Week 8- Behavioural Finance Flashcards
Why is traditional finance normative?
Traditional finance theory is normative because it indicates how
investors should make decisions. By contrast, the behavioural
finance approach is to understand why investors make the
observed decisions.
Why do behavioural finance proponents argue?
Behavioural finance proponents argue that investors frequently
make systematic errors and these errors can push the prices of
shares away from fundamental value for considerable periods.
What is the goal of behavioural finance?
Behavioural finance seeks to understand the market
implications of the psychological factors underlying investor
decisions and offers an alternative view of financial market
activity to the efficient market hypothesis.
What does Expected Utility Theory assume?
- Expected utility theory, which provides the basis for much of
modern finance theory, assumes that:
-people have complete information about possible
outcomes;
-the probability of these outcomes;
-can evaluate their preferences across different expected
options;
-then the optimal choice is determined by finding the highest
possible expected utility.
-people are risk averse, will take on risk if they receive
compensation.
what does Prospect theory: Tversky and Kahneman (1981) state?
- Expected utility theory is a normative model which describe how
people should behave, whereas actual behaviour provides the
basis for prospect theory. - People choose the course of action that satisfies their most
important needs, but the choice may not be optimal. “satisfice,”
rather than “optimize,”. - Optimal decision-making is limited because of cognitive
constraints and information availability. (ie not all investors are smart enough)
What is the utility function replaced by in prospect theory?
- The utility function is replaced by value function, which has a
reference point that is determined by the subjective impression
of the individual. - The value function shows the sharp asymmetry between the
value people put on gains and losses (loss aversion). Empirical
test show that losses are weighted about twice as heavily as
gain (losing £1 is twice as painful as the pleasure of gaining £1).
What is the shape of the value function in prospect theory? What does this show?
The value function is convex in the loss domain but concave for
gains. This reflects the observation that people’s choices reflect
risk taking when their decision involves losses, but risk aversion
for gains.
Why is the curve in the loss domain steeper than in the gain domain for prospect theory?
Loss aversion
How are traditional models in finance formulated?
Traditional models in finance are formulated as if the typical
decision maker is an individual who consider all relevant
information and comes up with the best decision. Anomalies
and their continued existence violate this assumption.
What is a heuristic? Why do they exist/why are they useful?
- Given that individuals face both cognitive and environmental
constraints, a heuristic is a useful rule‐of‐thumb or an intuitive
decision-making procedure that people can use for problem
solving. - The world is full of uncertainty and a person’s time is limited. A
decision needs to be made and a heuristic can promote
appropriate decision‐making under certain conditions, such as
a particular environment.
What are the 4 subsections of heuristics?
- Familiarity
- Representativeness
- Gamblers Fallacy
- Affect and feeling
Describe familiarity as a heuristic, what are the good bits?
- An investor chooses a stock to add to his portfolio from the
opportunity set that he knows or thinks he knows. This
strategy is wise if he is more likely to be familiar with stocks
that will perform well in the future. - Taking advantage of the information in the investor’s
environment can make heuristic‐based decision efficient and
optimal.
List 2 potential negatives of using familiarity as a heuristic:
- Home bias- investors are optimistic about their markets and
tend to favour that which is familiar. - Investing in the stocks of companies in which the investor
works. (ie Lehman brothers) - Both of these could lead to a lack of diversification
Describe representativeness as a heuristic
- People often assume that a particular person, object or outcome
is broadly representative of a larger class. - Judging things by how they appear rather than how statistically
likely they are.
What could be an issue between using representativeness as a heuristic?
People could mis interpret what is representative, ie the Linda Problem. This is called a conjunction fallacy- as people tend to associate the chances of events in conjunction being higher than the chance of a singular event.
When do people commit the Gambler’s Fallacy?
People commit the gambler’s fallacy when they assume that a
departure from what occurs on average, or in the long run, will be
corrected in the short run.
What is the issue with the Gambler’s Fallacy?
- Independent events: the odds of any specific outcome
happening in the next chance remine the same regardless of
what preceded it.
Explain the affects and feeling heuristic. Give an example:
The reliance on instinct instead of analysis in making decisions.
Instinct, intuition, and experience should be viewed as
complements to formal analysis, not substitutes.
Example: Firms with reputations for socially responsible policies or
attractive working conditions may generate higher affect in the
public perception.
