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Go Study’s
CFA Exam Level 3
®

Traditional vs. Behavioral

Finance

by GoStudy™
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Everything you need to pass & nothing you don’t

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Guided Notes for CFA® Level 3 – 2016

Copyright © 2016 by Go Study LLC.® All Rights Reserved. Published in 2016

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Reproduced and republished from 2016 Learning Outcome Statements, Level III CFA® Program
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Disclaimer: These guided notes condense the original CFA Institute study material into 300
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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.

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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).

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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.

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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).

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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.

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An excellent recap of the CAPM model can be found here.

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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.

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Obviously I can’t guarantee that you won’t be tested on something like this, but it’s really in the weeds.

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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.

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 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).

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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.

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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

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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

All investors are risk averse
Probability weight all investment outcomes
(i.e. use a Bayesian process)
Investors value gains and losses differently.
Some are risk averse to gains and risk seeking
to losses
Investors use “random” decision weights to
model different outcomes which leads to
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

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Calculating probability under prospect theory has the following equation: subjective utility alternative =
wPxUx,i+ wPyUy,i+ wPzUz,i

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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.

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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.

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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

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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

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