Chapter 3 - Behavioural Finance

[Bill SD]

Hi,
I have a specific and general question on this topic:
1) Specific - Please can you provide examples of the 'acceptance' and 'segregation' operations in the editing/framing process. (Acted provide 2 examples in the notes on pg 11 (Chapter 3) but unsure if refer to 'acceptance' and 'segregation', or other 'framing effects'.

2) General - Is it necessary in Paper A exam to use the correct name for a behavioural pattern/bias/heuristic or will receive full marks if just describe the bias correctly. (The exact names seem to have changed over time). Additionally, the behavioural pattern/bias/heuristics often seem overlapping depending on the circumstances. Would one receive credit for a reasonable, well-justified answer, even if doesn't appear on the examiners report (like this query: https://www.acted.co.uk/forums/index.php?threads/april-2021-cm2a-q7-iv.18062/) (suppose this similarly applies to any IFoA exam

Thanks very much

 

[Steve Hales]

Hi
When presented with a number of choices we usually conform to answering the stated question rather than challenge the options given. For example, when ordering coffee you might be asked whether you want the "medium" or "large". The acceptance principle says that most people will choose one of these two outcomes even though they really only wanted the "small".
Making decisions is hard, so we often reduce the problem to something more straightforward. Imagine purchasing a product from the supermarket where there are a range of possible quantities available (eg a 100g, 250g and 1kg option). The segmentation principle says that we often focus on the most relevant factors (eg the price of the item), but this might be missing the true factors (eg the price per 100g).

Where possible it is always best to use the key technical terms from the Core Reading when answering such questions. On the topic of behavioural finance there might not be a single correct answer, and so the instructional word could easily be "Discuss" rather than "State" in an exam question.

 

[Bill SD]

Thanks very much Steve - for segregation/segmentation, does 'relevant' just mean 'readily available' (ie. the item price which is displayed clearly on shelf/website) or does the meaning of 'relevant' change depending on the situation/individual decision maker?

And is the Question on pg 11 (copied below) an example of segregation/segmentation (and here 'relevant' means money received for certain) or is it a different type of framing effect?

"Identify which of the following two alternatives you would prefer:
1. $30 for certain plus a 50% chance of losing $20; or
2. $10 for certain plus a 50% chance of winning $20."

 

[Steve Hales]

"Relevant" is dependent on the scenario. In the Core Reading the word is in quotes marks to indicate that whilst the investor/consumer thinks that aspect is important - it might not actually be so.

In the example you've given there's a strong acceptance theme going on because there are only two outcomes and we're likely to answer in the prescribed format. The "relevant" factors used to make the decision could be a number of things; expected return, maximum possible return, maximum certain win etc.

 

[Bill SD]

Thanks again for your helpful answers. Three additional questions:

Q1: Is there a clear distinction between a behavioural pattern (eg endowment/isolation effects, probability weighting) and a behavioural bias (eg. status quo, self-attribution)?

Q2: And similarly is there a clear distinction between these two (behavioural patterns &biases) and heuristics? For example, reference dependence, isolation effects and status quo bias also help a brain reach quicker decisions.

Q3: Is Prospect Theory essentially the 'changing risk attitudes' behavioural pattern?

 

[Alvin Kissoon]

Hi,

Good questions! I'll take these in reverse order:

Q3: Prospect Theory talks about people make real-life decisions, based on gains and losses and decision weights (as opposed to Expected Utility Theory, based on wealth and probabilities). The 'changing risk attitudes' behavioural pattern (with diminishing sensitivity) does describe the shape of the utility function based on gains and losses. However, prospect theory is more than this - other features such as use of decision weights and isolation effect also explain how we evaluate choices. Prospect theory also covers the editing/framing phase.

Q1 and 2: Heuristics talks about how we use shortcuts to deliver quick decisions under System 1. Ideally these shortcuts would be accurate and would reach the same decision as if we used System 2. However behavioural biases are examples where our shortcuts do not arrive at the same result - where our shortcut does not reflect what is happening in reality. Behavioural patterns is referring to how we evaluate choices (rather than talking about shortcuts).

I hope this helps.

Alvin.

 

[Bill SD]

Thanks very much Alvin. Two further questions to make sure i understand:
Q4: Are all (i) irrational behavioural patterns, (ii) flawed heuristics & (iii) behavioural patterns considered part of prospect theory?
And Q5: Does prospect theory suggest that by default, system 1 conducts the two phases of prospect theory -editing and evaluation? And ideally a rational person should identify System 1's biases, flawed heuristics &behavioural patterns by consciously involving System 2 in both of these phases.

 

[Alvin Kissoon]

Hi Bill,
Q4 - Yes, you're right. Prospect theory covers all of these aspects, which are considered features of human decision-making.
Q5 - Essentially, yes. In practice, both System 1 and System 2 parts of the brain get involved when making a decision, but most of the time the more instinctive part (System 1) is dominant because we are in need of a quick decision and our brain wants to exert less mental energy. If we are forced to use our more logical part (System 2) more eg for more complex problems, then a more rational choice is made.
Alvin.

 

[Bill SD]

H
Q1 and 2: Heuristics talks about how we use shortcuts to deliver quick decisions under System 1. Ideally these shortcuts would be accurate and would reach the same decision as if we used System 2. However behavioural biases are examples where our shortcuts do not arrive at the same result - where our shortcut does not reflect what is happening in reality. Behavioural patterns is referring to how we evaluate choices (rather than talking about shortcuts).

Found it interesting &annoying! to see from past papers that examiners use the terms ((behavioural patterns, biases and heuristics) interchangeably. Eg. April 2021 Q7 asks to name 'behavioural biases' yet the Examiners Report focuses on the heuristics: anchoring, adjustment and familiarity. So unfortunately these questions can be quite time consuming working down the long list of patterns, biases and heuristics to identify and explain which is most appropriate. [I had originally hoped i could focus on whichever subset (ie. pattern, bias or heuristic) was mentioned in the question.]