Behavioral Finance

Question 1

Who is the father of economics?

Answer 1

Adam Smith

Question 2

When did behavioral finance/economics arise?

Answer 2

Around the 1990s

Question 3

What did Adam Smith mean by Invisible Hand?

Answer 3

The free market is the invisible hand directing the economy

Question 4

What are main points of Adam Smith’s Theory of Moral Sentiments?

Answer 4

• people want praise
• people don’t want praise for something they didn’t do
• mature people want not praise but to be praiseworthy
• mathematicians are not famous but vie to have praiseworthy achievements

Question 5

What are some roles of psychology in finance?

Answer 5

Prospect theory, overconfidence, cognitive dissonance, mental compartments, attention anomalies, anchoring, representative heuristic, disjunction effect, magical thinking, culture, antisocial personality disorder

Question 6

What is prospect theory?

Answer 6

Prospect theory demonstrates that people think in terms of expected utility relative to a reference point (e.g. current wealth) rather than absolute outcomes. Prospect theory is a behavioral model that shows how people decide between alternatives that involve risk and uncertainty (e.g. % likelihood of gains or losses).

Question 7

What is utility theory?

Answer 7

Everyone has a utility function, which depends on things they consume, which represent their happiness. Then, in a certain world they choose how much to buy at market prices to maximize utility. But, in an uncertain world, they use probabilities of possible events to calculate and maximize expected utility

Question 8

What are two elements inherent in prospect theory?

Answer 8

Value function and weighting function

Question 9

What does prospect theory replace?

Answer 9

The value and weighting function replace the utility function which had been dominating economic thought

Question 10

Draw a value function

Answer 10

Value 
                      |
                      |
Losses ——Ref — Gains 
                      |
                      |
Kink at reference point

Question 11

Draw a weighting function

Answer 11

P

Question 12

What does the weighting function mean?

Answer 12

Prospect Theory predicts that people multiply the perceived value of an outcome by a decision weight, and not, as in expected utility theory, multiply the perceived outcome by the objective likelihood the outcome will occur.

Question 13

What does prospect theory value function mean?

Answer 13

Prospect theory replaces the utility function u(·) over states of wealth with a value function v(·) over gains and losses relative to a reference point, with v(0)=0.

Question 14

What is the key motivator for the development of prospect theory?

Answer 14

Contrary to Expected Utility Theory, people have a skewed idea of probability, and don’t treat gains and losses the same. For example, if one financial advisor says a fund has 12% gains over 10 years, and another says something equivalent but mentions its loss years, even though they are the same fund, people will choose the first advisor.

Question 15

What is an indifference curve?

Answer 15

An indifference curve shows a combination of two goods that give a consumer equal satisfaction and utility thereby making the consumer indifferent.

Question 16

How does prospect theory replace utility theory?

Answer 16

First, they replaced the utility function with the value function, i.e., the idea of value replaced the idea of utility. Second, they replaced probabilities with subjective probabilities,i.e., relative to their own wealth.

Question 17

What are some reasons utility theory does not align with people’s psychology but prospect theory does?

Answer 17

People get overly worried about small losses. People will gamble after a series of losses to recoup those losses. In general people have a skewed perspective of probability and don’t treat gains and losses the same. Also, people are not necessarily maximizing; they might take a lower utility in exchange for certainty.

Question 18

What is the difference between a financial theorist and a financial engineer?

Answer 18

A theorist wants to make beautiful models, and an engineer wants to make a device that works under many real world conditions and with real people.

Question 19

What are some logical fallacies people fall prey to in financial situations?

Answer 19

Overconfidence, or wishful thinking; cognitive dissonance; mental compartments; attention anomalies; anchoring; representativeness heuristic; disjunction effect; magical thinking; quasi-magical thinking; culture and social contagion; anti-social personality disorder

Question 20

Name three overconfidences?

Answer 20

Wishful thinking; overconfidence in friends and leaders; overconfidence in people

Question 21

What is cognitive dissonance?

Answer 21

Mental conflict when one learns one’s beliefs are wrong, which can lead to avoidance behavior, e.g., keep the losing fund because of being in denial

Question 22

What is meant by mental compartments?

Answer 22

Portfolio divided into risk, or fun part of portfolio vs part where no or less risk is taken

Question 23

What are attention anomalies?

Answer 23

Everyone paying attention to one stock, for example, leading to overpriced stock

Question 24

What is anchoring?

Answer 24

The tendency in ambiguous situations to allow our decisions to be affected by an anchor, such as past stock values

Question 25

What is the representativeness heuristic?

Answer 25

People judge according to a perception that the stock is a familiar type, but it’s really a random walk , not seeing what os different

Question 26

What is the disjunction effect?

Answer 26

Inability to make a decision that is contingent on future information

Question 27

What is magic thinking?

Answer 27

Superstition; or when an unexplained event occurs, we have the tendency to attribute ourselves as a cause without evidence, i.e., we somehow were the cause

Question 28

What is quasi-magical thinking?

Answer 28

Describes cases in which people act as if they erroneously believe that their action influences the outcome, even though they do not really hold that belief. People may realize that a superstitious intuition is logically false, but act as if it were true because they do not exert an effort to correct the intuition.

Question 29

What is social contagion?

Answer 29

The tendency to adopt other people’s beliefs

Question 30

What is antisocial personality disorder?

Answer 30

Self-esteem from personal gain; no prosocial internal standards; lack of empathy; manipulative/deceitful; irresponsible/impulsive/risk-taking

Question 31

What is borderline personality disorder (among women mostly)?

Answer 31

Instability in interpersonal relationships and self image; extremes of over idealization and then devaluation of others; depressed moods lasting days; inappropriate intense anger; frantic efforts to avoid real or imagined abandonment

Question 32

Prospect theory says what about people’s behavior with respect to losses?

Answer 32

People will take big risks to escape losses. E.g., after a losing day at the card table, they’ll go all in on the gamble that they might erase their losses.

Question 33

What problems does prospect theory solve?

Answer 33

People don’t behave the way utility theory predicts