www.gostudy.io Go Study’s CFA Exam Level 3 ® Traditional vs. Behavioral Finance by GoStudy™ www.gostudy.io Everything you need to pass & nothing you don’t 1 www.gostudy.io Guided Notes for CFA® Level 3 – 2016 Copyright © 2016 by Go Study LLC.® All Rights Reserved. Published in 2016 The “CFA® and Chartered Financial Analyst® are trademarks owned by CFA Institute. CFA Institute does not endorse, promote, review, or warrant the accuracy of the products or services offered by www.cfaexamlevel3.com. Certain materials contained with this text are the copyrighted property of the CFA Institute. The following is the copyright disclosure for those materials: “Copyright, 2016, CFA Institute. Reproduced and republished from 2016 Learning Outcome Statements, Level III CFA® Program Materials, CFA Institute Standards of Professional Conduct, and CFA Institute’s Global Investment Performance Standards with permission from CFA Institute. 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We strive to answer every question a candidate has and are always incorporating Candidate feedback into what we build next. 2 www.gostudy.io Contents Behavioral Finance (Study Session 3) ............................................................................................ 3 Traditional versus Behavioral Finance (Reading 5) ................................................................... 4 The Rational Economic Man and Efficient Markets .............................................................. 5 The CAPM Model................................................................................................................... 6 Tweaks of the Efficient Market Hypothesis ........................................................................... 6 Utility Theory.......................................................................................................................... 7 Challenging EMH ................................................................................................................... 9 Behavioral Finance Frameworks .............................................................................................. 11 Summarizing the BF Frameworks ........................................................................................ 14 Behavioral Finance (Study Session 3) This is an important topic. It will probably be tested in the morning in an IPS question, as part of a stand-alone constructed response, and it could even show up in an item set in the afternoon accounting for up to 10% of the exam. That alone would make it worth a lot of time. But the themes found in the behavioral finance section also echo throughout the entire CFA L3 curriculum. Take portfolio management for example. The core of L3 is knowing the basic stuff that goes into managing someone else’s money. People aren’t robots after all! Thus to do a good job managing money you have to be aware of your clients’ unique financial circumstances, knowledge of finance, and their personality traits. The overarching point of this section is that only by treating clients as unique individuals can we, as portfolio managers, create tailored strategic asset allocation plans that also mitigate their weird quirks or sub-optimal behaviors (through education or accommodation). Bottom line: Knowing this section cold will let you score points and save valuable time. The outline of this section Like the CFA Institute curriculum we start from a very high level market wide perspective by defining the idea of an efficient market. We then move from the theory of how a market should work to introduce some behavioral challenges to this efficient market hypothesis. From there we think through the various challenges that people’s emotional and mental reaction to financial markets creates for managing their portfolios. After that we turn to identifying and categorizing the different emotional and cognitive biases that investors (and analysts) can face. Finally we end with three frameworks for classifying investors into different behavioral groups. 3 www.gostudy.io We spend a good deal of time in the beginning of this section because understanding the basic tenants of BF will let you earn a lot of points on the test throughout seemingly unrelated subjects. Specifically, as we move into the core L3 readings on Individual and Institutional Portfolio Management, your ability to relate those sections to BF will let you score a lot of points. So bear with us in the lengthy chapter. The payoff is worth it and we promise the notes get more concise again after. Traditional versus Behavioral Finance (Reading 5) Note that the order in which we present material for Reading 5 is, in a few cases, quite different from the order laid out in the curriculum. Key testable material / what you need to be able to do after learning this reading: Contrast traditional finance with behavioral finance and how that impacts investor decision making and portfolio construction Compare and discuss the consequences of Weak, Semi-strong form, and strong form modifications to EMH Describe and compare utility and prospect theory Talk about bounded rationality and cognitive limitations and its impact on investment decision making (satisfice, AMH) Describe the consumption and savings model, BAPM, and BPT and how they differ from traditional finance In order to set up the behavioral finance discussion it helps to take a step back and think about what exactly it is that behavioral finance is modifying—traditional finance. Traditional finance, which is what we’ve dealt with throughout L1 and