Bayesian Networks: A Decision Tool to Improve Portfolio Risk Analysis

This paper demonstrates how Bayesian Networks can aid decisions of individual security analysts and portfolio managers. We present a decision tool to improve analysts' forecasts, portfolio decision-making, and risk analysis. Our paper is related to findings in behavioral finance that show buying and selling behavior that is consistent with biased decision-making. However, most behavioral finance literature is descriptive, not normative. Our goal is to improve rational financial decision making by helping analysts de-bias their probability assessments and systematically improve value-at-risk forecasts. We illustrate how to combine historical quantitative information with qualitative information in a systematic way using a graphical modeling tool called Bayesian networks.

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