CFA L3 Behavioral Finance

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CFA L3 Behavioral Finance by Mind Map: CFA L3 Behavioral Finance

1. Cognitive Dissonance

2. Traditional Finance

2.1. Traditional Finance

2.1.1. Rational Economic Man

2.1.1.1. Exhibits

2.1.1.1.1. Perfect Rationality

2.1.1.1.2. Perfect Self-Interest

2.1.1.1.3. Perfect Information

2.1.1.2. Challenges to REM

2.1.1.2.1. Bounded Rationality

2.2. Theories

2.2.1. Decision Theory

2.2.2. Prospect Theory

2.2.2.1. A Client exhibiting prospect theory

2.2.2.1.1. overweighting the probability of a gain and under-weighting the probability of loss

2.2.2.2. Loss averse as opposed to risk averse.

2.2.2.3. Focuses on "changes" in wealth rather than "final" wealth.

2.2.2.4. Two phases to making a choice

2.2.2.4.1. 1) Editing/Framing phase

2.2.2.4.2. 2) Evaluation phase

2.2.2.5. Deal with establishing a REFERENCE POINT for making decisions regarding where values fall above or below that reference point.

2.2.3. Utility Theory

2.2.3.1. The 4 Axioms of Utility Theory (TICC)

2.2.3.1.1. Completeness

2.2.3.1.2. Independence

2.2.3.1.3. Contintuity

2.2.3.1.4. Transitivity

2.2.3.2. Bayes Formula

2.2.3.3. Wealth vs. Utility Graph

2.2.3.3.1. UTILITY Theory assumes an individual is RISK AVERSE and thus has a CONCAVE utility function

2.2.3.3.2. Challenges to Utility Theory. Double-Inflection Utility Function

2.2.3.4. Challenges to Utility Theory and the idea that individuals are risk averse.

2.2.3.4.1. Prospect Theory

2.2.3.5. The following statement is consistent with utility Theory

2.2.3.5.1. aka utitlity theory is based on the idea that consumers are able to exhibit SELF CONTROL and DEFER CONSUMPTION. He's also considering short term and long term goals to maximize utility

2.2.4. Bounded Rationality

2.2.4.1. satisfice rather than optimize.

2.2.4.2. Uses HEURISTICS rather than Bayes formula to make decisisions (prospect theory also uses heuristics)

2.2.4.2.1. Heurisitics is just a fancy way of saying "rule of thumb" or learn from experience.

2.2.4.3. An investor that goes with the first option presented to him that meets his criteria.

3. Normative vs. Descriptive

3.1. Normative

3.1.1. Utility Theory

3.1.2. Decision Theory

3.1.2.1. Prescriptive.

3.2. Descriptive

3.2.1. Prospect Theory

3.2.1.1. Prospect (alternatives)

3.2.1.2. When an individual is faced with a some choices to make there are two phases to making a choice

3.2.1.2.1. The FRAMING (editing) phase

3.2.1.2.2. "EVALUATION PHASE" Subsequent phase in which prospects are evaluated and chosen.

3.2.2. Bounded rationality

3.2.2.1. satisfice rather than optimize

3.2.2.2. "I'm content that the decision I am making is the best from what information I have collected and the time I have to collect it".

3.2.2.3. Bounded by mental ability to comprehend all things and thus not able to make "optimal" decisions.

4. Efficient Market Hypothesis

4.1. 3 forms of EMH

4.1.1. Strong Form

4.1.1.1. TA & FA & inside information cannot work.

4.1.2. Semi-Strong Form

4.1.2.1. Tech Analysis & Fund Analysis does not work.

4.1.3. Weak Form

4.1.3.1. Technical analysis does not work.

4.2. Challenges to the EMH

4.2.1. Fundamental Anomalies

4.2.2. Technical Anomalies

4.2.2.1. A client that believes technical anomalies exist in the Capital Markets

4.2.2.1.1. Based on the fact that he uses "buy & sell signals" when investing.

4.2.3. Calendar Anomalies

4.2.3.1. January Effect

5. Behavioral Finance

5.1. Alternative models of market behavior and Portfolio Construction

5.1.1. 4 Behavioral MODELS that BF's theorists have come up with to explain market behavior better.