L2, is built on the assumptions of: Rational individuals Perfect information Efficient markets that quickly absorb new information Behavioral economic theories modify these models by relaxing certain assumptions. BF acknowledges that people aren’t economic machines. We are weird. We don’t always act rationally. We make mistakes in processing things. On top of that, perfect information doesn’t exist. It’s impossible to know everything about everything at all times. This means that there are informational, cognitive, and emotional challenges to the theory of efficient markets. Another way to draw the distinction between traditional and behavioral finance lies in what each tries to do. Traditional finance is normative in that it seeks to predict actions. It offers theoretical models for how people and markets are supposed to behave in an ideal scenario. Behavioral finance is descriptive or observational. It looks to explain actual behavior by modifying traditional models to examine how we actually make decisions (both on an individual by individual level and in terms of why markets in the macro deviate from being perfectly efficient). 4 www.gostudy.io Again, the L3 curriculum is about the key principles of actually managing money. The ultimate goal or application of behavioral finance is prescriptive, i.e. it can provide practical advice and tools to achieve results that are as close to the normative ideal as possible. In other words, the overarching message being conveyed here is that combining behavioral and traditional approaches leads us to a better understanding of clients, and that makes us better portfolio managers and financial advisors. The Rational Economic Man and Efficient Markets If traditional finance is built on the assumption of Rational Economic Man (REM), then how does an REM act? And what does that behavior mean for financial markets? The rational economic man acts in accordance with a few basic theories that try to define his behaviors (derived from neoclassical economics). Basically a perfectly rational economic human: Thinks more (stuff) is better than less, e.g. is perfectly rational/self-interested Thinks less risk is better than more risk all else equal, i.e. is risk averse Has perfect information Uses Bayes’ formula to make probability adjusted decisions, i.e. is a mathematical genius1 The result, as we see below, is that an REM will try to obtain the highest possible utility given their budget constraints. From a market-wide perspective, traditional finance assumes that since all of these individuals base their decisions on perfect information (including past volume, price, and market/firm data) markets as a whole are also efficient. Efficient here means two things: 1. The price is right: In other words, asset prices reflect all available information and prices adjust instantaneously to incorporate that information 2. There is no free lunch: Since prices adjust immediately it is not possible to get an informational advantage and therefore earn above-average returns. In other words no alpha is consistently possible The result is our good friend capital market theory as represented by the CAPM. This is where there is a single efficient market frontier on which investors create their portfolio using expected returns, standard deviations, and co-variances of their investments. 1 In the CFA curriculum this discussion is followed by a brief explanation of Bayes’ formula for revising expectations given new information. While unlikely to be directly tested you should recognize the probability P(B|A) formula from L2 where: P(A|B) = ∗ P(A). Where the conditional probablities [P(A|B), P(B|A) use the new P(B) probabilities given the new information). 5 www.gostudy.io The CAPM Model2 Where: re = The required return on equity rf = Risk-free rate 𝑟𝑒 = 𝑟𝑓 + 𝛽(𝑟𝑚 − 𝑟𝑓 ) rm = The market return β = The stock market beta (rm-rf) = The Equity risk Premium (ERP) Thus in perfectly efficient markets it is the job of an investment manager to ID portfolios on the efficient frontier that meets the risk/reward profile of an investor. In reality, even traditional finance acknowledges that markets are unlikely to be perfectly efficient. Specifically, the assumption that all the relevant information is available and incorporated into market prices instantly has been challenged. As a result there are three modifications to completely efficient markets that have been proposed. Tweaks of the Efficient Market Hypothesis There are three challenges to the ‘Efficient Market Hypothesis (EMH): weak, semi-strong, and strong. Each relaxes the assumption of perfect information to a different degree. Distinctions between them are often tested. Modifications to the Efficient Market Hypothesis (EMH) Weak Form Semi-Strong Form Strong Form Prices reflect all past Prices reflect all past Prices reflect all past price and volume data price and volume data Definition price and volume data AND all public and all public AND information nonpublic information Charts/technical trading Charts/technical trading AND fundamental No excess returns Implications will not lead to excess analysis will not lead to possible returns excess returns Fundamental Analysis Insider info can lead to Significance No alpha possible can lead to alpha alpha Challenges to these theories include fundamental anomalies (value investing, small-cap) which challenges semi-strong/strong) and technical anomalies (calendar, moving average/momentum) which challenge the weak form. 2 An excellent recap of the CAPM model can be found here. 6 www.gostudy.io Types