Behavioral Finance for CMT Level 2
Behavioral finance examines how psychological biases affect investment decisions and market outcomes. It's a significant portion of the CMT Level 2 curriculum.
Key Cognitive Biases
Overconfidence Bias
Investors overestimate their knowledge and ability to predict market movements, leading to excessive trading.
Anchoring
Relying too heavily on the first piece of information encountered (the "anchor") when making decisions.
Confirmation Bias
Seeking information that confirms existing beliefs while ignoring contradictory evidence.
Loss Aversion
The pain of losses is psychologically about twice as powerful as the pleasure of equivalent gains (Kahneman & Tversky).
Prospect Theory
Developed by Kahneman and Tversky, prospect theory describes how people choose between alternatives involving risk:
- People are risk-averse for gains
- People are risk-seeking for losses
- The value function is concave for gains, convex for losses
Herd Behavior
Markets exhibit herd behavior when investors follow the crowd rather than their own analysis. This contributes to:
- Momentum effects
- Bubble formation
- Panic selling
Market Anomalies
- January Effect: Stocks tend to rise in January
- Momentum Effect: Winners continue winning over medium timeframes
- Mean Reversion: Extreme performers tend to revert to average
- Disposition Effect: Investors sell winners too early and hold losers too long