Tutorials 1: The behavioral finance perspective

Mimi Fong, CFA, a private wealth manager with an asset management firm, has been asked

to make a presentation to her colleagues comparing traditional and behavioral finance. She

decides to enliven her presentation with statements from colleagues and clients. These

statements are intended to demonstrate some key aspects of and differences between

traditional and behavioral finance.

Statement 1 “When new information on a company becomes available, I adjust my

expectations for that company’s stock based on past experiences with similar information.”

Statement 2 “When considering investments, I have always liked using long option

positions. I like their risk/return tradeoffs. My personal estimates of the probability of gains

seem to be higher than that implied by the market prices. I am not sure how to explain that,

but to me long options provide tremendous upside potential with little risk, given the low

probability of limited losses.”

Statement 3 “I have always followed a budget and have been a disciplined saver for decades.

Even in hard times when I had to reduce my usual discretionary spending, I always managed

to save.”

Statement 4 “While I try to make decisions analytically, I do believe the markets can be

driven by the emotions of others. So I have frequently used buy/sell signals when investing.

Also, my 20 years of experience with managers who actively trade on such information

makes me think they are worth the fees they charge.”

Statement 5 “Most of my clients need a well-informed advisor to analyze investment choices

and to educate them on their opportunities. They prefer to be presented with three to six
viable strategies to achieve their goals. They like to be able to match their goals with specific

investment allocations or layers of their portfolio.”

Statement 6 “I follow a disciplined approach to investing. When a stock has appreciated by

15 percent, I sell it. Also, I sell a stock when its price has declined by 25 percent from my

initial purchase price.”

Statement 7 “Overall, I have always been willing to take a small chance of losing up to 8

percent of the portfolio annually. I can accept any asset classes to meet my financial goals if

this constraint is considered. In other words, an acceptable portfolio will satisfy the following

condition: Expected return – 1.645 x Expected standard deviation -8%.”

1. Which of the following statements is most consistent with expected utility theory?

a. Statement 1.

b. Statement 2.

c. Statement 3.

Expected Utility Theory is a critical concept in traditional finance that describes how

investors make decisions under uncertainty based on their preferences, or utilities, for

different outcomes. It implies that individuals choose among risky prospects by comparing

their expected utilities rather than just expected values, taking into account their risk

aversion.

Looking at the provided statements:

Statement 1 “When new information on a company becomes available, I adjust my

expectations for that company’s stock based on past experiences with similar information.”
- **Statement 1** suggests adjusting expectations based on new information and past

experiences. This could be related to the Bayesian approach or adaptive expectations, but it

doesn't directly speak to expected utility theory, which is more about the trade-offs between

risk and return from a utility perspective.

Statement 2 “When considering investments, I have always liked using long option

positions. I like their risk/return tradeoffs. My personal estimates of the probability of gains

seem to be higher than that implied by the market prices. I am not sure how to explain that,

but to me long options provide tremendous upside potential with little risk, given the low

probability of limited losses.”

- **Statement 2** describes using long option positions due to perceived risk/return tradeoffs

and personal estimates of probabilities. This statement aligns more closely with expected

utility theory because the individual is considering their personal risk-return preferences (the

utility) in decision-making. The reference to personal estimates of probabilities and the

risk/return tradeoffs directly ties into how expected utility theory operates, as individuals

weigh the utility of different outcomes based on their personal risk aversion.

Statement 3 “I have always followed a budget and have been a disciplined saver for decades.

Even in hard times when I had to reduce my usual discretionary spending, I always managed

to save.”

- **Statement 3** focuses on budgeting and saving, showcasing disciplined financial

behavior. While it reflects prudent financial management, it doesn't directly relate to expected

utility theory, which involves choices under uncertainty and considering different risk-return

trade-offs.
Therefore, **Statement 2** is most consistent with expected utility theory as it involves

personal assessments of risk and return, indicative of the decision-making process described

by expected utility theory.

2. Which of the following statements most likely indicates a belief that technical anomalies

exist in the capital markets?

a. Statement 2.

b. Statement 4.

c. Statement 6.