of Market Anomalies This is an odd stand-alone section which the curriculum adds to the end of the behavioral finance section. It shouldn’t be too important, but it exists to remind us that when investors act according to certain biases then the entire markets will behave irrationally too. The best and most famous explanation of this ever is undoubtedly Benjamin Graham’s description of Mr. Market. Anomaly 1: Value vs. Growth & Small-cap vs. Large-cap Value stocks have outperformed growth stocks over a period of 20 years. Similarly, small cap stocks have outperformed large cap stocks over that time period. The curriculum also includes a discussion about why these anomalies may not actually be anomalies—just reflections of different type of risk. Anomaly 2: Bubbles & Crashes Bubbles and Crashes are both symptoms of investor herding behavior which can be caused by availability bias or fear of regret (trend-chasing). Bubbles happen during periods of irrationally high asset prices and exuberance in the markets. They are usually caused by overconfidence, self-attribution, and confirmation biases. Crashes are defined as a fall in market prices of > 30%. They are often caused by herding behavior as a result of the availability bias or fear of regret (trend-chasing). Don’t worry all of these terms are explained below. Utility Theory The concept of rational economic man and investing along a CAPM frontier should be very familiar from previous levels. What hasn’t been covered before is that those concepts are actually built on the economic theory of utility. Rational economic man is rational precisely because he makes utility-maximizing choices. When you combine rational man with a few basic assumptions about the way he or she thinks about maximizing their own self-interests you get something called Utility. Utility is just an economic term describing how you measure your best possible outcome. Its official definition is “the level of relative satisfaction received from the consumption of a good or service.” Utility theory depends on four assumptions (which “won’t” be directly tested):3 Completeness: Individuals know their preferences and can choose between them Transitivity: If A > B and B > C then, A > C Independence: Rankings are additive. So assuming from above that B> C, the following must be true: A + B > A +C Continuity: Utility curves are continuous. If C> B > A then there is a combo of C &A=B To make the concept of Utility clearer let’s give a simple example. 3 Obviously I can’t guarantee that you won’t be tested on something like this, but it’s really in the weeds. 7 www.gostudy.io Say you have a simple tradeoff to make between working and making money on the one hand OR hanging out but having less money on the other. Obviously you need some money or hanging out isn’t much fun. But if all you do is work, your money isn’t worth much either because you have no time to use it. The more of either leisure or work you have, the less valuable having a little bit more of that becomes. Thus utility assumes diminishing marginal returns. As a consequence you maximize your utility by choosing some combination of work and leisure that “works” for you according to your preferences and your constraints.4 A Standard Utility Curve (IC) Plotted Against an Efficient Frontier All points on IC reflect same utility Diminishing returns and a diminishing marginal rate of substitution give the Indifference Curve (IC) its convex shape The straight line represents an efficient frontier and point A is the maximum obtainable utility given resource constraints This works exactly the same in thinking about risk and reward tradeoffs in investing. The more wealth you have the more the expected return of an investment must increase to offset risk. That’s because each dollar you earn has less and less utility (The double-inflection utility function). Graphically, the fact that returns must increase at an increasing rate is represented by the shape on the IC curve from the left of point A. The less leisure time you have, the more someone is going to have to pay you to give it up. From an investor’s perspective think of it this way. Since you’re already rich you care more about keeping what you have versus getting more. Each additional dollar is subject to diminishing returns. You are risk averse because you accept less risk per additional dollar you earn. Behavioral finance relaxes this assumption so that people can be risk-neutral or even risk- seeking5 depending on their level of wealth. This leads to different types of behaviors in the pursuit of wealth/investment returns. The key takeaway from this entire section is summed up in the graphs below. If you know what the graphs below are telling you and why, you know enough about this section. 4 Graph from http://en.wikipedia.org/wiki/Labour_economics. 