Behavior Finance Flashcards
Behavior Finance
Attempts to understand and explain observed investor and market behaviors. At its core, behavior finance is about understanding how investors and market behave
Traditional Finance
Based on hypotheses about how investors and markets should behave
Utility Theory
In utility theory, people maximize the present value of utility subject to a present budget contraint.
Utility
thought of as the level of relative satisfaction received from the consumption of goods and services
Axioms of Utility Theory
Assumes that a rational decision maker follows rules of preference consistent with the axioms and the utility function of a rational decision maker reflects the axioms
The basic axioms of Utitlity Theory are?
- Completeness
- Transitivity
- independence
- Continuity
Completeness
Assumes that an individual has well-defined preferences and can decide between any two alternatives
Axiom (Completeness)
Given choices A and B, the individual either prefers A to B, prefers B to A, or is indifferent between A and B
Transitivity
Assumes that, as an individual decides according to the completeness axiom, an individual decides consistently
Axiom (Transitivity)
Transitivity is illustrated by the following examples: Given choices A, B, and C, if an individual prefers A to B and prefers B to C., then the individual prefers A to C; if an individual prefers A to B and is indifferent between B and C, then the individual prefers A to C; or if an individual is indifferent between A and B and prefers A to C, then the individual prefers B to C
Independence
Also pertains to well-defined preferences and assumes that the preference order of two choices combined in the same proportion with a third choice maintains the same preference order as the original preference order of the two choices
Axiom (Independence)
Let A and B be two mutually exclusive choices, and let C be a third choice that can be combined with A or B. If A is preferred to B and some amount, x, of C is added to A and B, then A plus xC is preferred to B plus xC. This assumption allows for additive utilities. If the utility of A is dependent on how much of C is available, the utilities are not additive.
Continuity
Assumes there are continuous (unbroken) indifference curves such that an individual is indifferent between all points, representing combinations of choices, on a single difference curve
Axiom (Continuity)
When there are three lotteries (A, B, and C) and the individual prefers A to B and B to C, then there should be a possible combination of A and C such that the individual is indifferent between this combination and the lottery B. The end result is continuous indifference curves.
Bayes’ Formula
A mathematical rule explaining how existing probability beliefs should be changed given new information
Bayes’ Formula shows how one conditional probability is inversely related to the probability of another mutually exclusive outcome.
The formula is
P(A|B) = [P(B|A)/P(B)] P(A)
where
P(A|B) = conditional probability of event A given B. It is the updated probability of A given the new information B
P(B|A) = conditional probability of B given A. It is the probability of the new information B given event A
P(B) = prior (unconditional) probability of information B
P(A) = prior probability of event A, without new information B. This is the base rate or base probability of event A.
Example of Bayes’ Formula
You have two identical urns, U1 and U2. U1 has 2 red balls (R) and 3 white balls (W). U2 has 4 red balls and 1 white ball. You randomly choose one of the urns to pick out a ball. A red ball is pulled out first. What is the probability that you picked U1, based on the fact that a red ball was pulled out first, P(U1|R)?
Solution:
P(R|U1) is the conditional probability of a red ball being pulled out, given U1 is picked:
2 red balls/5 balls = 40%
P(U1) is the probability of picking U1:
1 urn/2 urns = 50%
P(R) is the probability of a red ball being picked regardless of which urn is picked:
2 red balls in U1 + 4 red balls in U2 = 6 red balls
6 red balls/10 balls = 60%
P(U1|R) is the objective of the exercise. Based on the above formula, we calculate:
P(U1|R) = [P(R|U1)/P(R)] P(U1) = [40%/60%]50% = 33.3%
This solution can also be shown using a probability tree. In Exhibit 1, we can see that the probability of U1 being picked and a red ball being chosen is P(U1) × P(R|U1) = (0.5 × 0.4) = 0.20. The probability of picking a red ball if either urn is picked is P(R) = (0.20 + 0.40) = 0.60. Therefore, because we know that a red ball was picked, we can find the probability of having chosen U1 by dividing the probability of choosing both U1 and a red ball by the probability of choosing ared ball. This gives us 0.333 or 33.3% [= 0.20/0.60].
Rational economic man (REM)
Uses indifference curves to make choices
Behavioral Perspectives
- REM is invalid
- Decision-making abilities inherently limited
- Disregards inner conflicts (e.g. spending vs. saving, individual vs.
societal goals) - Imperfect information
- Individuals unlikely to perform complex indifference curve
analyses - Individual can exhibit risk-seeking behavior (e.g. lottery tickets)
- Prospect theory
Risk Evaluation
Empirically, individuals do not always exhibit risk aversion. Risk evaluation is reference-dependent. In other words, risk evaluation depends on the wealth level and circumstances of the decision maker. Prospect theory accounts for this phenomenon by assigning value to changes in wealth rather than to final wealth.
Bound Rationality
Bounded rationality relaxes the assumptions of perfect information and utility maximization.
Prospect Theory
An alternative to expected utility theory, prospect theory describes how individuals make choices between risky alternatives and how they evaluate potential gains/losses. Prospect theory is a two-stage process involving a framing stage that uses heuristics to quickly analyze and sort the alternatives, followed by an evaluation phase in which the alternatives are evaluated and selected following a process similar to utility theory but with a focus on gains and losses rather than absolute wealth.
Framing stage:
(1) Codification - outcomes are categorized as either gains or losses; (2) Combination - summing of the probabilities of alternatives with identical outcomes;
(3) Segregation - the riskless and risky components of each alternative are separated;
(4) Cancellation - common outcome probability pairs are discarded; (5) Simplification - probabilities are rounded off;
(6) Detection of dominance - outcomes that are strictly dominated are eliminate
Efficient Market Hypothesis (EMH)
Markets fully, accurately, and instantaneously incorporate all available information into market prices
EMH Anomalies
- Fundamental anomalies - irregularities that emerge when one considers a stock’s future performance based on fundamental assessments
- Company size, value vs. growth, etc.
- Technical anomalies - irregularities that emerge when one considers past prices and volume levels
- Buy and sell signals generated by moving averages, range
breaks, and other technical analysis techniques
- Buy and sell signals generated by moving averages, range
- Calendar anomalies - irregularities that emerge in patterns of trading behavior at certain times of the year
- January effect, turn-of-the-month effect, etc.
Traditional Finance Perspective
- week-form efficient: current prices incorporate all past price and volume data. If markets are weakly efficient, managers cannot consistently generate excess returns using technical analysis.
- semi-strong form: prices reflect all public information. If markets are semi-strong efficient, managers cannot consistently generate excess returns using technical or fundamental analysis.
- strong-form efficiency: price reflects all privileged nonpublic information. No analysis based on inside and/or public information can consistently generate excess returns.
Fundamental Anomalies
technical anomalies
calendar anomalies
Consumption and savings
Behavioral asset pricing
