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Level III Schweser’s QuickSheet: CRITICAL CONCEPTS FOR THE 2019 CFA EXAM
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uickSheet Cr it ic a l C o n c e pt SS1&2: ETHICS AND SS3: THE ASSET MANAGEMENT INDUSTRY Review the SchweserNotes™ and work the questions. SS4: BEHAVIORAL FINANCE • Bounded rationality —Individuals act as rationally as possible, but are constrained by lack of knowledge and cognitive ability. • Satisfice —Making a reasonable but not necessarily optimal decision. The Traditional Finance Perspective • The price is right —Asset prices reflect and instantly adjust to all available information. • No free lunch —No manager should be able to generate excess returns (alphas) consistently. M arket Efficiency • Weak-form efficient —Prices incorporate all past price and volume data. • Semi-strong form efficient - Prices reflect all public information. • Strong-form efficient - All information reflected in prices. No one can consistently earn excess returns. TH E BEHAVIORAL FINANCE PERSPECTIVE 1. Consumption and savings: • Framing —The way income is framed affects whether it is saved or consumed. • Self-control bias —Favor current consumption rather than saving income for future goals. • Mental accounting - Assigning different portions of wealth to meet different goals. 2. Behavioral asset pricing: • Sentiment premium —Added to discount rate; causes price deviation from fundamental values. 3. Behavioral portfolio theory (BPT): • Investors structure their portfolios in layers according to their goals. 4. Adaptive markets hypothesis (AMH): • Apply heuristics until they no longer work, then adjust them. Must adapt to survive. COGNITIVE ERRORS AND EM OTIONAL BIASES • Cognitive errors —Result from incomplete information or inability to analyze. • Emotional biases —Spontaneous reactions that affect how individuals see information. Cognitive Errors • Conservatism bias —Emphasizing information used in original forecast over new data. • Confirmation bias —Seeking data to support beliefs; discounting contradictory facts. • Representativeness bias —If-then stereotype heuristic used to classify new information. • Base rate neglect —Too little weight on the base rate (e.g., probability of A given B). • Sample size neglect —Inferring too much from a small new sample of information. • Control bias —Individuals feel they have more control over outcomes than they actually have. • Hindsight bias —Perceiving actual outcomes as reasonable and expected. • Anchoring and adjustment —Fixating on a target number once investor has it in mind. • Mental accounting bias —Each goal, and corresponding wealth, is considered separately. • Framing bias - Viewing information differently depending on how it is received. s for the 2019 CFA® E x a m Availability bias - Future probabilities are impacted by memorable past events. Emotional Biases • Loss aversion bias —Placing more “value” on losses than on a gain of the same magnitude. ♦ Myopic loss aversion —If individuals systematically avoid equity to avoid potential short run declines in value (loss aversion), equity prices will be biased downward (and future returns upward). • Overconfidence bias —Illusion of having superior information or ability to interpret. ♦ Prediction overconfidence —Leads to setting confidence intervals too narrow. ♦ Certainty overconfidence —Overstated probabilities of success. • Self-attribution bias —Self-enhancing bias plus self-protecting bias causes overconfidence. ♦ Self-enhancing bias —Individuals take all the credit for their successes. ♦ Self-protecting bias —Placing the blame for failure on someone or something else. • Self-control bias —Suboptimal savings due to focus on short-term over long-term goals. • Status quo bias —Individuals’ tendency to stay in their current investments. • Endowment bias —Valuing an asset already held higher