5 We all have a casino-loving gambling friend after all. 8 www.gostudy.io The Concave shape of the risk-averse investor's utility function indicates diminishing marginal utility. Thus as the overall wealth increases, utility begins to increase at a decreasing rate The risk-neutral investor acts as if unaware of risk (considers only returns) The utility function for the risk-seeking individual is convex, indicating increasing marginal utility. Thus each additional unit of wealth provides more and more utility” Challenging EMH So far we’ve introduced traditional finance and explained some of its key implications for how both individuals and markets behave. In this section we’re going to take a more specific look at some of the alternative theories to efficient markets presented in the behavioral finance reading. This coverage will be picked up again in Reading 7 on behavioral finance and asset allocation. Bounded Rationality Bounded rationality is a key concept in understanding behavioral finance. Essentially, bounded rationality states that it is impossible for every individual to have perfect information about every possible outcome for every single decision. The result is that people practice satisfice. Satisfice means getting to an acceptable outcome, even if that outcome isn’t optimal or return maximizing. The idea of bounded rationality + satisfice is a key behavioral finance concept because it recognizes that people: (1) Gather some but not all available info (2) Use heuristics (rules-of-thumb) to analyze that info (3) Have intellectual/computational limits The result is Satisfice (satisfy + suffice). Prospect Theory This is the first modification to traditional finance presented in the curriculum. Prospect theory relaxes the assumption of utility maximization and substitutes it with loss aversion (or risk aversion). Loss aversion is an important concept in understanding how investors actually behave. At its most basic it means that investors care more about a loss of a dollar than they do the gain of a dollar (see more at Loss Aversion). 9 www.gostudy.io More generally, prospect theory assumes investors aren’t thinking about total returns, instead they are analyzing risk relative to possible gains and losses. Under prospect theory investors care more about relative changes to wealth than about absolute changes. Prospect Theory What the above graph shows is that there may be levels of return at which an investor is a risk seeker (in the convex area of losses) and levels where an investor is risk neutral or risk averse (the concave positive gain area).6 In other words, if investors fear losses they may actually take on greater risk in an attempt to reverse them. The key testable takeaway here is that loss aversion can lead to investors selling winning stocks too early (to lock in gains) and/or holding on or even doubling down on losers. Decision making in Prospect Theory The curriculum also discusses the framework for how investors make decisions in prospect theory. This is pretty detailed but unlikely to be directly tested. Don’t burn too much time memorizing the steps. Decision making under prospect theory is a two-step process where we figure out our choices (editing), and then evaluate those choices (evaluation phase). The editing phase consists of an investor figuring out/clarifying the choices they can make. The six steps in the editing phase are: Codification, Combination, Segregation, Cancellation, Simplification, and Dominance. 6 People tend to be risk averse when there is moderate or high probability of gains or low probability of losses and people are risk seeking when there is low probability of gains or high probability of losses 10 www.gostudy.io 1. Codification: Code outcomes as gains or losses and place a probability7 on each; Codification starts from a specific point in time 2. Combination: Combine outcomes with the same expected value 3. Segregation: Separate certain and uncertain outcomes 4. Cancellation: Eliminate identical outcomes 5. Simplification: Simplify probabilities (for example, round 17.7% up to 20%) 6. Determine Dominance: Eliminate inferior options The key takeaway is that the way options are framed matters for the choices an investor makes (also see this concept at work in analyst errors). In the second, evaluation phase, investors value their alternatives based on expected outcome. Prospect theory also introduces several behavioral aspects including framing bias, isolation effect, and the tendency to overreact to low- probability outcomes which we cover in greater detail later. Again don’t spend too much time memorizing these steps. Just remember that investors use heuristics and think about changes in wealth instead of absolute amounts of wealth. Comparing Utility Theory and Prospect Theory Utility Theory – Traditional Finance Prospect Theory – Behavioral Finance Investors value gains and losses differently. All investors are risk averse Some are risk averse to gains and risk seeking to losses Investors use “random” decision weights to Probability weight all investment outcomes model different outcomes which leads to (i.e. use a Bayesian process) lower probability events having higher weights than they deserve Behavioral Finance Frameworks There are four main behavioral finance models that seek to explain and offer suggestions for how to adjust a “rational” asset allocation to account for a client’s unique characteristics, i.e. to construct a behaviorally modified asset allocation plan. You should be broadly familiar with these models and why they are sub-optimal, but the real key for the exam will come in Reading 7. There we focus on how to actually decide, based on an investor’s actual financial situation and behavioral profile, whether we can/should accommodate their behavioral quirks based on how risky that would be. Consumption and Savings Model People feel differently about spending money vs. saving. Consumption triggers immediate gratification whereas saving involves delaying gratification. Let’s put it this way, most people like buying things, so they’re more likely to spend their money on something today than save for some more abstract idea in the future. This self-control bias leads to different ways of framing 7 Calculating probability under prospect theory has the following