Topic 9: Behavioural Finance

Question 1

Prisoner’s Dilemma - analyse role in behavioural finance

Answer 1

1. singular pursuit of self interest does not necessarily lead to socially optimal outcome
2. payoffs constructed to introduce a double cross incentive
3. shows what happens when information flow between two prisoners is removed
4. shows what happens when trust is removed
5. conditional on knowing what the other did (and believing in that) you’d choose differently and get a lighter sentence.

Question 2

Main point of Prisoner’s dilemma

Answer 2

1. Rational pursuit of self interest doesn’t always lead to socially optimal outcome
2. Disproves that the market will always find the best outcome
3. What is rational
4. Lack of information influences the outcome

Question 3

Moral hazard:
Disaster Myopia:
Self Attribution Bias:
Confirmation Bias:

Answer 3

Moral hazard: taking risks where others bear the consequences
Disaster Myopia: = propensity to underestimate the likelihood of adverse outcomes. Tendency for overconfidence, whereas risk is underestimated. eg lower flood insurance if it hasn’t occurred for a while. Also, failure to challenge/question
Self Attribution Bias: long period of boom attributed to own skill.
Confirmation Bias: tendency to search for or interpret information in a way that supports one’s own preconceptions.

Question 4

List 5 traits in behaviour that arise when humans make decisions. Explain / demonstrate relevance

Answer 4

1. Over confidence and over optimism (more confident in abilities than warranted)
2. Self attribution bias (good things happen - attributed to self rather than random event)
3. Over optimism (extended market prosperity leading to over optimism)
4. Disaster myopia (people may choose risky investments without adequate reward)
5. confirmatory bias (look for evidence to support position)
6. illusion of control (doing something makes you feel better)
7. Falling for a story (easier)
8. Maximisers vs satisficers
9. Representative and availability bias (judge likelihood by how similar it is to recent experience, availability - overemphasize recent or strong remembrances
10. Anchoring