Below, you’ll find my personal CFA level 3 behavioral finance notes…
You can find a list of the other categories here: CFA Level 3 Notes, Formulas, and Weights.
Utility Theory tries to maximize the present value given budget constraints. The four axioms of utility theory to hold true are completeness, transitivity, independence and continuity.
Bayes’ Formula adjusts old probabilities given new information… P(A|B) = [P(B|A)/P(B)]P(A)
The Rational Economic Man (REM) seeks to gain the best possible economic outcome or utility given available info and budget constraints.
Certainty Equivalent is the max amount of money a person would pay to play… or the minimum amount a person would accept to not play.
Double Inflection Utility Functions change based on wealth levels… example: concave -> convex -> concave
Prospect Theory is an alternative to Expected Utility Theory. It assigns value to individual gains and losses and weights them (utility theory focuses on final wealth). The two Prospect Theory phases are framing and evaluation. Prospect Theory proposes loss aversion opposed to risk aversion.
Neuro-Economics is still in its early-stages of study and still has yet to have a big impact on economic theory. Dopamine kicks in for a reward and the expectation of a reward. This helps explain risk-taking behavior. A reduction in Serotonin is tied to anxiety, depression, impulsiveness and irritability.
Decision Theory is set to determine an optimal decision given various values and probabilities. Bounded Rationality accepts that people don’t always act rationally. People will Satisfice by choosing a non-optimal outcome that’s still adequate.
Efficient Market Hypothesis (EMH)
Weak-Form assumes all past info is fully reflected in market prices so technical analysis won’t produce alpha.
Semi-Strong-Form assumes all past and present public info is fully reflected in market prices… so both technical and fundamental analysis won’t produce alpha.
Strong-Form assumes all public and private info is fully reflected in market prices so even insider info won’t produce alpha.
Behavioral Portfolio Theory (BPT) uses a probability-weighting function. Investors construct portfolios in layers that vary with risk and return expectations.
Adaptive Markets Hypothesis (AMH) factors in adaptation, competition, and natural selection with behavioral alternatives. AMH is a revised version of EMH that also factors in bounded rationality and satisficing.
Behavioral Biases of Individuals
Cognitive Errors – Belief Perseverance Biases
Conservatism Bias leads people to inadequately factor in new information. They tend to stick to their old beliefs and underweight new info. An example is that analyst earnings forecasts tend to lag actual earnings.
Confirmation Bias leads people to seek information that confirms their beliefs. By avoiding contradictory info, people limit cognitive dissonance. Confirmation bias can lead to under diversifying a portfolio.
Representativeness Bias pushes people to sort new information based on past experiences and classifications. It’s a mental shortcut like all biases but the new information might not fit perfectly into the old models. Two types of rep bias…
- Base-Rate Neglect is that the probability of the categorization isn’t adequately considered (similar to stereotyping).
- Sample-Size Neglect is that the sample is assumed to represent the population.
Illusion of Control Bias leads people to believe that they have more impact on outcomes than they actually do. They tend to trade too frequently and inadequately diversify their portfolio.
Hindsight Bias leads people to believe they could have easily predicted a past outcome given only the old info (hindsight is 20/20). This can lead to a false sense of confidence.
Cognitive Errors – Information Processing Biases
Anchoring and Adjustment Bias happens when a previously set number is adjusted based on new information. Original estimates are often given an over-weighting.
Mental Accounting Bias leads people to bucket money and treat them differently… although, money is inherently fungible. Mental accounting also neglects opportunities to reduce risk by combining assets with low correlations.
Framing Bias occurs when questions are asked in a certain way to draw out a different answer. For example, highlighting potential gains over losses in a question can lead people to take on more risky positions.
Availability Bias occurs when people use easy to recall memories to estimate a probability of an outcome. Availability bias can lead to limiting investment opportunity set and lack of diversification. There are four sources of availability bias…
- Categorization – If it is difficult to categorize, the result is likely grouped and biased
- Narrow Range of Experience – Not enough insight to make informed decisions
- Resonance – A bias based on relating to personal experiences
- Retrievability – The first answer that comes to mind is more likely chosen
Loss-Aversion Bias leads people to prefer avoiding losses as opposed to obtaining gains. Loss-Aversion pushes investors to keep holding onto losing positions and selling winners too quickly (Disposition Effect).
Overconfidence Bias is excessive confidence in one’s own reasoning and actions. This ties into the Illusion of Knowledge.
Self-Control Bias is when people lack self-discipline and seek short-term gratification at the expense of long-term goals.
Status Quo Bias leads people to avoid change and miss opportunities.
Endowment Bias pushes people to value an asset they own more than the same asset if they didn’t own it.
Regret Aversion Bias occurs when people try avoiding the pain of regret from bad decisions. For example, investors avoid selling winning positions fearing that they will miss out on more gains. This bias breaks down into error of commission (acting) and error of omission (not acting).
Barnewall Two-Way Model distinguishes two investor types (Active and Passive)
Bailard, Biehl, and Kaiser (BB&K) Five-Way Model
- Adventures aren’t likely to take advice and often take risk by concentrating their bets.
- Celebrities like attention and have opinions but will take some advice.
- Individualists are independent and confident. They’re easier to advise and preform careful analysis.
- Guardians seek to protect their investments. People become guardians as the near retirement.
- Straight Arrows are in the middle. They seek some risk but in return for an adequate return.
4 Behavioral Investment Types
- Passive Preservers (PP) have a low risk tolerance and primarily emotional biases.
- Friendly Followers (FF) have a low to medium risk tolerance and primarily cognitive biases.
- Independent Individualists (II) have a medium to high risk tolerance and primarily cognitive biases.
- Active Accumulators (AA) have a high-risk tolerance and primarily emotional biases.
Also remember… Naïve Diversification, Loyalty Effects, and Home Bias
Gamblers’ Fallacy occurs when people believe short-term trends will persist but the true probability shows otherwise.
Conjunction Fallacy states that the probability of two independent events occurring together can’t be higher than the individual.
Halo Effect is when a favorable view of something is extended.
Please comment below if you have any suggestions or questions. Also, the next category in my CFA level 3 study list is Individual Investors.