BF flash cards
A good bet based on the analysis of something’s value
Real life arbitrage
Four key features of experience effects
Long-lasting effects, Recency bias, most recent experiences get larger weight, and Domain-specific effects
No cost, profits up front, and no risk
Textbook arbitrage
Arbitrage
According to textbook arbitrage, costs equal zero, profit up front, and no risk. This is however not what we observe in real life. Arbitrage in real life is more like a “good bet”, where you most of the time have risk.
When a stock is overvalued, what do you do?
Short the overvalued stock and long a heavily correlated one
When a stock is undervalued, what do you do?
Long the undervalued stock, and short a heavily correlated one
Long short trades
This concept is heavily used when it comes to arbitrage. You are long/short the stock that is under-/overpriced and short/long an asset that is correlated. Since it is almost impossible to be 100% sure of the fundamental value and the correlation, there will always be some risk in real life.
Limits to arbitrage, short sales constraints:
90% of lending balances are less than 1%, and the rest are usually hot stocks that are expensive to borrow, leading to higher risk and less demand. This refers to short-sales constraints where you can’t short a stock. Short selling does not make you popular; after all, you are betting for something to go bad. During crises, there can be short-selling bans, as in 2020 and 2008.
Participants in the shorting market:
- Borrowers, investors looking to short a stock.
- Owners own the share the borrowers want to borrow.
- Intermediaries, banks that manage the shares for the owner, for a %.
When investors disagree on the value of a stock, what risk does it have?
Noise trader risk
Limits to arbitrage, noise trader risk:
When investors do not agree on the price of a security, for example, GameStop, tesla. When this happened there will be noise trader risk, you short something that is worth shorting when other buys it making it go up in value.
What do rational and irrational beliefs and rational preferences affect?
Decision-making
What affects decision-making?
- Rationality concerning beliefs: If people receive new information, they update their beliefs instantly, and correctly.
- Irrationality concerning beliefs: Beliefs are not updated instantly or correctly.
- Rationality concerning preferences: Given their beliefs, people make choices that are consistent with their utility function (more specifically, EUT). Preferences can differ but cannot be irrational. But one can act irrationally given their preferences.
Biases or Heuristics are?
Mistakes when it comes to beliefs
What are mistakes when it comes to belifes called?
Biases or Heuristics
What are the 12 biases?
CARWASH SCOOB
Conservatism, Anchoring, Representativeness, Wishful thinking, Availability, Self-attribution, hindsight, status-quo bias, Confirmation, Optimism, Overconfidence, Belief perseverance
This is when people are too slow to update their beliefs based on evidence. For example, someone might continue to believe that all dogs are dangerous even after meeting several friendly dogs.
Conservatism
Conservatism
This is when people are too slow to update their beliefs based on evidence. For example, someone might continue to believe that all dogs are dangerous even after meeting several friendly dogs.
This is the tendency to hold onto beliefs even after they’ve been proven wrong. For instance, someone may still believe in a false rumor about a celebrity even after it’s been publicly debunked.
Belief Perseverance
Belief Perseverance
This is the tendency to hold onto beliefs even after they’ve been proven wrong. For instance, someone may still believe in a false rumor about a celebrity even after it’s been publicly debunked.
This is when an individual relies too heavily on an initial piece of information when making decisions. For example, if a store first shows you a $500 watch, then a $200 watch, you might perceive the second watch as a bargain.
Anchoring
Anchoring
This is when an individual relies too heavily on an initial piece of information when making decisions. For example, if a store first shows you a $500 watch, then a $200 watch, you might perceive the second watch as a bargain.
This is when individuals attribute successful outcomes to their own skills or traits and unsuccessful outcomes to external factors. For instance, a student might credit their high test score to their intelligence (not their study habits), but blame a low score on an unfair test.
Self-Attribution Bias
Self-Attribution Bias
This is when individuals attribute successful outcomes to their own skills or traits and unsuccessful outcomes to external factors. For instance, a student might credit their high test score to their intelligence (not their study habits), but blame a low score on an unfair test.
This is when one believes they would have predicted an event after it has already happened. For example, after a sports game, a fan might claim, “I knew we were going to win!”
Hindsight Bias
Hindsight Bias
This is when one believes they would have predicted an event after it has already happened. For example, after a sports game, a fan might claim, “I knew we were going to win!”
This bias occurs when a person’s confidence in their judgments is greater than the accuracy of those judgments. For instance, a driver might be confident they can text and drive safely, even though this is generally not true.
