CFA Level 3: Behavioral Finance (Part 2)

Behavioral Finance (cont.)

Utility Theory

• Used to derive the efficient frontier and the CML/SML
• Investors assumed rational and select portfolio lying on indifference curve representing most utility.
• Utility function is concave for risk-averse investors showing a diminishing marginal utility
• Utility function is convex for risk-seeking individual showing an increasing marginal utility
• Risk-neutral investor experiences constant marginal utility, acts as if unaware of risk (considers only returns)

Utility Curves

• Measures investors' utility derived from changes in wealth
• Attempts to marginal utility gained (lost)

Prospect Theory

• Assumes investors analyze risk in terms of gains and losses:
  • More concerned with the change in wealth than they are in the level of wealth
  • Tend to place a greater value on a loss than on a gain of the same amount
• Investors make decisions in two phases: 1.) the editing phase and 2.) the evaluation phase
  1. Editing (6 steps)
     • Codification: Investor identifies and "codifies" outcomes as gains or losses and assigns a probability to each
     • Combination: Investor combines outcomes with identical values
     • Segregation: Investor separates different risks
     • Cancellation: Identical outcomes between choices are eliminated
     • Simplification: Investor doesn't think in precise numbers/probabilities
     • Dominance: Investor will eliminate any choice that is strictly dominated by another

Cancellation can lead to the isolation effect; investors focus on one factor or outcome while consciously eliminating or subconsciously ignoring others (e.g., when faced with two outcomes − one very large gain with a near-zero probability and, the other, a very small gain with a large probability − the individual might tend to focus on the large outcome, ignoring its low probability (e.g., lottery players)) 2. Evaluation

• Investors place values on alternatives in terms of expected utility, utilizing subjective probabilities; the expected utility of an alternative is the probability-weighted average of the utilities of its possible outcomes. Pi = the investor's subjective probability that event x, y, or z will occur

• Bounded Rationality - individuals act as rationally as possible, but recognize that they are bounded by a lack of knowledge and cognitive ability

• Satisfice - making a reasonable but sub-optimal decision

  • Gather what they consider to be an adequate amount of information and apply heuristics (experience-based techniques for problem solving, learning, and discovery) to analyze and shape the information into an acceptable decision

• Investor takes steps to achieve intermediate(short-term) goals, as long as they advance the investor toward the desired goal. Investor does not necessarily make the optimal decision from a traditional finance perspective Market Efficiency

• Weak-form: Prices reflect all past price and volume data: technical analysis will not generate excess returns

• Semi-strong form: Prices reflect all public information, including past price and volume data: neither technical nor fundamental analysis will generate excess returns; only holders of nonpublic (inside) information can earn excess returns

• Strong-form: Prices reflect all information, public and private: No analysis based on nonpublic or public information can consistently generate excess returns

Behavioral Finance Models

• Behavioral Life-Cycle Model: Individuals classify their wealth as:

  1. Current income
  2. Currently-owned assets
  3. Present value of future income

• An individual's marginal propensity to consume is greatest for current income.

• Individuals are subject to framing, self-control bias, and mental accounting, so they will not necessarily achieve the optimal balance of short-term consumption and saving (long-term investing).

• Behavioral Asset Pricing: A sentiment premium is added to required returns and is determined by a stochastic discount factor (SDF) and is based on investor sentiment relative to fundamental value (proxied by dispersion of analysts' forecasts).

• Behavioral Portfolio Theory (BPT)
  • Rather than hold well-diversified portfolios, individuals tend to hold a combination of nearly riskless assets and high risk assets
  • Investors structure their portfolios in layers (pyramiding) according to their goals (mental accounting)
• Adaptive Markets Hypothesis (AMH):
  • Successful market participants apply heuristics until they no longer work and then adjust them accordingly
  • Success in the market is an evolutionary process;those who do not or cannot adapt do not survive
  • Investors satisfice rather than maximize utility

AMH leads to 5 conclusions:

1. Investors make decisions to help them survive, or satisfice, rather than optimize, or maximize utility
2. Investors must adapt to survive
3. Since participants adapt, no investment strategy can persistently outperform
4. Risk premiums will vary depending on investors' perceptions of and aversion to risk
5. Since investors satisfice, assets can be temporarily mispriced