Reading 06 - The Behavioral Finance Perspective

Five implications of the AMH are:

1) The relationship between risk and reward varies over time (risk premiums change over time) because of changes in risk preferences and such other factors as changes in the competitive environment 2) Active management can add value by exploiting arbitrage opportunities 3) Any particular investment strategy will not consistently do well but will have periods of superior and inferior performance 4) the ability to adapt and innovate is critical for survival; 5) survival is the essential objective. In other words, recognizing that things change, the survivors will be those who successfully learn and adapt to changes.

Decisions under uncertainty This is how RATIONAL investors make decisions according to Traditional Finance List 4 steps

1. Adhere to the axioms of utility theory 2. Assign a probability measure to possible events 3. Incorporate NEW INFO by conditioning probability measures according to Bayes' formula 4. Choose an action that MAXIMIZES the utility function subject to BUDGET constraints • People have COGNITIVE limitations not accounted for in EXPECTED utility theory • BF says that it seems highly UNLIKELY that people actually take each of these steps every time they make a decision

Portfolio construction is primarily a function of five factors 1. What is the investor goal and what is the importance of that goal?

1. Allocation to different layers depends on investor goals & the importance assigned to each goal

• Principles that govern REM's economic decisions:

1. Perfect rationality 2. Perfect self-interest 3. Perfect information

Prospect theory: What are the 2 main assumptions?

1. Relaxes the assumptions that individuals are RISK-AVERSE and make decisions consistent with expected UTILITY theory 2. Assumes that individuals are LOSS-AVERSE

Prospect theory: In prospect theory, based on descriptive analysis of how choices are made, there are TWO phases to making a choice: EARLY PHASE *LATER PHASE*

2) LATER PHASE in which prospects are EVALUATED and CHOSEN Edited prospects are evaluated and the prospect of HIGHEST PERCEIVED VALUE is chosen

Portfolio construction is primarily a function of five factors 2. Allocation within a layer depend on the goal for the layer

2. Allocation of funds within a layer to specific assets will depend on the goal set for the layer HIGHER GOAL = assets likely to be riskier or more speculative in nature

Portfolio construction is primarily a function of five factors 3. Number of asset in a specific layer depend on the UTILITY FUNCTION (concave means higher number of assets

3. Number of assets chosen for a layer depends on the shape of the investor's UTILITY function Risk-averse individuals have concave utility functions The greater the concavity of the utility curve, the earlier the satiation for a specific security. Thus, the GREATER the CONCAVITY of the utility curve, the GREATER the NUMBER OF SECURITIES INCLUDED in a layer

Portfolio construction is primarily a function of five factors 4. Concentration of a particular security may occur if investor believes that it has a great information advantage

4. CONCENTRATED POSITIONS in some securities may occur if investors believe they have an informational advantage with respect to the securities

Portfolio construction is primarily a function of five factors 5. If don't like to realize losses then it can just hold more cash so not to have to sell security at a loss to meet liquidity

5. Investors reluctant to realize LOSSES may hold higher amounts of CASH so that they do not have to meet liquidity needs by selling assets that may be in a loss position Further, the portfolios of investors reluctant to realize losses may continue to hold some securities not because of the securities' potential, but rather because of the investor's aversion to realize losses Although the resulting portfolios may appear well-diversified, they may not, in fact, be well-diversified from a mean-variance perspective In other words, the portfolio may not be mean-variance efficient

4.2. TRADITIONAL PERSPECTIVE ON PORTFOLIO CONSTRUCTION

A "RATIONAL" portfolio is one that is MEAN VARIANCE efficient The portfolio for an investor is constructed HOLISTICALLY by considering the investor's: 1. TOLERANCE for RISK, 2. INVESTMENT OBJECTIVES, 3. INVESTMENT CONSTRAINTS, 3. UNIQUE circumstances

2.2.2. Utility Maximization and Counter Point Provide some counter points for the assumption of utility maximization

A useful way to assess the validity of rational economic theory is to use indifference curves The aim of indifference curve analysis is to demonstrate the basis on which a rational consumer substitutes certain quantities of one good for another

3.3. PROSPECT THEORY What is prospect theory?

ALTERNATIVE to expected UTILITY theory Prospect theory describes HOW INDIVIDUALS MAKE CHOICES that involve RISK & how they EVALUATE potential GAINS & LOSSES Prospect theory considers how choices are perceived based on their framing, how gains and losses are evaluated, and how uncertain outcomes are weighted

AXIOMS of UTILITY THEORY 3. Independence:

Also pertains to well-defined preferences & assumes that the preference order of 2 choices combined in the same proportion with a 3rd choice maintains the same preference order as the original preference order of the 2 choices

What is preference anomaly? Between the choice A and B, I focus on the differences between A and B and not the similarities between A and B. The problem is that every choice pair will have a different way to look at it. So it is not a consistent process.... The way the prospect WAS FRAMED has an effect on my choice.