Overconfidence
Wishful Thinking
This is when beliefs are based more on what is pleasing to imagine than on evidence or rationality. For instance, a lottery player might overestimate their chances of winning, simply because they like imagining the possibility.
This is when beliefs are based more on what is pleasing to imagine than on evidence or rationality. For instance, a lottery player might overestimate their chances of winning, simply because they like imagining the possibility.
Wishful Thinking
Optimism Bias
This is when a person believes they are less at risk of experiencing a negative event compared to others. For example, a smoker might think they are less likely to get lung cancer than other smokers.
This is when a person believes they are less at risk of experiencing a negative event compared to others. For example, a smoker might think they are less likely to get lung cancer than other smokers.
Optimism Bias
Representativeness Bias
This is when people judge probabilities according to measures of representativeness. For example, upon hearing that someone loves books and is quiet, you might assume they’re a librarian, even though many people who aren’t librarians also love books and are quiet.
This is when people judge probabilities according to measures of common traits. For example, upon hearing that someone loves books and is quiet, you might assume they’re a librarian, even though many people who aren’t librarians also love books and are quiet.
Representativeness Bias
Status quo bias
Preference for the current state of affairs, people tend to hold on to what they have
Preference for the current state of affairs, people tend to hold on to what they have
Status quo bias
Availability Bias
This is a mental shortcut that relies on immediate examples that come to mind when evaluating a specific topic. For instance, if someone asks you whether dogs or sharks are more dangerous, you might say sharks because shark attacks are more memorable, even though dogs actually injure more people each year.
This is a mental shortcut that relies on immediate examples that come to mind when evaluating a specific topic. For instance, if someone asks you whether dogs or sharks are more dangerous, you might say sharks because shark attacks are more memorable, even though dogs actually injure more people each year.
Availability Bias
This leads individuals to only see evidence that confirms their pre-existing beliefs. For example, if you are a racist, you only look for information that confirms your hatred.
Conformation bias
Confirmation bias
This leads individuals to only see evidence that confirms their pre-existing beliefs. For example, if you are a racist, you only look for information that confirms your hatred.
Overconfidence
This bias occurs when a person’s confidence in their judgments is greater than the accuracy of those judgments. For instance, a driver might be confident they can text and drive safely, even though this is generally not true.
What is the economic theory that assumes individuals are rational and always make decisions that provide them with the highest expected utility?
EUT
Expected Utility Theory (EUT):
Individuals maximize their utility under uncertainty relative to a final wealth position. The utility is defined as consumption of goods and services
is a behavioral economic theory that describes how people make choices when faced with potential gains and losses. It was developed by psychologists Daniel Kahneman and Amos Tversky in 1979.
Prospect theory
Prospect theory
Prospect Theory is a behavioral economic theory that describes how people make choices when faced with potential gains and losses. It was developed by psychologists Daniel Kahneman and Amos Tversky in 1979.
Here are the key points of Prospect Theory:
Value Function: People make decisions based on the potential value of losses and gains rather than the final outcome. This value function is believed to be concave for gains (indicating risk aversion), convex for losses (indicating risk-seeking behavior), and steeper for losses than for gains (indicating loss aversion).
Reference Point: People’s choices depend on how they perceive gains and losses, and this perception is influenced by a reference point. Anything below the reference point is considered a loss and anything above it is considered a gain.
Loss Aversion: People tend to prefer avoiding losses to acquiring equivalent gains. In other words, the pain of losing is psychologically about twice as powerful as the pleasure of gaining.
Probability Weighting: People tend to overestimate the probability of unlikely events and underestimate the probability of likely events. This leads to risk-seeking behavior in the realm of low-probability gains and high-probability losses, and risk-averse behavior in the realm of high-probability gains and low-probability losses.
In essence, Prospect Theory suggests that people’s decisions are not always rational, especially when it comes to risk and uncertainty. It has been widely used to explain various economic and financial behaviors, including investment decisions and insurance purchasing behavior.
Probability weighting:
People do not weight outcomes by their objective probabilities p, but rather transformed probabilities or decision weights. They overweight low probabilities and underweight high probabilities.
What is the reference point?
People’s choices depend on how they perceive gains and losses, and this perception is influenced by a reference point. Anything below the reference point is considered a loss and anything above it is considered a gain.
When the probabilities are unknown
Ambiguity
Ambiguity
When the probabilities are unknown.
