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<title>Study Session 3 | Reading 7 | The Behavioral Finance Perspective</title>
<meta name="description" content="Chartered Financial Analyst Level 3 Study Materials">
<meta name="author" content="MacLane Wilkison">
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<section>
<h1>Reading 7</h1>
<h3>The Behavioral Finance Perspective</h3>
<p>
<small>Created for <a href="http://alchemistsacademy.com">AlchemistsAcademy</a> by <a href="http://alchemistsacademy.com/about">MacLane Wilkison</a></small>
</p>
</section>
<section>
<h2>Introduction</h2>
<p><em>Definition: A discipline of financial theory that focuses on how investors and markets behave in practice rather than traditional theory</em></p>
<ul>
<li>Normative analysis - defines an ideal that actual decisions should strive to approximate</li>
<li>Descriptive analysis - describes the manner in which real people make real decisions</li>
<li>Prescriptive analysis - prescribes practical advice and tools with which people can more closely align their decisions with the normative ideal</li>
</ul>
</section>
<section>
<section>
<h1>Behavioral versus Traditional Perspectives</h1>
</section>
<section>
<h2>Traditional Perspectives</h2>
<ul>
<li>Utility theory - individuals maximize PV of utility</li>
<ul>
<li>Completeness</li>
<li>Transitivity</li>
<li>Independence</li>
<li>Continuity</li>
</ul>
<li>Bayes' formula - application of conditional probabilities</li>
<ul>
<li>P(A|B) = [P(B|A)/P(B)]×P(A)
</ul>
<li>Rational economic man (REM) - uses indifference curves to make choices</li>
<li>Perfect rationality, self-interest, and information</li>
<li>Risk aversion</li>
</ul>
<aside class="notes">
In utility theory, individuals maximize the PV of utility subject to a PV budget constraint. Utility is defined as the level of relative satisfaction received from the consumption of goods or services. Basic axioms of utility theory: (1) Completeness - Given choices A and B, the individual either prefers A to B, prefers B to A, or is indifferent between A and B; (2) Transitivity - Given choices A, B, and C, if an individual prefers A to B and prefers B to C, then the individual prefers A to C; (3) Independence - Let A and B be two mutually exclusive choices, and let C be a third choice that can be combined with A or B. If A is preferred to B and C is added to A and B, then A plus C is preferred to B plus C; (4) Continuity - Given three divisible choices (A, B, and C) and an individual that prefers A to B and B to C, then there should be a possible combination of A and C such that the individual is indifferent between this combination and B. Given new information, an individual updates his beliefs regarding probabilities using Bayes' formula: P(A|B) = conditional probability of A given B; P(B|A) = conditional probability of B given A; P(B) = unconditional probability of B; P(A) = unconditional probability of A.
</aside>
</section>
<section>
<h2>Behavioral Perspectives</h2>
<ul>
<li>REM is invalid</li>
<ul>
<li>Decision-making abilities inherently limited</li>
<li>Disregards inner conflicts (e.g. spending vs. saving, individual vs. societal goals)</li>
<li>Imperfect information</li>
</ul>
<li>Individuals unlikely to perform complex indifference curve analyses</li>
<li>Individual can exhibit risk-seeking behavior (e.g. lottery tickets)</li>
<ul>
<li>Prospect theory</li>
</ul>
</ul>
<aside class="notes">
Empirically, individuals do not always exhibit risk aversion. In fact, it is evident that risk evaluation is reference-dependent. In other words, risk evaluation depends on the wealth level and circumstances of the decision maker. Prospect theory accounts for this phenomenon by assigning value to changes in wealth rather than to final wealth.
</aside>
</section>
</section>
<section>
<h2>Decision Making</h2>
<ul>
<li>Bounded rationality</li>
<ul>
<li>No perfect information</li>
<li>Decision tools/ability are limited and heuristics are used</li>
<li>Individuals satisfice rather than optimize</li>
</ul>
<li>Prospect theory</li>
<ol>
<li>Framing stage</li>
<ul>
<li>Codification</li>
<li>Combination</li>
<li>Segregation</li>
<li>Cancellation</li>
<li>Simplification</li>
<li>Detection of dominance</li>
</ul>
<li>Evaluation stage</li>
</ol>
</ul>
<aside class="notes">
Bounded rationality relaxes the assumptions of perfect information and utility maximization. An alternative to expected utility theory, prospect theory describes how individuals make choices between risky alternatives and how they evaluate potential gains/losses. Prospect theory is a two-stage process involving a framing stage that uses heuristics to quickly analyze and sort the alternatives, followed by an evaluation phase in which the alternatives are evaluated and selected following a process similar to utility theory but with a focus on gains and losses rather than absolute wealth. Framing stage: (1) Codification - outcomes are categorized as either gains or losses; (2) Combination - summing of the probabilities of alternatives with identical outcomes; (3) Segregation - the riskless and risky components of each alternative are separated; (4) Cancellation - common outcome probability pairs are discarded; (5) Simplification - probabilities are rounded off; (6) Detection of dominance - outcomes that are strictly dominated are eliminated.
</aside>
</section>
<section>
<section>
<h1>Perspectives on Market Behavior and Portfolio Construction</h1>
</section>
<section>
<h2>Traditional Perspectives on Market Behavior</h2>
<p><em>Efficient Market Hypothesis (EMH): Markets fully, accurately, and instantaneously incorporate all available information into market prices</em></p>
<ul>
<li>Weak form - all past market price and volume data are fully reflected</li>
<li>Semi-strong form - all publicly available information, past and present, is fully reflected</li>
<li>Strong form - all information, public and private, is fully reflected</li>
</ul>
</section>
<section>
<h2>EMH Anomalies</h2>
<ul>
<li>Fundamental anomalies - irregularities that emerge when one considers a stock's future performance based on fundamental assessments</li>
<ul>
<li>Company size, value vs. growth, etc.</li>
</ul>
<li>Technical anomalies - irregularities that emerge when one considers past prices and volume levels</li>
<ul>
<li>Buy and sell signals generated by moving averages, range breaks, and other technical analysis techniques</li>
</ul>
<li>Calendar anomalies - irregularities that emerge in patterns of trading behavior at certain times of the year</li>
<ul>
<li>January effect, turn-of-the-month effect, etc.</li>
</ul>
</ul>
</section>
<section>
<h2>Traditional Perspectives on Portfolio Construction</h2>
<p>Mean-variance optimized portfolios constructed holistically using the investor's risk tolerance, investment objectives, constraints, and unique circumstances</p>
</section>
<section>
<h2>Behavioral Perspectives</h2>
<ul>
<li>Consumption and savings - life-cycle theory that incorporates self-control, mental accounting, and framing biases</li>
<li>Asset pricing - focuses on market sentiment derived from systemic judgement errors by investors as a major determinant of asset pricing</li>
<li>Portfolio theory - investors construct "layered" portfolios with varying risk and return objectives</li>
<li>Adaptive market hypothesis (AMH) - applies principles of evolution (competition, adaptation, and natural selection) to financial markets</li>
</ul>
</section>
</section>
<section>
<h1>THE END</h1>
<h3><a href="http://alchemistsacademy.com">AlchemistsAcademy.com</a></h3>
</section>
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