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Behavioral Finance > Block 1 > Flashcards

Block 1 Flashcards

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1
Q

What is the distinction between descriptive and normative decisions?

A

descriptive:
- how we make decisions

normative:
- how we should make decisions

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2
Q

What does rationality refering to?

A

Rationality refers to:
- Preferences: how people compare two or more alternatives -> Choice under certainty
- Beliefs: the way people update their beliefs when new information arrives -> Judgement under risk and unvertainty

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3
Q

What is a preference?

A

How people compare two or more alternatives

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4
Q

How can you be rational/ make rational choices?

A
  • you have a rational preference ordering
  • you choose the most preffered item
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5
Q

Which theory is used to descirbe preferences?

A

Utility function

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6
Q

How does a uitilty funciton look like?

A
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7
Q

is the utility function ordinal or cardinal?

A
  • ordinal
  • but not cardinal

-> more is better, but the slope gets flather with increasing value.

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8
Q

What kind of phenomena are insconsistent with the theory of choice under certainty?

A
  • opportunity costs
  • sunk costs
  • decoy effect
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9
Q

What are opportunity costs?

A
  • it is the value of the most valuable alternative option
  • in practice, people frequently overlook or underestimate opportunity costs
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10
Q

What is the sunk cost fallacy?

A
  • people hold on to failed investment, stay in failed relationship etc.
  • rational choices are completely forward-looking. things that happened in the past matter only insofar as they affect future outcomes.
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11
Q

What is the decoy effect?

A
  • adding an inferior option may influence preferences
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12
Q

Most real-life decisions are not choices under certainty -> therefore, we need the theory of probability

A
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13
Q

What kind of attitudes towards risk do we have? (3)

A
  1. risk averse: if you would reject a gamble in favor of a sure CHF amount equal to its expected value.
  2. risk prone or loving: if you would accept a gamble rather than a sure CHF amount equals to its expected value.
  3. risk neutral: if you are indifferent between a gamble and a sure CHF amount equal to its expected value
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14
Q

What phenomena are inconsistent with the theory of choice under risk and uncertainty?

A
  1. Allais problem
  2. Ellsberg problem
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15
Q

What is the endowment effect?

A

something that we own has a bigger value for us than something we don’t

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16
Q

What is the expected value of a gamble?

A

what you expect to win on average, in the long run, when you play the gamble

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17
Q

What are the drawbacks of the expected value?

A

it is only possible to compute EV when consequences can be described in numerical terms.

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18
Q

What is the St. Petersburg Paradox?

A

The St. Petersburg Paradox is a situation in which a theoretical game has an infinitely high average payoff, but in reality, people wouldn’t pay much to play it. This happens because the huge potential winnings are very unlikely, so the average value (expected value) of the game doesn’t match what people feel is a fair price to play. This paradox shows that people’s real-life decisions about risk and reward don’t always align with mathematical expectations.

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19
Q

How can be the St. Petersburg Paradox be resolved?

A

by assuming that people maximize expected utility rather than expected value -> individual probablities

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20
Q

If you accept the gable your payoff looks like this (+CHF 10, 0.5; CHF 0, 0.5). If you reject, you will get CHF 4. How much is the Expected value? How much is the Expected Utility if your u(x) =Wurzel X?

A
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21
Q

Ellsberg problem: How are people according to risk, when the probabilities of potential outcomes are unknown?

A

People may be more risk-averse when the probabilities of potential outcomes are unknown.

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22
Q

Allais problem

A

Decisions should not be influenced by sure things

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23
Q

What is Framing?

A

Framing refers to the way information or a problem is presented to people, which can significantly influence their decisions and judgement.

-> but in EUT the decisions should not depend on how the problem is framed.

24
Q

What is the prospect theory?

A

it describes how people make decisions involving risk and uncertainty. It contrast with the traditional expected utility theory, which assumes that people always make rational decisions to maximize expected utility.

25
Q

Prospect theory: Is the risk attitude the same across gainsa nd losses?

A

No it is not. it is the change in wealth, rather than the level, that matters to people.

26
Q

What does the EUT assume?

A

Expected Utility Theory assumes that people value outcomes based on the final wealth position, regardless of the person’s initial wealth.

27
Q

Prospect theory: What about losses?

A

People are averse to losses because losses loom larger than gains.

28
Q

Differentiate between the terms “loss aversion” and “risk aversion”. How are these captured in the shape of the value function in the prospect theory.

A
29
Q

What is the base-rate neglect?

A

People usually expect the probability to be much higher than it is. They ignore the low probability of being sick in this case.

30
Q

Explain why the prospect theory is consistent with the results that people frequently reject gambles with an expected value of zero?

A

losses loom larger than gains. losing is not the same as winning. the concept is referred to a loss aversion

31
Q

Confirmation bias

A

Facts are erceived/ intepreted according to preconceived options. Defending this option is the main effort when gathering further information

32
Q

House money effect

A

taking greater risks with perceived gains or “house money”

33
Q

Value investing

A

undervalued outperform overvalued

34
Q

momentum and reversal

A

short-term trends continue, but may reverse in the long term

35
Q

Mental Accounting

A

creating mental accounts for different types of income and expenses, influencing spending and investment decisions

36
Q

disposition effect

A

the tendency to sell winning investment too early and hold on to loosing investment too long due to fear of loss

37
Q

Equity premium puzzle

A

stocks have higher long-term returns than bonds, more than expected

38
Q

Myopic Loss aversion

A

Focus on short-term losses over long-term gains, avoiding losses more than equivalent gains

39
Q

Danning-Kruger Effect

A

Individuals with low ability overestimate themselfs while those with high underestimate their competence

40
Q

Hindsight bias

A

tendency to belief that after an event has occurred, that one would have predicted the outcome beforehand

41
Q

home bias

A

tendency to favor domestic investments over foreign ones, often resulting in portfolio overweights to home country assets

42
Q

Overconfidence

A

Tendency to overestimate one’s knowledge, abilities and control over events

43
Q

base rate neglect/ fallacy

A

ignoring statistical base rates in favor of specific information

44
Q

conjunction fallacy

A

believing that specific combined condition are more probable than a single general one

45
Q

disjunction fallacy

A

misjudging the probability of one or more events happening as less likely than a single event

46
Q

Representativeness

A

Judging the probability of an event based on how much it represents the population

47
Q

Gambler’s Fallacy

A

Believing that past events affect the likelihood of future independent events

48
Q

Hot hand

A

Belief that a person experiencing success will continue to do so

49
Q

Herding Behavior

A

When investors follow the actions of a larger group or trend, ignoring their own analysis

50
Q

Anchoring bias

A

the tendency to be overly influenced by an initial piece of information when making decisions

51
Q

availability bias

A

judging based on easily recalled information

52
Q

overreaction in the stock market

A

Excessive response to news affecting stock prices

53
Q

Efficient market hypothesis

A

Prices reflect all relevant information

54
Q

lagged reaction to earnings

A

slow stock price response to earnings reports

55
Q

small-firm effect

A

small cap outperform larger ones

Behavioral Finance (1 decks)

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