Block 1 Flashcards
What is the distinction between descriptive and normative decisions?
descriptive:
- how we make decisions
normative:
- how we should make decisions
What does rationality refering to?
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
What is a preference?
How people compare two or more alternatives
How can you be rational/ make rational choices?
- you have a rational preference ordering
- you choose the most preffered item
Which theory is used to descirbe preferences?
Utility function
How does a uitilty funciton look like?
is the utility function ordinal or cardinal?
- ordinal
- but not cardinal
-> more is better, but the slope gets flather with increasing value.
What kind of phenomena are insconsistent with the theory of choice under certainty?
- opportunity costs
- sunk costs
- decoy effect
What are opportunity costs?
- it is the value of the most valuable alternative option
- in practice, people frequently overlook or underestimate opportunity costs
What is the sunk cost fallacy?
- 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.
What is the decoy effect?
- adding an inferior option may influence preferences
Most real-life decisions are not choices under certainty -> therefore, we need the theory of probability
What kind of attitudes towards risk do we have? (3)
- risk averse: if you would reject a gamble in favor of a sure CHF amount equal to its expected value.
- risk prone or loving: if you would accept a gamble rather than a sure CHF amount equals to its expected value.
- risk neutral: if you are indifferent between a gamble and a sure CHF amount equal to its expected value
What phenomena are inconsistent with the theory of choice under risk and uncertainty?
- Allais problem
- Ellsberg problem
What is the endowment effect?
something that we own has a bigger value for us than something we don’t
What is the expected value of a gamble?
what you expect to win on average, in the long run, when you play the gamble
What are the drawbacks of the expected value?
it is only possible to compute EV when consequences can be described in numerical terms.
What is the St. Petersburg Paradox?
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.
How can be the St. Petersburg Paradox be resolved?
by assuming that people maximize expected utility rather than expected value -> individual probablities
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?
Ellsberg problem: How are people according to risk, when the probabilities of potential outcomes are unknown?
People may be more risk-averse when the probabilities of potential outcomes are unknown.
Allais problem
Decisions should not be influenced by sure things
What is Framing?
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.
What is the prospect theory?
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.
Prospect theory: Is the risk attitude the same across gainsa nd losses?
No it is not. it is the change in wealth, rather than the level, that matters to people.
What does the EUT assume?
Expected Utility Theory assumes that people value outcomes based on the final wealth position, regardless of the person’s initial wealth.
Prospect theory: What about losses?
People are averse to losses because losses loom larger than gains.
Differentiate between the terms “loss aversion” and “risk aversion”. How are these captured in the shape of the value function in the prospect theory.
What is the base-rate neglect?
People usually expect the probability to be much higher than it is. They ignore the low probability of being sick in this case.
Explain why the prospect theory is consistent with the results that people frequently reject gambles with an expected value of zero?
losses loom larger than gains. losing is not the same as winning. the concept is referred to a loss aversion
Confirmation bias
Facts are erceived/ intepreted according to preconceived options. Defending this option is the main effort when gathering further information
House money effect
taking greater risks with perceived gains or “house money”
Value investing
undervalued outperform overvalued
momentum and reversal
short-term trends continue, but may reverse in the long term
Mental Accounting
creating mental accounts for different types of income and expenses, influencing spending and investment decisions
disposition effect
the tendency to sell winning investment too early and hold on to loosing investment too long due to fear of loss
Equity premium puzzle
stocks have higher long-term returns than bonds, more than expected
Myopic Loss aversion
Focus on short-term losses over long-term gains, avoiding losses more than equivalent gains
Danning-Kruger Effect
Individuals with low ability overestimate themselfs while those with high underestimate their competence
Hindsight bias
tendency to belief that after an event has occurred, that one would have predicted the outcome beforehand
home bias
tendency to favor domestic investments over foreign ones, often resulting in portfolio overweights to home country assets
Overconfidence
Tendency to overestimate one’s knowledge, abilities and control over events
base rate neglect/ fallacy
ignoring statistical base rates in favor of specific information
conjunction fallacy
believing that specific combined condition are more probable than a single general one
disjunction fallacy
misjudging the probability of one or more events happening as less likely than a single event
Representativeness
Judging the probability of an event based on how much it represents the population
Gambler’s Fallacy
Believing that past events affect the likelihood of future independent events
Hot hand
Belief that a person experiencing success will continue to do so
Herding Behavior
When investors follow the actions of a larger group or trend, ignoring their own analysis
Anchoring bias
the tendency to be overly influenced by an initial piece of information when making decisions
availability bias
judging based on easily recalled information
overreaction in the stock market
Excessive response to news affecting stock prices
Efficient market hypothesis
Prices reflect all relevant information
lagged reaction to earnings
slow stock price response to earnings reports
small-firm effect
small cap outperform larger ones
