Behavioral Finance

Prepared by: PRINCESS THERESE B. PACUÑO

E-mail Address: [email protected]

DATA CENTER COLLEGE of the Philippines

Brgy.Ubbog, Lipcan, Bangued, Abra
Tel./Fax No.: (074) 752 - 5162

Instructional Module for BEHAVIORAL

FINANCE
First Term S.Y 2021 – 2022

Module 1
Topic 2 Foundations of Finance II

Name:
Course/Year:

I. Learning Activities
2.1 RISK and RETURN for INDIVIDUAL ASSETS

The PRICING of RISK

Price risk is the risk of a decline in the value of a security or an

investment portfolio excluding a downturn in the market, due to multiple
factors. Investors can employ a number of tools and techniques to hedge
price risk, ranging from relatively conservative decisions.

• Modern Portfolio Theory provides a practical framework that

assumes that investors are risk averse and preferences are defined
in terms of the mean and variance of returns.
• This theory is based on statistics. So, it is empirically based and the
variables are measurable.
• We can think of the return on an asset as being a random variable.
In other words, the return next period is not perfectly predictable,
but it is determined by a probability distribution.
Parameters describing probability distribution:
a) Expected Value of Returns = 𝐸(𝑅𝑖 ), where E(•) denotes
expectation.
- The expected value is a kind of distributional average
b) Variance of Returns = 𝜎𝑖2 reflects squared deviations from the
mean, so, large deviations above or below the mean count equally.
c) Standard Deviation of Returns = (𝜎𝑖 ) is simply the positive square
root of the variance.
d) Mean Return is computed as:
𝒏
𝟏
𝑹̅ 𝒊 = ∑ 𝑹 𝑖, 𝑡
𝒏
𝒕=𝟏
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2.2 Behavioral Finance

The mean return is our best estimate of the true distributional expected
value of returns. The sample variance of returns is:
𝑛
1
2.2 𝑠𝑖2 ∑ (𝑅𝑖,𝑡 − 𝑅̅𝑖 )2
𝑛−1
𝑡=1
The sample standard deviation of returns is:
2
2.3 𝑆𝑖 = √𝑆 𝑖
• Sample variance and sample standard deviation are estimates of the
true distributional variance and deviation.
• These measures for mean return and risk, the investor can make risk-
return trade-off comparisons.

2. 2 RISK and RETURN for PORTFOLIOS of ASSETS

• Smart investors understand the risk of a portfolio is not simply

the average risk of the assets in the portfolio.
• By combining assets in a portfolio, investors can eliminate
some, but not all, variability.
• “don’t put all your eggs in one basket.” – principle of
diversification which is an important factor when setting an
investment strategy
• Statistical measures of how random variables are related are
covariance and correlation
e) Covariance of a sample including n returns for assets i and j is:
𝑛
1
2.4 𝜎̂ (𝑅𝑖 , 𝑅𝑗 ) = ∑( 𝑅𝑖,𝑡 − 𝑅̅𝑖 ) (𝑅𝑗,𝑡 − 𝑅̅𝑗 )
𝑛−1
𝑡=1
f) The sample correlation is the sample covariance divided by the
product of the standard deviations of returns for each asset or:
𝜎̂ (𝑅𝑖 , 𝑅𝑗 )
2.5 𝜌̂𝑖,𝑗 =
𝑠𝑖 𝑆𝑗
• Note that true distributional parameters (covariance and
correlation) are written as 𝜎(𝑅𝑖 , 𝑅𝑗 ) and 𝜌𝑖,𝑗 which means we
merely remove the “hats”
• The correlation always lies between -1.0 and +1.0, whereas the
covariance can take any positive or negative value.
• With a measure of how the returns for the two assets move
together or apart, we can compute the portfolio is simply the
weighted average of the mean returns of each asset, with the
weights (𝑤𝑖 ) representing the percentage amount invested in
each asset.
2.6 ̅̅̅𝑝̅ = 𝑤𝑖 𝑅̅𝑖 + 𝑤𝑗 𝑅̅𝑗
𝑅
• Weights must sum to 1.0 (representing 100%) because our
money must be invested somewhere. It can be shown that the
sample variance of portfolio is:
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 Behavioral Finance

𝑠𝑝2 = 𝑤𝑖2 𝑆𝑖2 + 𝑤𝑖2 𝑆𝑖2 + 2𝑤𝑖 𝑤𝑗 𝜌̂𝑖,𝑗 𝑠𝑖 𝑠𝑗

• Correlation is less than 1.0, the standard deviation of returns for

the portfolio will be lower than the weighted average of the
standard deviations of returns for the two assets.
2.8
̅̅̅𝑝̅ = 𝑤𝑖 𝑅̅𝑖 + 𝑤𝑖 𝑅̅𝑗 + 𝑤𝑘 𝑅̅𝑘
𝑅

• The variance is:

2.9 𝑠𝑝2 = 𝑤𝑖2 𝑠𝑖2 + 𝑤𝑗2 𝑠𝑗2 + 𝑤𝑘2 𝑠𝑘2 + 2𝑤𝑖 𝑤𝑗 𝜌̂𝑖,𝑗 𝑠𝑖 𝑠𝑗 +
2𝑤𝑖 𝑤𝑘 𝜌̂𝑖,𝑘 𝑠𝑖 𝑠𝑘 + 2𝑤𝑗 𝑤𝑘 𝜌̂𝑗,𝑘 𝑠𝑗 𝑠𝑘

• As more assets are added to the portfolio, the expressions

expand analogously, and additional variability is eliminated
through the diversification – up to a limit.