5.1.1.1. Behavioral Approach to Consumption and Savings

5.1.1.2. Behavioral Approach to Asset Pricing

5.1.1.2.1. Believes that markets can be influenced by others emotions.

5.1.1.2.2. Focuses on Emotions driving markets.

5.1.1.2.3. Adds a sentiment premium to the CAPM.

5.1.1.3. Behavioral Portfolio Theory

5.1.1.3.1. Sounds similar to Goal based planning in that we are allocation money into layers/buckets based on "aspirational" level and "minimum" level she would be willing to let assets drop to.

5.1.1.3.2. Sell a stock when it has gone up to your "aspiration level" or sell a stock when it has dropped to your "lowest acceptable price" or declined x% from initial purchase price

5.1.1.4. Adaptive Market Hypothesis

5.1.1.4.1. 5 conclusions of AMH

6. What sounds a lot a like but is actually has subtle differences.

6.1. This statement sounds like a Behavioral Finance statement but is actually someone that subscribes to traditional finance. The freaking guy throws out a satsifactory standard deviation and expected return. Clearly emotions don't bother him. He is investing based on statistics.

6.1.1. This dude is also a utility theory believer

6.1.2. He also does not have any bias to hold any asset classes.

7. Classifying Investor Behavior Types

7.1. Barnewall Two-Way Model

7.1.1. Active Investor

7.1.1.1. Willing to take advice but ultimately wants to maintain control.

7.1.2. Passive Investor

7.2. Bailard, Beihl & Kaiser 5-Way Model

7.2.1. The Adventurer

7.2.2. Celebrity

7.2.2.1. Holds strong opinion yet willing to take advice because he understands his limitations

7.2.3. Individualist

7.2.4. Guardian

7.2.5. Straight Arrow

7.2.5.1. Unique to this reading vs. when BBK model gets mentioned in other readings in other books.

7.2.5.2. Falls in the middle of the investor types.

7.2.5.3. Not extreme with regard to confidence, anxious, careful, fast to act.

7.3. The Behavioral Alpha Process: A Top-Down Approach (Pompian's Model)

7.3.1. Built his model off of Barne-wall 2 way model which looks at two types of investors and takes a top down approach from there.

7.3.1.1. Active

7.3.1.1.1. Then based on Risk Tolerance

7.3.1.2. Passive

7.3.1.2.1. Then based on Risk Tolerance

7.3.2. Test for Behavioral Biases to determine the BIT (behavioral investor type)

7.3.2.1. The two BIT's on the far left and far right side exhibit emotional biases

7.3.2.2. The two BIT's in the middle FF & II's exhibit cognitive biases.

7.4. Limitations of Categorizing Investors into BIT's.

7.4.1. Investors may exhibit BOTH emotional and cognitive biases

7.4.2. Investors may exhibit characteristics of multiple investor types

7.4.3. Individuals will likely go through behavioral changes as they age.

7.4.4. Human behavior is sooo complex that individuals are likely to need unique treatment (vs. the generic treatment that you would get by fallling into one of the BIT's)