The belief in technical anomalies refers to the idea that patterns, trends, or other data derived

from past market activity can inform future market movements, a concept often associated

with technical analysis.

Statement 2 “When considering investments, I have always liked using long option

positions. I like their risk/return tradeoffs. My personal estimates of the probability of gains

seem to be higher than that implied by the market prices. I am not sure how to explain that,

but to me long options provide tremendous upside potential with little risk, given the low

probability of limited losses.”

- **Statement 2** discusses using long option positions based on personal estimates of the

probability of gains and mentions a risk-return tradeoff but doesn't directly relate to technical

anomalies or patterns in market prices.

Statement 4 “While I try to make decisions analytically, I do believe the markets can be

driven by the emotions of others. So I have frequently used buy/sell signals when investing.

Also, my 20 years of experience with managers who actively trade on such information

makes me think they are worth the fees they charge.”

impact of the emotions of others on the markets. The use of buy/sell signals and the belief in

the value of managers who trade based on such information suggest a belief in technical

anomalies, as these signals often come from technical analysis which uses past market data to

predict future market behavior.

Statement 6 “I follow a disciplined approach to investing. When a stock has appreciated by

15 percent, I sell it. Also, I sell a stock when its price has declined by 25 percent from my

initial purchase price.”

- **Statement 6** describes a disciplined approach to investing based on specific price

movements (appreciation or decline from purchase price), which is a systematic strategy, but

it doesn't directly suggest the use of historical market patterns or technical data to inform

these decisions; it is more related to a set of personal rules or threshold-based investing.

Given these descriptions, **Statement 4** most likely indicates a belief that technical

anomalies exist in the capital markets.

3. Statement 4 is most consistent with:

a. The adaptive markets hypothesis.

b. A behavioral approach to asset pricing.

c. Savage’s subjective expected utility theory.

Statement 4 “While I try to make decisions analytically, I do believe the markets can be

driven by the emotions of others. So I have frequently used buy/sell signals when investing.
Also, my 20 years of experience with managers who actively trade on such information

makes me think they are worth the fees they charge.”

Statement 4 mentions the influence of emotions on market dynamics and the use of buy/sell

signals, which suggests a departure from traditional, rational-based financial theories. Now,

let's analyze the options provided:

a. **The Adaptive Markets Hypothesis (AMH)**: This theory, proposed by Andrew Lo,

combines principles from the Efficient Markets Hypothesis (EMH) with behavioral finance.

AMH suggests that market efficiency is not a static condition but rather one that can adapt to

changes in market participants, conditions, and rules. It acknowledges that investors might

act irrationally due to psychological factors and that these behaviors can influence market

dynamics.

b. **A behavioral approach to asset pricing**: This approach incorporates psychology-based

theories into traditional finance to provide explanations for various market anomalies that

cannot be explained by classical theories. It acknowledges that investors' decisions can be

influenced by biases, emotions, and other psychological factors.

c. **Savage’s subjective expected utility theory**: This is a decision-making framework that

extends the expected utility theory. It accounts for personal beliefs and attitudes towards

uncertainty but remains grounded in the rational decision-making framework and does not

explicitly address market dynamics or the influence of emotions and psychological biases on

decision-making.
**Statement 4** aligns most closely with **b. A behavioral approach to asset pricing**.

This is because the statement emphasizes the role of emotions in market movements and

suggests the use of strategies (like buy/sell signals) that are influenced by market participants'

behaviors, which is a key consideration in behavioral finance. While the Adaptive Markets

Hypothesis also considers changes in market behavior, it is more about the evolution of

market efficiencies over time, not specifically about the emotional drives of market

participants that the behavioral approach addresses.

4. The clients of Statements 5 most likely exhibit:

a. Loss-aversion.

b. Bounded rationality.

c. Mental accounting bias.

