Week 7

Question 1

How does behavioural finance differ from neoclassical finance in terms of preferences?

Answer 1

• Neoclassical finance –> expected utility theory: Prospect G is made up of a series of payoffs xi , each of which is associated w probability pi –> expected utility of prospect G = U(G) = sum from i=1 to n of piu(xi).
• Behavioural finance –> prospect theory: Prospect G = V(G) = sum from i=1 to n of πiν(zi) –> v(.) is value func ; πi are decision weights.

Question 2

What are the 3 deviations from the predictions of expected utility theory?

Answer 2

1) Allais Paradox –> people exhibit inconsistent preferences when presented w choices that have same expected value but diff probability distributions –> expected utility theory assumes consistent risk preferences.
2) Common Ratio Effect –> tendency of individuals to exhibit risk aversion in choices involving gains but risk-seeking behavior in choices involving losses when probabilities expressed in common ratio (e.g. probs of certain/risky wins/losses in same proportion)–> individuals may prefer certain gain over risky prospect w higher expected value but for losses, individuals may be more inclined to take risks w hope of avoiding certain loss, even if expected value lower –> expected utility theory assumes individuals evaluate choices solely based on their expected values.
3) Framing effect –> way in which info presented/framed may affect decision making e.g. if framed as ‘potential win/loss’ even if objective outcomes are same –> expected utility theory assumes decisions should be independent of how choices are presented.

Question 3

What are the 4 elements that distinguish prospect theory from expected utility theory?

Answer 3

1) Reference dependence –> zi for value function represents change relative to reference point e.g. gains/losses in wealth as opposed to absolute level of wealth xi used in utility function.
2) Diminishing sensitivity –> people affected more by additional $ of gain (or loss) when at lower levels of gains (or losses) –> in gain domain, concave value function (consistent w risk aversion) –> in loss domain, convex value function (consistent w risk seeking).
3) Loss aversion –> ‘hurt’ caused by losses greater than ‘pleasure’ caused by gains (of same magnitude) –> value function steeper for losses than for gains –> concave expected utility function assumes risk aversion due to diminishing marginal utility of wealth as individuals less willing to take on additional risk, preferring certainty & wealth preservation over potential for higher but uncertain outcomes.
4) Probability weighting function –> uses decision weights instead of objective probabilities in utility function –> probability weighting function overweights low probabilities & underweights high probabilities –> slope of probability weighting function is relatively steep ~ 0-1 prob.