2. 3 THE OPTIMAL PORTFOLIO

• Sample statistics for a set of portfolio returns ̅̅̅

(𝑅𝑝 , 𝑠𝑝2 )
• When choosing optimal portfolios, it is important to use distributions that
generate returns in the future
• Remember that historical sample estimates are only estimates for the true
distributional parameters
• True distributional variances (𝐸(𝑅𝑝 ), 𝜎𝑝2 )3
Example:
Suppose there are only two stocks and a risk-free asset in a market. The stocks are
ownership interests in High Tech Corporation and Low-Tech Corporation, and the
risk-free asset can be thought of as investing in short-term government bonds such
as U.S Treasury bills or depositing funds in a bank. Information for the three
investment opportunities is summarized as:

Standard Deviation of
Expected Return
Returns
High Tech (HT) 15% 30%
Low Tech (LT) 8% 10%
Risk-free Asset (RF) 4% 0%
Correlation between HT and LT -0.10
Correlation between HT and RF 0
Correlation between LT and RF 0

✓ High Tech has the highest expected return of 15% but also the highest
variability in returns of 8% and variability of 10%. The risk-free asset
provides a low, but risk-free return of 4%.
✓ The returns to High Tech and Low Tech are negatively correlated.
✓ The risk-free asset’s returns are certain and uncorrelated with the other
asset’s returns
✓ Zero variability in returns is what is meant by risk-free investment
✓ Now, using the formula given. Suppose you put 40% of your funds in High
Tech and 60% in Low Tech. The expected return for the portfolio is:
𝐸 (𝑅𝑃 ) = 0.40(0.15) + 0.60(0.08) = 0.108
✓ And the variance of portfolio returns is:

𝜎𝑝2 = 0.402 0.302 + 0.602 0.102 + 2(0.40)(0.60)(−0.10)(0.30)(0.10)

= 0.0166
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✓ Taking the square root of variance gives a standard deviation of 0.1288 or

12.88%
✓ Notice that the standard deviation is less than the weighted average of the
standard deviations of each stock

Moreover, if there are many stocks to choose from, how much should we invest in
each? Here is where the efficient set comes in. We begin with figure 2.1 below:

Figure 2.1

✓ Figure 2.1 depicts all possible risk-return combinations of High Tech and
Low Tech.
✓ The curve in the figure is constructed by varying the weights for each asset
and recalculating the expected return and standard deviation.
✓ The curvature of this relationship stems from the correlation between the two
securities: the lower the correlation, the greater the curvature

Figure 2.2

✓ Figure 2.2 shows that investors actually have thousands of risky investment
opportunities.
✓ So, if we consider all combinations of securities, it can be shown that a graph
depicting all these combinations would show a solid curved mass which is
sometimes compared to a “bullet.”
✓ With the figure 2.2, notice that several individual investments (A-D) and
several portfolios (E-G) are shown.
✓ In the manner of Figure 2.1, if we combine individual investments on a
pairwise basis, we achieve diversification as reflected in the risk-return trade
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 Behavioral Finance

off curves.
✓ By mixing together, we can do even better. Because, when we have moved
as far as to the left as possible in all portfolios, we have reached the “skin”
of the bullet.
✓ Above to the right of the minimum risk point is the curve we called “efficient
frontier”

a) Efficient Frontier represents that set of portfolios that maximize expected

return for a given level of risk.
- Represents that set of portfolios that maximize expected returns for a
given level of risk
- No investor would choose a portfolio under the curve because this would
not be optimal
- Rational investors would choose a portfolio on the efficient frontier
b) Diversifiable risk or non-systematic risk is when there are more assets
added on the portfolio, the investor can eliminate more risks because assets
seldom move in tandem.
- The risk that can be diversified is specific to the asset in the question
- For a common stock, this would reflect firm specific events
c) Non-diversifiable risk or systematic risk is the risk we cannot eliminate.
- This is common to all risky assets in the system. So, w cannot diversify
it away no matter how may stocks are added in the portfolio
- If we add the assumption that all investors have the same, or
homogenous, expectations, then all investors have the same efficient
frontier

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 Behavioral Finance

II. Assessment

Activity 2.1
Define the following terms in your own
definitions.
1. Systematic and Nonsystematic Risk
2. Beta and Standard Deviation
3. Direct and Indirect Agency Costs
4. Weak, Sem-strong, and Strong Form Market Efficiency

Activity 2.2
1. Angelique Alvaro has been a very successful investor. Now, she’s
interested in investing in the Technology sector. Their portfolio
contains the following:
• Lazo Inc., P500, 000 invested and an expected return of 15%
• Viste Inc. P200, 000 invested and an expected return of 6%
• Acosta Inc P300, 000 invested and an expected return of 9%
With a total portfolio value of P1 Million, the weights of Lazo,
Viste, and Acosta in the portfolio are 50%, 20% and 30%
respectively.
a. What is the total expected return of the portfolio?
b. Which stock is riskier?

2. Griethe Belle owns stock in two competing restaurant chains. The

price of one chain's stock plummets because of an outbreak of
foodborne illness. As a result, the competitor realizes a surge in
business and its stock price. The decline in the market price of one
stock is compensated by the increase in the stock price of the other.
How will you lessen further risk?

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III. References

• Behavioral Finance: Psychology, Decision Making and

Market; Lucky Ackert & Richard Deaves; 2013, Cengage
Learning Asia Pte Ltd.
• https://www.investopedia.com/terms/p/pricerisk.asp#:~:text=P
rice%20risk%20is%20the%20risk%20that%20the%20value%
20of%20a,tool%20to%20mitigate%20price%20risk.

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