An example of a preference anomaly is the ISOLATION EFFECT Tendency of people to DISREGARD outcome probability pairs that the alternatives SHARE (cancellation) and to focus on those which DISTINGUISH them Because DIFFERENT CHOICE PROBLEMS can be decomposed in DIFFERENT WAYS, this can lead to INCONSISTENT preferences How the prospects were FRAMED had an effect on the choice

AXIOMS of UTILITY THEORY 2. Transitivity:

An individual decides consistently A better B and B better C then A better C

4.1.3. Studies Challenging the EMH: Anomalies 4.1.3.2. Technical Anomalies: What is 2 examples of a TECHNICAL anomaly? Explain these.

Anomaly that happens when one considers PAST PRICES & VOLUME LEVELS Technical analysis encompasses a number of techniques that try to forecast securities PRICES by studying PAST PRICES & VOLUME levels Common technical analysis strategies are based on: 1. RELATIVE STRENGTH 2. MOVING AVERAGES 3. SUPPORT & RESISTANCE

4.1.3. Studies Challenging the EMH: Anomalies 4.1.3.1. Fundamental Anomalies What is an example of a FUNDAMENTAL anomaly? Explain Why might this be happening?

Anomaly that happens when one considers a stock's future performance based on a fundamental assessment of the stock's value 1. Performance of SMALL-capitalization companies & LARGE-capitalization 2. VALUE companies compared to GROWTH Investors consistently *OVERESTIMATE* the prospects of GROWTH companies and UNDERESTIMATE the prospects of VALUE companies As a result, VALUE stocks appear to generate anomalously *HIGH RETURNS* compared to *GROWTH stocks* FF dismisses that saying that is a result of INCOMPLETE ASSET PRICING MODEL

AXIOMS of UTILITY THEORY 4. Continuity:

Assumes there are continuous (unbroken) indifference curves such that an individual is indifferent between all points, representing combinations of choices, on a single indifference curve. The completely RATIONAL individual makes decisions based on the axioms of utility theory in order to maximize expected utility.

3.1. DECISION THEORY What does bounded rationality assumes: 1. 2.

BOUNDED RATIONALITY theory, relaxes the assumptions: 1. PERFECT INFORMATION is available 2. That ALL AVAILABLE INFORMATION IS PROCESSED according to expected UTILITY theory BOUNDED RATIONALITY theory assumes that individuals are LIMITED in their abilities to GET and PROCESS information

BPT: Layers

BPT uses a probability-weighting function rather than the real probability distribution used in Markowitz's portfolio theory In BPT investors construct their portfolios in layers and expectations of returns and attitudes toward risk vary between the layers

Bayes Formula:

Bayes' formula is a mathematical rule saying how EXISTING PROBABILITIES beliefs should be changed given NEW information... In order to develop the calculation, all possible events must be: 1. MUTUALLY exclusive 2. EXHAUSTIVE events with KNOWN probabilities

Bayes' formula

Bayes' formula: Shows how one conditional probability is inversely related to the probability of another mutually exclusive outcome The formula is: P (A|B) = [P (B|A)/P (B)] x P (A) Different people may make different decisions because: a. different utility functions b. different beliefs about the probabilities of different outcomes

The following operations are applied to 2 or more prospects: Cancellation (throw away common outcomes)

Cancellation involves DISCARDING COMMON OUTCOMES probability pairs between choices For example: The pairs (200, 20%; 100, 50%; 20, 30%) and (200, 20%; 300, 40%; -50, 40%) Are reduced to: (100, 50%; 20, 30%) (300, 40%; -50, 40%)

Combination

Choices are simplified by COMBINING the probabilities associated with IDENTICAL GAINS or LOSSES For example: A choice initially coded as: 250 @ 20% 200 @ 25% 200 @ 15% 150 @ 40% Will be simplified to: 250 @ 20% 200 @ 40% 150 @40%

3.1. DECISION THEORY What is decision theory and what does it assumes? What is bounded rationality and what does it assumes?