7.4.5. Investors act irrational at different times and without predictability

8. How Behavioral Finance Influences Market Behavior

8.1. Momentum

8.1.1. Herding

8.1.2. Regret

8.1.2.1. an expression of HINDSIGHT BIAS

8.1.2.2. Regret leads to another type of bias called TREND CHASING-EFFECT

8.1.2.2.1. TREND CHASING EFFECT

8.1.3. Gamblers Fallacy

8.1.4. Disposition Effect

8.1.5. Anchoring

8.1.6. Recency Effect (aka availability bias)

8.1.6.1. Causes investors to place too much emphasis on samples that are small or that provide an imperfect picture.

8.2. Value and Growth

8.2.1. Halo Effect

8.2.2. Home Bias

9. How Behavioral Factors affect Portfolio Construction

9.1. Inertia and Default

9.1.1. Consistent with status quo bias.

9.2. Naive Diversification

9.3. Company Stock: Investing in the familiar

9.3.1. Reasons employees invest in the company stock include

9.3.1.1. Familairity & Overconfidence

9.3.1.2. Naive Extrapolation of past returns

9.3.1.3. Framing and Status quo effect of matching contributions

9.3.1.4. Loyalty Effect

9.3.1.5. Financial Incentives

9.4. Home Bias

9.5. Excessive Trading

9.6. Behavioral Portfolio Theory

9.6.1. Structures of Mean-Variance and Behavioral Portfolios.

9.6.1.1. MEAN VARIANCE PORTFOLIOS

9.6.1.1.1. Covariance between assets is crucial

9.6.1.2. BEHAVIORAL PORTFOLIOS

9.6.1.2.1. Covariance between securities is ignored. (not considered important)

9.6.2. BB 3 Pg 39 Construct the BPT optimal portfolio for each investor

9.6.2.1. Solution Refer to Blue index card)

10. How Behavioral Factors influence committee decision making

10.1. Social Proof

10.1.1. Resolving

10.1.1.1. EOC answer

11. The Behavioral Biases of Invidividuals

11.1. Cognitive and Emotional Biases

11.1.1. Cognitive Error

11.1.1.1. Belief Perseverence

11.1.1.1.1. CCRIH

11.1.1.2. Information Processing

11.1.1.2.1. FAMA

11.1.2. Emotional Biases

11.1.2.1. LOSERS

11.1.2.1.1. Loss Aversion

11.1.2.1.2. Overconfidence

11.1.2.1.3. Self-Control

11.1.2.1.4. Endowment effect

11.1.2.1.5. Regret Aversion

11.1.2.1.6. Status Quo Bias

11.1.2.2. Advising clients with Emotional Biases

11.1.3. Psychological Traps made by ANALYSTS when making forecasts. (This is actually covered in Capital Market Expectations Reading. (O-CRAPS)

11.1.3.1. Anchoring Trap

11.1.3.2. Status Quo Trap

11.1.3.3. Comfirming Evidence Trap

11.1.3.4. Overconfidence Trap

11.1.3.5. Prudence Trap

11.1.3.5.1. Analyst tries to temper forecast and think they are being "prudent" by tempering forecast so that they do not appear extreme.

11.1.3.5.2. They feel it is more prudent to be close to other analyst forecasts vs. being bold.

11.1.3.6. Recallability Trap

11.1.3.6.1. Forecasts being made by an analyst are overly influenced by events that have left a strong impression on that analysts memory. Maybe they experienced a traumatic event or previous forecast that went 100% in the opposite direction.

11.2. Investment Policy & Asset Allocation

11.2.1. Behaviorally Modified Asset Allocation

11.2.1.1. A behaviorally modified portfolio

11.2.1.1.1. Determine which type of biases dominate (Emotional or Cognitive)

11.2.1.1.2. The LEVEL OF WEALTH of the investor is also very important when constructing a Behaviorally Modified Portfolio.

11.2.1.1.3. "Moderate & Adapt" for clients that have either a high level of wealth but show cognitive biases OR clients that have a LOW level of wealth and show emotional biases.

11.2.1.2. How much to Moderate or Adapt

11.2.1.2.1. Depends on their Standard of Living Risk.

12. Key Takeaways

12.1. Investors that exhibit Cognitive Biases are more likely to follow a Mean Variance approach to investing since they are more likely and willing to be taught correct principles and thus the bias can be moderated to.

12.2. When a question gives several clients with differing biases. Look at each ones biases and see if there is a dominating biases (aka more cognitive or more emotional biases)