsight bias: a bias with selective perception and retention aspects. 1. overestimate the degree to which they predicted an investment outcome, thus giving them a false sense of confidence. 2. unfairly assess money manager or security performance

      ask questions, record and examine their investment decsions

  • information processing biases

    • anchoring and adjustment bias: the use of a psychological heuristic influences the way people estimate probabilties 1. stick too closely to their original estimates

      ask questions

    • mental accounting bias: treat one sum of money differently from another equal-sized sum based on which mental account the money is assigned to. 1. neglect opportunities to reduce risk by combining assets with low correlations. 2. irrationally distinguish between returns derived from income and those derived from capital appreciation

      recognize the drawbacks of engaging in this behavior

      focus on total return

    • framing bias: in which a person answers a question differently based on the way in which it is asked (framed). 1. misidentify risk tolerances by how risk tolerance were framed 2. choose suboptimal investments 3. focus on short-term price fluctuations, which may result in excessive trading

      ask questions

    • availability bias: people take a heuristic appraoch to estimating the probability of an outcome based on how easily the outcome comes to mind.

      • retrievability

      • categorizaiton

      • narrow range of experience

      • resonance

      • choose investment based on advertising rather than a thorough analysiss

      • limit their invesmten opportunity set

      • fail to diversify

      • fail to achieve an appropriate asset allocation

      develop an appropriate investment policy strategy, carefully research and analyze investment decsions before making them, and focus on long-term results.

      ask questions

• Emotional biases

  • loss-aversion bias: tend to strongly prefer avoiding losses as opposed to achieving gains 1. hold longer in loss position 2. sell investments in a gain position earlier 3. limit the upside potential of a portfolio bu selling winners and holding losers 4. trade excessively 5. hold riskier portfolios

    investment based on fundamental analysis

  • overconfidence bias

    • illusion of knowledge

      • prediction overconfidence

      • certainty overconfidence

    • self-attribution(自我归因)

      • self-enhancing

      • self-protecting

    • underestimate risks and oversetimate expected returns

    • hold poorly diversified portfolios

    • trade excessively

    • experience lower returns than those of the market

    review trading records

  • self-control bias: fail to act in pursuit of their long-term, overarching goals because of a lack of self-discipline. 1. save insufficiently for the future 2. accept too much risk in their portfolios in an attempt to generate higher returns. 3. cause asset allocation imbalance problems.

    have a proper investment plan and a personal budget

  • Status Quo bias(懒得动) 1. unknowingly maintain portfolios with risk characteristics that are inappropriate for their circumstances 2. fail to explore other opportunities

    education is essential

  • endowment bias: people value an asset more when they hold rights to it than when they do not. 1. fail to sell off certain assets and replace them with other assets 2. maintain an inappropriate asset allocation 3. continue to hold classes of assets with which they are familiar

    ask quesiton

  • regret-aversion bias: people tend to avoid making decisions that will result in action out of fear that the decision will turn out poorly. 1. too conervative 2. engage in herding behavior

    education is essential; quantify the risk-reducing and return-enhancing advantages of diversification and proper asset allocation

investment policy and asset allocation

SLR: Standard of living risk, the risk that the current or a specified acceptable lifestyle may not be sustainable

how much to moderate or adapt

--	Cognitive error	emotional bias
High wealth / Low SLR	modest asset allocation change suggestion: +/- 5 to 10% Max per asset class	stronger, +/- 10 to 15%
Low wealth / High SLR	close to the rational asset allocation suggestion: +/- 0 to 3%	modest, +/- 5 to 10%

classifying investors into types

• Barnewall two-way model

  • passive investors: 打工

  • active investors: 企业家

• BBK five-way model

  • adventurer (confident + impetuous):

    • hold highly undiversified portfolio

    • willing to take chances

    • make own decisions and reluctant to take advice

    • a challenge for an investment adviser

  • celebrity (anxious + impetuous):

    • like to be center of attention

    • may hold opinions about some things

    • may be willings to seek and take advice about investing

  • guardian (anxious + careful):

    • cautious and concerned about the future

    • may seek advice from those they perceive as being more knowledgeable than themselves

  • individual (confident + careful):

    • independent and confident

    • make own decisions but only after careful analysis

    • pleasant to advise

  • straight arrow (-)

• Pompian

  risk tolerance	low	medium low	medium high	high
  Investment style	conservative	moderate	growth	aggressive
  bias types	emotinal	cognitive	cognitive	emotional
  BITs	Passive Preserver (PP)	Friendly Follower (FF)	Independent Individualist (II)	Active Accumulator (AA)