Decision theory is concerned with IDENTIFYING VALUES, PROBABILITIES about a decision and using that info to arrive at a OPTIMAL decision. Decision theory is NORMATIVE, meaning that it is concerned with identifying the IDEAL decision. It assumes that the decision maker: • Is fully informed • Is able to make quantitative calculations with accuracy • Is perfectly rational

Editing Phase

Depending on the number of prospects, there may be UP TO 6 operations in the editing process: • Codification • Combination • Segregation • Cancellation • Simplification • Detection of dominance

2.1.4. Risk Aversion What does expected utility theory assume about investors related to risk? What is the shape of the utility curve? And have ...marginal utility of wealth

Expected utility theory generally assumes that individuals are RISK-AVERSE This means that: • Individual may refuse a fair bet (a bet with an expected value = 0) • Utility functions are CONCAVE & show DIMINISHING MARGINAL UTILITY OF WEALTH

*Double inflection utility function*

Friedman and Savage try to explain why people may take low-probability, high-payoff risks (e.g., lottery tickets), while at the same time insuring against low risks with low payoffs (e.g., flight insurance) To see this, presume one is at inflection point B between risk-averse and risk-seeking. Suppose one faces two lotteries, one yielding A or B, another yielding B or C These lotteries are captured by the solid line segments between the respective payoffs AB and BC. Expected utility of the first gamble is notated as E(u) and is depicted in Exhibit 4 at point E—where, obviously, E(u) is less than the utility of the expected outcome of the first gamble, u[E(z)] Consequently, a risk-averse agent would pay a premium to avoid it. The second gamble yields expected utility E(u') at point E' on the BC segment, which is greater than the utility of the expected outcome u[E(z')]. A risk-seeking agent would pay a premium to undertake this gamble Thus, we can view risk-averse behavior with regard to AB as a case of insurance against small losses and the risk-seeking behavior with regard to BC as a case of purchasing lottery tickets

Basic axioms of utility theory How does a RATIONAL decision maker makes decisions from a set of alternatives?

From any set of alternatives: RATIONAL investors makes decisions based on the AXIOMS of UTILITY THEORY, They chooses the combination of decisions that *MAXIMIZES EXPECTED UTILITY*

Explain what it means to be risk averse, risk neutral and risk seeking?

Given 2 choices: a. investing to receive an exp value w/ certainty b. investing in an uncertain choice that generates the same expected value o Risk-averse (TF): Prefers to invest to receive an expected value with CERTAINTY o Risk-neutral: Will be indifferent between the two investments o Risk-seeking: Prefers to invest in the uncertain alternative

2. BEHAVIORAL VERSUS TRADITIONAL FINANCE PERSPECTIVE a. Contrast TRADITIONAL and behavioral finance perspectives on investor decision making; Traditional FINANCE PERSPECTIVE What are TF major assumptions?

Grounded in *neoclassical economics* Individuals are assumed to be: 1. Risk-averse 2. Self-interested utility maximizers In other words, that individuals are RATIONAL At the mkt level, assume that: 1. Prices incorporate & reflect ALL available & relevant information In other words, that markets are EFFICIENT • TF theory is based on the assumptions that individuals act rationally and consider all available information in the decision-making process and that markets are efficient.

2. BEHAVIORAL VERSUS TRADITIONAL FINANCE PERSPECTIVE Behavioral FINANCE PERSPECTIVE

Grounded in psychology • Tries to understand & explain observed INVESTOR & market behaviors & bases its assumptions on OBSERVED financial behavior instead of IDEAL financial behavior • Does not assume that people act rationally • Does not assume people consider all available information in decision-making • Does not assume market are efficient

Prospect theory: In prospect theory, based on descriptive analysis of how choices are made, there are TWO phases to making a choice: *EARLY PHASE* LATER PHASE

In prospect theory, based on descriptive analysis of how choices are made, there are TWO phases to making a choice: 1) EARLY PHASE in which choices are FRAMED (or EDITED) People use heuristics to do a preliminary analysis of the prospects, often resulting in a simpler representation Decide which outcomes they see as economically equal & then create a reference point to consider where these prospects rate Outcomes BELOW the reference point are viewed as *LOSSES* Outcomes ABOVE the reference point are viewed as *GAINS*

What is the main difference of PROSPECT theory value FUNCTION from expected utility FUNCTION?

