Reading 5 Flashcards
normative analysis
- 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
descriptive analysis
concerned with the manner in which real people actually make decisions
ex: behavioral finance explanations of behaviors
prescriptive analysis
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
2 categories of behavioral finance
- 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
2 typed of behavioral biases
cognitive errors and emotional biases
cognitive errors
errors due to stats, info processing or memory aka due to faulty thinking
emotional biases
stem from implude or intuition or reasoning that’s influenced by feelings
utility theory
people maximize the present value of utility subject to a present value budget constraint
axioms of utility theory
completeness
transitivity
independence
continuity
completeness
individuals have well defined preferences and can decide between any two alternatives
transitivity
an individual decides consistently
if a>b
b>c
then a>c
independence
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
continuity
there are indifference curves where an individual is indifferent between all points
Bayes formula
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)
rational economic man (REM)
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.
certainty equivalent
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
how can the degree of risk aversion be measured?
by the curvature of the utility function
linear: risk neutral
concave: risk averse
convex: risk seeking
bounded rationality
assumes that individual’s choices are rational but are subject to limitations of knowledge and cognitive capacity
Friedman Savage double inflection utility function
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
prospect theory
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)
neuro economics
attempts to explain investor behavior based on functioning of brain
decision theory
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
did btwn expected utility and expected value, and who did it?
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
Knight’s distinctions between risk and uncertainty
risk: randomness with knowable probabilities
uncertainty: randomness with unknowable probabilities
bottom line is that risk is measurable but uncertainty is not
Subjective Utility Theory (SEU)
- 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
bounded rationality
- Simon
- people are not fully rational when making decisions and do not necessarily optimize but rather satisfice and use bounded rationality
bounded rationality
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.
satisfice
combines satisfy and suffice
describes decisions, actions and outcomes that may not be optimal but they are adequate
aspiration level
- 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
prospect theory
- 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
Editing/framing stage of prospect theory
- 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