  • PP

    • passive; low risk, emotional; a great deal on financial security; focus on family and security; more receptive to "big picture"

  • FF

    • passive; low to medium risk tolerance, cognitive; follow leads from others; be in the latest investment without regard to current market conditions; overestimate their risk tolerance; comply with proffesional advice when getting it; regret aversion

  • II

    • active; medium to high risk tolerance, cognitive; self-assured when making decisions while susceptible to acting on informaiton available; sometime make an investment without consulting anyone; maintain the opinion even when market conditions change; most likely to be contrarian

  • AA

    • active; high risk tolerance,emotional bias; most aggressive; entrepreneurial and first generation to create wealth; overconfidence; high turnover rate; heavily involved in decision making process

limitations

1. individuals may exhibit both cognitive errors and emtional bias

2. individuals may exhibit characteristics of multiplt investor types

3. individuals will likely go through behavioral changes as they age

4. individuals are likely to require unique treatment even if they are classified as the same investor type because human behavior is so complex

5. individuals act irrationally at different times and without preidictability.

client - adviser relations

1. understands the clients' goal

2. maintains a systematic approach

3. invest as the client expects

4. the relationship benefits both client and adviser

how behavioral factors affect portfolio construction

defined contribution (DC) plan

• inertia and default

  • consistent with status quo

  • target date fund: 定期变动fund

• naive diversification: 1/n strategy, of framing bias

• investing in the familiar: company stock

  • familarity and overconfidence

  • naive extrapolation of past returns: representativeness bias

  • framing and status quo

  • loyalty effects

  • financial incentives

• excessive trading:

  • overconfidence

  • disposition effect: sell winner and hold on to loser

• home bias: 只买自己国家的

  • availability bias

• BPT

behavioral finance and analyst forecasts

• overconfidence in forecasting

  • illusion of knowledge: poor job of estimating probabilities but believe they do it well

  • self-attribution

  • illusion of control

  • representativeness

  • availability

  • hindsight bias

• influence of company's managemment on analysis

  • framing

  • anchoring and adjustment

  • availability

• analyst biases in conducting research

  • confirmation bias

  • gamblers' fallacy

  • representativeness

how behavioral factors affect committee decision making

• social proof: a bias in which individuals are biased to fllow the beliefs of a group

how behavioral factors influences market behavior

• anomalies

• momentum or trending effect

  • herding

  • regret: trending-chasing effect

• bubbles and crash: deviate from the mean value by over 2 sigma

  • overconfidence

  • confirmation bias, self-attribution bias

  • illusion of knowledge

  • disposition effect

  • hindsight bias

• value and growth

  • halo effect(光环效应): an emotional bias that extends a favorable evaluation of some characteriscs to other characteristics

  • home bias: a preference for securities listed on the exchanges of one's home country.

九大challenge

1. Economic data

   1. time lag

   2. revised

   3. rebased

2. measurement bias

   1. transcription error

   2. survival bias: Expected return 高估

   3. appraisal data: 标准差和cov低估

3. historical data

   1. nostationary: regime change

   2. prefer long term period:

      1. statistical requirement

      2. longer, more accurate

      3. asynchronous

4. expost -> ex ante bias

   1. 收益高估，风险低估

   2. rare negative events 低估

5. analyst's method

   1. data mining: 巧合当规律

   2. time period: 短期当长期规律

analysis of economic growth

• 原因：exogenous shocks:

  • unanticipated

  • 6各因素：科技、金融危机、政治、自然

• GDP分解

  • labor input:

    • growth of labor

    • participation

  • productivity

    • capital

    • technology

  • inlfation

Equity return = $\Delta$GDP% + $\Delta$S% + $\Delta$P/E% + Dividend yield

• Approaches

  • economic method: structured model / reduced model

  • economic indicator: leading, 同步, trailing

  • checklist

The monetary and fiscal policy mix

normal rate = real rate + expected inflation

• Fiscal policy:

  • loose: high real rates

  • tight: low real rates

• Monetary policy:

  • loose: high expected inflation

  • tight: low expected inflation

The yield curve

• Fiscal policy:

  • loose: 长期利率稍稍提高

  • tight: 长期利率稍稍降低

• Monetary policy:

  • loose: 短期利率显著降低

  • tight: 短期利率显著提高

• if both policy stimulative, the yield curve is steep and the economy is likely to grow

• if both policy restrictive, the yield curve is inverted and the economy is likely to contract

• if monetary is restrictive and fiscal is stimulative, the yield curve is flat and the economy is less clear

• if monetary is stimulative and fiscal is restrictive, the yield curve is less steep and the economy is less clear