In prospect theory: 1. VALUES are attached to CHANGES rather than FINAL STATES 2. DECISION WEIGHTS need not coincide with PROBABILITIES PROSPECT THEORY VALUE FUNCTION measures GAINS & LOSSES but NOT ABSOLUTE WEALTH and is REFERENCE-dependent REFERENCE DEPENDENCE is a feature of prospect theory and is central to prospect theory's perspective on how people make decisions under uncertainty

3.3.1. The Evaluation Phase key SLIDE

In the evaluation phase of prospect theory... People behave as if they COMPUTE a VALUE (utility) FUNCTION based on the potential outcomes and their respective probabilities and then choose the alternative that has a HIGHER UTILITY U = w x (prob1) V x (outcome 1) + w(prob2)v(outcome2) + ... * w is a probability-weighting function o expresses the fact that people tend to overreact to small probability events but underreact to mid-sized and large probabilities * v is a function that assigns a value to an outcome o The value function (graph for gain & loses vs value), which passes through the reference point, is s-shaped; moreover, as its asymmetry implies, given the same variation in absolute value there is a bigger impact of losses than of gains (loss aversion). People are not risk-averse but rather are LOSS AVERSE

AXIOMS of UTILITY THEORY 1. Completeness:

Individual has well-defined preferences & can decide between any two choices A or B

4.1.3.3. Calendar Anomalies

Irregularity identified when patterns of trading behavior that OCCUR IN CERTAIN TIMES OF THE YEAR are considered

4.3.2. A Behavioral Approach to Asset Pricing Describe the Behavioral Approach to Asset Pricing

MODIFIES the CLASSIC CAPM The discount factor to reflect this bias is a function of INVESTOR SENTIMENT relative to fundamental value The model focuses on MARKET SENTIMENT as a major determinant of ASSET PRICING Sentiment causes asset prices to deviate from values determined using TRADITIONAL FINANCE approaches Dispersion of analysts' forecasts serves as a PROXY for the SENTIMENT RISK PREMIUM in the model The discount rate on a security is the sum of: 1. Risk-free rate 2. Fundamental premiums (corresponding to efficient prices) 3. SENTIMENT PREMIUM (reflecting SENTIMENT -BASED risk)

4.1.3. Studies Challenging the EMH: Anomalies 4.1.3.2. Technical Anomalies: What is 2 examples of a TECHNICAL anomaly? Moving Averages

MOVING AVERAGES: Buy & sell signals are generated by the crossing of a SHORT moving average with a LONG moving average - When the SHORT moving average moves ABOVE the LONG moving average, the signal is to BUY - When the SHORT moving average moves below the LONG moving average, the signal is to sell Common MA of 50, 150, & 200 days with short moving averages of 1, 2, and 5 days

The following operations are applied to 2 or more prospects: Detection of Dominance

Outcomes that are strictly dominated are scanned and rejected without further evaluation

3.2. BOUNDED RATIONALITY ***IMPORTANT for EXAM*** This is how normal people make decisions Describe Bounded Rationality

People are: 1. NOT FULLY RATIONAL when making decisions 2. DO NOT necessarily "OPTIMIZE" but rather "SATISFICE" when arriving at their decisions • Gather SOME (BUT NOT ALL) available information • Use heuristics (rules of thumb) to make the process of analyzing the information easier • Stop when they have arrived at a satisfactory, not necessarily optimal decision The term "SATISFICE" combines "satisfy" & "suffice" and describes decisions, actions, and outcomes that may *NOT BE OPTIMAL*, but they are *ADEQUATE*

Codification

People perceive outcomes as GAINS & LOSSES rather than final states of wealth A gain or loss is defined with respect to some REFERENCE POINT Prospects are coded as (gain or loss, probability; gain or loss, probability; ...) such that the probabilities initially add to 100%

Prospect theory EXPLAINS APPARENT DEVIATION in decision making from the RATIONAL decisions of TF These deviations result from ....? 2 things