equation: subjective utility alternative = wPxUx,i+ wPyUy,i+ wPzUz,i 11 www.gostudy.io and bucketing current income, owned assets, and future savings, where an investor’s marginal propensity to consume is highest for current income. The way people save, invest, and think about their money is also different depending on their stage of life.8 In this case, the consumption and savings model is almost like a form of mental accounting, which is where someone places wealth into different buckets in order to meet different goals. This is inefficient because it ignores the fungible nature of wealth. See Framing, Self-control bias, & Mental Accounting. Behavioral Asset Pricing Model (BAPM) BAPM adds a sentiment premium to the CAPM model 𝑟𝑒= 𝑟𝑓 + 𝛽(𝑟𝑚 − 𝑟𝑓 ) + 𝑠𝑒𝑛𝑡𝑖𝑚𝑒𝑛𝑡 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 Where: Rf = The risk free interest rate Re = The expected rate of return The sentiment premium is an estimate derived from analyst forecasts. The greater the dispersion of analysts’ predictions, i.e. the more they disagree, the larger the sentiment premium. Behavioral Portfolio Theory (BPT) Under BPT the assumption is that people build their portfolio layer by layer according to their goals. The premise is that they will match the risk of their investments based on how much they need the money (see mental accounting and Goal Based Investing). How these layers are grouped together depends on: How important the goal is The required return to meet the goal The investor’s specific utility function The degree of information they have about the investment (> info > concentration > risk) How loss averse they are For survival essentials an investor would hold risk free assets (treasuries). For their dream yacht on the other hand they would hold riskier assets. Generally, an investor would build the risk free layer up before taking on more risk and moving up the pyramid. Think of it as mirroring Maslow’s hierarchy of needs where until you satisfy the first level you aren’t moving up. 8 In fact, when we get to the IPS section, determining an investor’s ‘stage of life’ can be key to deciding what their risk tolerance is. 12 www.gostudy.io Behavioral Portfolio Theory BPT is sub-optimal in a traditional sense because the portfolio is built with no thought to the correlation between different asset classes. Still, the disciple of allocating in this way can help investors stay calm and stick with their asset allocation strategy. Put differently, it is easier to avoid making stupid irrational investment decisions (and therefore avoiding catastrophic loss) when you know you can pay your rent next month. Adaptive Market Hypothesis (AMH) AMH refers to using heuristics (rules of thumb) until the markets evolve and you have to adapt your rules. AMH is basically efficient market theory with the idea of bounded rationality + satisficing + evolution. The adaptive market hypothesis offers a few conclusions about how to approach the market: Risk and return relationships are not stable Active management CAN generate alpha as the markets take time to adapt to new strategies Markets DO end up evolving. NO strategy works all the time (adapt or die dinosaur!) Adaption/Innovation ARE critical to success and surviving in markets 13 www.gostudy.io Summarizing the BF Frameworks Comparing the Implications of the different BF Frameworks Model What Implications Assumes investors aren’t thinking about Investors selling winning stocks too early total returns but are analyzing risk relative Prospect (to lock in gains) and holding-on or even to possible gains and losses, with loss Theory doubling down on losers to try to avoid or aversion when facing a loss & risk- recover from a loss. aversion when holding gains. The self-control bias leads to different ways People feel differently about spending of framing and bucketing current income, Consumption money vs. saving. Consumption triggers owned assets, and future savings, where an & Savings immediate gratification whereas saving investor’s marginal propensity to consume requires delaying gratification. is highest for current income. BAPM adds a sentiment premium to the The sentiment premium is an estimate CAPM model derived from analyst forecasts. The greater BAPM the dispersion of analysts’ predictions, i.e. 𝑟𝑒 = 𝑟𝑓 + 𝛽(𝑟𝑚 − 𝑟𝑓 ) the more they disagree, the larger the + 𝑠𝑒𝑛𝑡𝑖𝑚𝑒𝑛𝑡 𝑝𝑟𝑒𝑚𝑖𝑢𝑚 sentiment premium. BPT assumes that people build their portfolio layer by layer according to their Behavioral goals. The premise is that they will match BPT is sub-optimal in a traditional sense the risk of their investments based on how Portfolio because the portfolio is built with no much they need the money. For survival Theory thought to the correlation between different essentials an investor would hold risk free (BPT) asset classes. assets (treasuries). For their dream yacht on the other hand they would hold riskier assets. Risk and return relationships are not AMH refers to using heuristics (rules of stable over time thumb) until the markets evolve and you Active management CAN generate alpha Adaptive have to adapt your rules. AMH is basically as the markets take time to adapt to new Market efficient market theory with the idea of strategies Hypothesis bounded rationality + satisficing + Markets DO end up evolving. NO strategy evolution. works all the time (adapt or die!) Adaption/Innovation ARE critical to success and surviving in markets Want more notes? Get them plus a study app + mock exams and more www.gostudy.io Questions? Email
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