Reading 5

Question 1

normative analysis

Answer 1

• concerned with the rational solution to the problem at hand
• defines an ideal that actual decisions should strive to approximate
• ex: traditional finance assumptions about behavior

Question 2

descriptive analysis

Answer 2

concerned with the manner in which real people actually make decisions

ex: behavioral finance explanations of behaviors

Question 3

prescriptive analysis

Answer 3

practical advice and tools that might help people achieve results more closely approximating those of normative analysis

ex:efforts to use behavioral finance in practice

Question 4

2 categories of behavioral finance

Answer 4

• BFMI:behavioral finance micro => looks at factors that distinguish INDIVIDUAL INVESTORS from rational actors in finance theory
• BFMA: behavioral finance macro => considers MARKET ANOMALIES that distinguish mkts from the efficient mkts in traditional finance

Question 5

2 typed of behavioral biases

Answer 5

cognitive errors and emotional biases

Question 6

cognitive errors

Answer 6

errors due to stats, info processing or memory aka due to faulty thinking

Question 7

emotional biases

Answer 7

stem from implude or intuition or reasoning that’s influenced by feelings

Question 8

utility theory

Answer 8

people maximize the present value of utility subject to a present value budget constraint

Question 9

axioms of utility theory

Answer 9

completeness

transitivity

independence

continuity

Question 10

completeness

Answer 10

individuals have well defined preferences and can decide between any two alternatives

Question 11

transitivity

Answer 11

an individual decides consistently

if a>b
b>c
then a>c

Question 12

independence

Answer 12

ppl have well defined preferences

preference order of two choices combined in the same proportion with a third choice maintains the same preference order as the original preference order

Question 13

continuity

Answer 13

there are indifference curves where an individual is indifferent between all points

Question 14

Bayes formula

Answer 14

explains that existing probability beliefs should be changed given new info.
assumes all possible events must be mutually exclusive and exhaustive events with known probabilities

P(A|B)=[P(B|A)/P(B)]P(A)

Question 15

rational economic man (REM)

Answer 15

tries to obtain the highest possible economic well being given budget constraints and available info about opportunities, and basing considerations only on his own personal utility.

Question 16

certainty equivalent

Answer 16

used to evaluate attitudes towards risk

given an opportunity go participate or forgo participating in an event for which the outcome is uncertain, sees how much $ a person would pay to participate or not participate

Question 17

how can the degree of risk aversion be measured?

Answer 17

by the curvature of the utility function

linear: risk neutral
concave: risk averse
convex: risk seeking

Question 18

bounded rationality

Answer 18

assumes that individual’s choices are rational but are subject to limitations of knowledge and cognitive capacity

Question 19

Friedman Savage double inflection utility function

Answer 19

risk evaluation is reference dependent

there may be levels of wealth for which an investor is a risk seeker and levels of wealth for which an investor is risk neutral

at both low income levels and high income levels ppl are risk averse
in between these two levels, people are risk loving

Question 20

prospect theory

Answer 20

assigns value to gains and losses (changes in wealth) rather than to final wealth and probabilities are replaced by decision weights

the value function is defined by deviations from a refence point and is steeper for losses than gains (risk aversion)

Question 21

neuro economics

Answer 21

attempts to explain investor behavior based on functioning of brain

Question 22

decision theory

Answer 22

identifying values, probabilities and other uncertainties relevant to a given decision and using that info to arrive at a theoretically optimal decision

it’s normative (concerned with identifying the ideal decision)

assumes the decision maker is fully informed, can make calculations with accuracy and is rational

Question 23

did btwn expected utility and expected value, and who did it?

Answer 23

Bernoulli

expected value: based on its price and is the same for everyone

expected utility: based on the worth assigned to it by a person and hence dif from person to person

Question 24

Knight’s distinctions between risk and uncertainty

Answer 24

risk: randomness with knowable probabilities
uncertainty: randomness with unknowable probabilities

bottom line is that risk is measurable but uncertainty is not

Question 25

Subjective Utility Theory (SEU)

Answer 25

• introduced by Savage
• builds on expected utility theory (u choose what gived u the highest utility) to situations with only subjective probabilities
• so with the subjective probabilties u can make a probability dist of variables and choose the highest utility option

Question 26

bounded rationality

Answer 26

• Simon
• people are not fully rational when making decisions and do not necessarily optimize but rather satisfice and use bounded rationality

Question 27

bounded rationality

Answer 27

people gather some but not all available info and use heuristics(shortcuts) to analyze the info and stop when they have arrived at a satisfactory, not necessarily optimal, decision.

Question 28

satisfice

Answer 28

combines satisfy and suffice

describes decisions, actions and outcomes that may not be optimal but they are adequate

Question 29

aspiration level

Answer 29

• term Simon uses in his theory of bounded rationality
• instead of looking at every alternative, people set constraints as to what will satisfy their needs…the constraints show what is aspired to
• constraints=aspiration levels
• set based on experiences and comparisons with others

Question 30

prospect theory

Answer 30

• Kahneman and Tversky
• 2 phases of making a choice
• an early phase in which prospects are framed (or edited) and a subsequent phrase in which prospects are evaluated and chosen

Question 31

Editing/framing stage of prospect theory

Answer 31

• alternatives are ranked according to a basic heuristic that’s chosen by the decision maker
• this contrasts with the elaborate algorithms of expected utility theory
• understanding how choices are presented impacts the final stage
• ultimate purpose is to simplify the evaluation of choices by reducing the number of choices that needs to be more thoroughly evaluated
• there may be 6 operations in the editing process: codification, combination, segregation, cancelation, simplification, detection of dominance