Prospect theory EXPLAINS APPARENT DEVIATION in decision making from the RATIONAL decisions of TF. These deviations result from: 1. OW LOW probability outcomes 2. UW moderate & high probability outcomes And having a VALUE FUNCTION for changes in wealth (gains and losses) that is in general: 1. CONCAVE for GAINS, 2. CONVEX for losses, and STEEPER for LOSSES than for GAINS As a result, people are: RISK-AVERSE: - HIGH probability of GAINS or a LOW probability of LOSSES RISK = SEEKING: - LOW probability of GAINS or a HIGH probability of LOSSES

The following operations are applied to 2 or more prospects: Simplification (rounded off)

Prospects are likely to be ROUNDED off A prospect of (51, 0.49) is likely to be seen as an even chance to win 50 Also, extremely unlikely outcomes are likely to be discarded or assigned a probability of zero

2.2. BEHAVIORAL FINANCE PERSPECTIVE ON INDIVIDUAL BEHAVIOR 2.2.3. Attitudes Toward Risk TF Assumption: Assuming that individuals are RISK-AVERSE and that utility curves are CONCAVE and exhibit DIMINISHING marginal utility seems reasonable, but observed behaviors are not always consistent with the assumption of an individual who is constantly RISK AVERSE What does BF Assumes?

RISK EVALUATION is REFERENCE-DEPENDENT Meaning risk evaluation depends in part on the WEALTH LEVEL and circumstances of the decision maker

Risk attitude towards wealth Describe the utility curve for a risk averse individual?

Risk-AVERSE individuals have: 1. CONCAVE utility functions Utility INCREASE at a DECREASING RATE with INCREASE in WEALTH 2. Individual has a DIMINISHING MARGINAL utility of wealth

Risk attitude towards wealth Describe the utility curve for a risk neutral individual?

Risk-NEUTRAL individuals have: 1. LINEAR utility functions Utility INCREASES at a CONSTANT rate with INCREASES in WEALTH 2. Individual has a CONSTANT MARGINAL utility of wealth

Risk attitude towards wealth Describe the utility curve for a risk seeking individual?

Risk-SEEKING individuals have: 1. CONVEX utility functions Utility increases at an INCREASING RATE with INCREASES in WEALTH 2. Individual has an INCREASING MARGINAL utility of wealth

4.1. TRADITIONAL PERSPECTIVE ON MARKET BEHAVIOR SEMI STRONG FORM MARKET EFFICIENCY

SEMI-STRONG-form market efficiency assumes that all PUBLIC available information, PAST AND PRESNT, is fully reflected in securities' prices If a market is semi-strong-form efficient: *TECHNICAL & FUNDAMENTAL analyses will not generate excess returns*

4.1. TRADITIONAL PERSPECTIVE ON MARKET BEHAVIOR STRONG FORM MARKET EFFICIENCY

STRONG-form market efficiency assumes that ALL information, PUBLIC AND PRIVATE, is fully reflected in securities' prices If a market is strong-form efficient: *INSIDER INFORMATION will not generate excess returns*

THE TURN OF THE MONTH EFFECT:

Stocks earn higher returns on the LAST DAY & FIRST 4 days of EACH month

JANUARY EFFECT:

Stocks in general—and SMALL STOCKS, in particular Have delivered high returns during the month of January

4.1.3. Studies Challenging the EMH: Anomalies 4.1.3.2. Technical Anomalies: What is 2 examples of a TECHNICAL anomaly? Explain these.

TRADING RANGE BREAK (Support and Resistance): BUY signal is when the price breaks the RESISTANCE level SELL SIGNAL is when the price breaks the SUPPORT level

2.1.2. Rational Economic Man Another way to explain the TF perspective on decision making What are some of the principals of a REM?

