CFA Level III - Reading 7

An approach to finance based on the observation that psychological variables affect and often distort individuals’ investment decision making.

A focus on individual level behavior that examines the behavioral biases that distinguish individual investors from the rational decision makers of traditional finance.

A focus on market level behavior that considers market anomalies that distinguish markets from the efficient markets of traditional finance.

The level of relative satisfaction received from the consumption of goods and services.

Theory whereby people maximize the present value of utility subject to a present value budget constraint.

An alternative to expected utility theory, it assigns value to gains and losses (changes in wealth) rather than to final wealth, and probabilities are replaced by decision weights. In prospect theory, the shape of a decision maker’s value function is assumed to differ between the domain of gains and the domain of losses

The notion that people have informational and cognitive limitations when making decisions and do not necessarily optimize when arriving at their decisions

A hypothesis that applies principles of evolution—such as competition, adaptation, and natural selection—to financial markets in an attempt to reconcile efficient market theories with behavioral alternatives

Assumes that investors are rational: Investors are risk-averse, self-interested utility-maximizers who process available information in an unbiased way.

Apparent deviations from market efficiency (fundamental anomaly, calendar anomaly, technical anomaly)

Assumes investors exhibit framing, self-control bias, and mental accounting. Due to lack of self-control, they can fail to maximize the trade-off between current consumption and long-term planning. Mental accounting is caused by framing and can lead to suboptimal portfolios but can also lead to the protection of certain assets from consumption.

Suggests that the discount rate used to value an asset should include a sentiment risk premium.

Suggests that portfolios are constructed in layers to satisfy investor goals rather than to be mean–variance efficient.

Suggests that people classify their assets into non-fungible (co the thay the duoc) mental accounts and develop spending (current consumption) and savings (future consumption) plans that, although not optimal, achieve some balance between short-term gratification (satisfaction) and long-term goals.

A self-interested, risk-averse individual who has the ability to make judgments using all available information in order to maximize his/her expected utility.