A risk management framework flows logically from the definition of risk management that was previously given: It is the infrastructure, process, and analytics needed to support effective risk management in an organisation. Despite customisation, every risk management system or framework should address the following key factors:
Risk, broadly speaking, is exposure to uncertainty. Risk is also the concept used to describe all of the uncertain environmental variables that lead to variation in and unpredictability of outcomes. More colloquially, risk is about the chance of a loss or adverse outcome as a result of an action, inaction, or external event. Risk exposure is…
Defining Market Anomalies Anomalies are apparent deviations from the efficient market hypothesis, identified by persistent abnormal returns that differ from zero and are predictable in direction. Not every deviation is anomalous. Misclassifications tend to stem from three sources: choice of asset pricing model, statistical issues, and temporary disequilibria. Momentum Bubbles and Crashes
Loss-Aversion Bias Overconfidence Bias Overconfidence bias is a bias in which people demonstrate unwarranted faith in their own abilities. Overconfidence may be intensified when combined with self-attribution bias, in which people take too much credit for successes (self-enhancing) and assign responsibility to others for failures (self-protecting). Overconfidence has aspects of both cognitive and emotional errors but is…
Belief Perseverance Biases Belief perseverance biases result from the mental discomfort that occurs when new information conflicts with previously held beliefs or cognitions, known as cognitive dissonance. Conservatism Bias Conservatism bias is a belief perseverance bias in which people maintain their prior views or forecasts by inadequately incorporating new, conflicting information.
In general, behavioral biases come in two forms: faulty cognitive reasoning, known as cognitive errors, and those based on feelings or emotions, known as emotional biases. Both forms of bias, regardless of their source, may cause decisions to deviate from what is assumed by traditional finance theory.