Analyzing Statement 5 and the options given:

Statement 5 “Most of my clients need a well-informed advisor to analyze investment choices

and to educate them on their opportunities. They prefer to be presented with three to six

viable strategies to achieve their goals. They like to be able to match their goals with specific

investment allocations or layers of their portfolio.”

a. **Loss aversion**: This is a concept from behavioral economics indicating that people

prefer avoiding losses to acquiring equivalent gains; that is, the pain of losing is

psychologically about twice as powerful as the pleasure of gaining. There isn't a direct

indication in Statement 5 that clients are more concerned about losses than they are about

gains.
 b. **Bounded rationality**: This concept suggests that individuals make decisions based

on the limited information they have available and their limited mental capacity to

process information. They use satisficing rather than optimizing strategies due to these

limitations. Statement 5 implies that clients rely on advisors to make sense of complex

information and to present a manageable number of strategies, which aligns with the idea

of bounded rationality.

c. **Mental accounting bias**: This refers to the tendency for individuals to divide their

money into separate accounts based on various subjective criteria, such as the source of

the money or the intended use. This can lead to irrational decision-making. While

Statement 5 mentions clients wanting to match their goals with specific investment

allocations or layers of their portfolio, which sounds a bit like mental accounting, it's

more about strategic allocation and less about the psychological bias of separating funds

into different mental accounts without economic basis.

Given these considerations, the clients in Statement 5 **most likely exhibit b. Bounded

rationality**. They seem to need help understanding their investment choices and prefer

having a simplified number of strategies to choose from, which aligns with the concept of

making decisions within the constraints of limited information and cognitive processing

capabilities.

5. The client of Statement 6 is most likely behaving consistently with:

a. Prospect theory.

b. Expected utility theory.

Statement 6 “I follow a disciplined approach to investing. When a stock has appreciated by

15 percent, I sell it. Also, I sell a stock when its price has declined by 25 percent from my

initial purchase price.”

Prospect theory, a key concept within behavioral economics formulated by Daniel Kahneman

and Amos Tversky, proposes that people value gains and losses differently, leading to

decisions that deviate from standard logic as described by the expected utility theory. One of

the most notable behaviors explained by prospect theory is loss aversion, where the pain of

losing is psychologically about twice as powerful as the pleasure of gaining.

Statement 6 describes a strategy where a stock is sold after it appreciates by 15 percent and

sold when it has declined by 25 percent from the purchase price. This behavior indicates a

predefined set of rules for selling based on specific gains and losses, which might suggest an

attempt to manage the emotional impact of gains and losses rather than maximizing expected

utility.

This strategy does not perfectly align with traditional expected utility theory, which would

have the investor continuously update their utility based on changes in wealth, without strict

thresholds for action. However, it does also not align directly with classic interpretations of

prospect theory, which would typically manifest in a more pronounced aversion to losses than

the acceptance of equivalent gains – the investor here seems to treat both scenarios with

predetermined actions, but not necessarily an unequal weighting of gains versus losses.
The closest match among the given options is **a. Prospect theory**, mainly because the

behavior demonstrates rules that reflect the psychological impact of gains and losses, typical

in prospect theory. However, it's important to note that the statement does not perfectly fit the

typical loss aversion scenario since the actions (selling after a certain percentage gain or loss)

could also be seen as a risk management strategy. But among the provided choices, prospect

theory is the closest in capturing the essence of the behavior described.

6. The client of Statement 7 would most likely agree with which of the following

statements?

a. I strive for a mean-variance efficient portfolio.

b. I construct my portfolio in layers to meet my goals.

c. I am loss-averse and have a value function that is steeper for losses than gains.

Statement 7 “Overall, I have always been willing to take a small chance of losing up to 8

percent of the portfolio annually. I can accept any asset classes to meet my financial goals if

this constraint is considered. In other words, an acceptable portfolio will satisfy the following

condition: Expected return – 1.645 x Expected standard deviation -8%.”

This statement is most aligned with a. I strive for a mean-variance efficient

portfolio. The description involves the use of expected return and standard

deviation, which are components of modern portfolio theory (MPT) focusing on

creating an efficient frontier for the best possible expected level of return for

varying levels of risk, including defining acceptable levels of risk and return,

which is a hallmark of seeking a mean-variance efficient portfolio.