Behavioral Finance is an important topic on the CFA Level 3 exam. Investment Advisors often use Behavioral Finance analysis to better understand their clients’ needs and investment requirements. In addition, Behavioral Finance is important in Portfolio Management because it influences the allocation of capital and the choices of investment assets chosen by investors in their portfolios.
So what is the difference between Traditional Finance and Behavioral Finance?
Traditional Finance focuses on how individuals should behave. Individuals are considered as being “Rational Economic Men”. This leads to markets where prices reflect all available relevant information.
Behavioral Finance recognizes that the way the information is presented to investors can affect how they make decisions and it can lead to emotional and cognitive biases. Behavioral Finance focuses on why investors behave the way they do. Since investors’ decisions are not always optimal, this results in markets that are temporary or persistently inefficient.
Behavioral Finance is also separated in Micro and Macro analysis.
Micro Behavioral Finance deals with individuals. It attempts to explain why individuals deviate from the Traditional Finance theory.
Macro Behavioral Finance deals with markets. It attempts to explain why markets deviate from efficient markets.
Traditional Finance is based on neoclassical economics. It assumes individuals are risk-averse, have perfect utility function and focus on maximizing the personal utility function. Hence, “Rational Economic Men” create efficient markets.
Four self-evident rules for a rational investor:
- Completeness: all preferences are known.
- Transitivity: their preferences are consistently applied.
- Independence: rankings are additive and proportional.
- Continuity: indifference curves are continuous. An unlimited combinations of weights are possible.
Baye’s Formula is used to asses how new information influences the existing belief about an event or an idea about securities market value for example. What is the probability for an event A to occur given the occurrence of event B? In more practical terms, what is the probability of the stock price going up following the upcoming news release from the firm?
A risk averse investor suffers a greater loss of utility for a given loss of wealth than she gains in utility from the equivalent rise in wealth. The risk averse investor has a concave utility function.
A risk neutral investor suffers a the same loss of utility for a given loss of wealth than she gains in utility from the equivalent rise in wealth. The risk neutral investor has a straight line utility function.
A risk seeking investor suffers a smaller loss of utility for a given loss of wealth than she gains in utility from the equivalent rise in wealth. The risk seeking investor has a convex utility function.
Challenges to Traditional Finance and the concept of “Rational Economic Men”:
- Decisions can be impacted by a lack of information or an erroneous decisions process.
- Investors’ personal preferences for short-term gains versus the long-term rewards.
- Investors lack the perfect knowledge.
- Even risk averse investors can on occasion pursue risk seeking behaviors.
Traditional Finance is based on utility theory with the assumption of diminishing marginal returns. This means that risk-averse utility functions are concave. The indifference curves are convex due to diminishing rates of substitution.
Behavioral Finance observes that individuals sometimes can have both risk-averse and risk-seeking behaviors.
What is Bounded Rationality and why it is important in Behavioral Finance?
Bounded Rationality states that there are limits to what and how people process information. This removes the assumption of perfect information.
Individuals instead practice satisfice which creates outcomes that offer sufficient satisfaction instead of optimal utility.
What is Prospect Theory in Behavioral Finance?
Prospect Theory focuses on loss aversion instead of risk aversion. Instead of framing decisions based on return and risk, investors frame their decisions based on gains and losses. This means that for these investors the change in their wealth is more important than the level of their wealth. Investors place a greater deal on losses than they do on similar amounts of gains.
This increase in utility given a level of gain is smaller than the decrease in utility given a similar loss.
In conclusion, here is a simple and easy to remember summary of the differences between Traditional Finance and Behavior Finance:
Traditional Finance assumes:
- Unlimited prefect knowledge
- Utility maximization
- Full rational decision making
- Risk aversion
Behavior Finance assumes:
- Bounded Rationality and Prospect Theory
- Capacity limitations of knowledge
- Cognitive limitations on decision making
- Satisfice instead of Optimize
- Prospect Theroy: views of gains & losses versus returns and risk.
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