TRADITIONAL FINANCE assumes that AFTER GETTING INFORMATION AND analyzing it according to BAYES' formula, individuals will MAKES DECISIONS CONSISTENT WITH with the decisions of RATIONAL ECONOMIC MAN (REM)

4.3.4. Adaptive Markets Hypothesis

The AMH applies principles of evolution to financial markets in an attempt to reconcile EFFICIENT market theories with BEHAVIORAL alternatives Principles of evolution: Competition, adaptation, and natural selectio Similar to factors that influence an ecological system (bold theory!!!) , markets are influenced by COMPETITION for SCARCE resources and the ADAPTABILITY of participants ie. LTCM Biases identified by those researching in behavioral finance may be consistent with the AMH These biases are simply the result of applying previously learned heuristics to a changed environment where they no longer work The successful participant will adapt to the changed environment and develop new heuristics Success is defined as SURVIVAL rather than as having maximized expected utility

4.3. ALTERNATIVE MODELS OF MARKET BEHAVIOR AND PORTFOLIO CONSTRUCTION 4.3.1. A Behavioral Approach to Consumption and Savings "Traditional life-cycle model": Spend & save money rationally to achieve an optimal ST & LT consumption plan Describe the Behavioral Approach to Consumption & Savings

The BEHAVIORAL life-cycle theory incorporates: 1. Self-control 2. Mental accounting 3. Framing biases In addition: People classify their sources of wealth into 3 basic buckets 1. *Current income* (mostly likely to be spent) 2. *Currently owned assets* 3. *The PV of future income* (least likely to spend) People *LACK SELF-CONTROL* when it comes to CURRENT INCOME Any CURRENT INCOME that is SAVED is reclassified as CURRENT ASSETS or FUTURE income The portion saved will increase with income

Given a new information, how does a rational decision maker makes decision?

The RATIONAL decision maker, given NEW information, is assumed to UPDATE beliefs about PROBABILITIES according to Bayes' formula

Segregation (segregate risk free from risky)

The RISK-LESS component of any prospect is separated from its RISKY component For example: a prospect initially coded as: 300 @ 80% 200 @ 20% Decomposed into: 200 @ 100% sure gain 100 @ 80% + 0.0 @ 20% risky The same process is applied for losses o The above operations are applied to each prospect separately.

2.2. BEHAVIORAL FINANCE PERSPECTIVE ON INDIVIDUAL BEHAVIOR What are 4 things BF disputes about TF? I guess that based on this, TF decision making is based on Utility Theory not the other stuff which is related to behavior and revise expectations.

The assumptions of TF with respect to the BEHAVIOR OF INDIVIDUALS are not universally observed to hold true Investors: 1. Don't make decisions consistent with UTILITY theory 2. Don't revise expectations consistent with BAYES' formula 3. Exhibit behavior that is NOT SELF-INTERESTED or RISK-AVERSE 4. They don't have access to perfect information & may not process all available information

4.1.3.5. Limits to Arbitrage Explain Limits to Arbitrage

They assume that IMPLICIT RESTRICTIONS are placed on a fund's ability to arbitrage by investors' ability to withdraw their money. The potential for withdrawal of money imposes limits on the ability of the fund to take advantage of arbitrage situations in which two securities ARE NOT RATIONALLY PRICED, because securities' prices MAY remain in a non-equilibrium state for long periods of time. In other words, when a firm or PM is viewed as incompetent or simply wrong about a trade, because certain securities remain irrationally priced for extended periods of time, investors may withdraw their money before the irrational pricing corrects itself and the position may have to be closed prematurely. IMPLICIT in the limits to the arbitrage IDEA is that the EMH DOES NOT HOLD. If investors are engaged in a highly leveraged arbitrage trades and prices move against them, they may have to liquidate the position prior to prices returning to fundamental value. This is the reason why there is LOCK UP PERIODS for investors in certain funds.

2.2.1. Challenges to Rational Economic Man (REM) How can someone challenge REM? What is proposed instead for perfect information and perfect rationality?

Those who challenge REM do so by attacking the basic assumptions : 1. perfect information 2. perfect rationality 3. perfect self-interest BOUNDED rationality is proposed as an alternative to the assumptions of PERFECT INFORMATION AND PERFECT RATIONALITY One of the strongest criticisms of REM challenge the underlying assumption of PERFECT INFORMATION - It is obvious that many ECONOMIC DECISIONS decisions are made in without perfect information

SATISFICE This is how normal people make decisions What is Satisfice? Why decision makers satisfice?

To satisfice is to find a solution in a decision-making situation that MEETS THE NEED OF THE SITUATION and ACHIEVES THE GOALS of the decision maker Satisficing is finding an ACCEPTABLE solution as opposed to OPTIMIZING, which is finding the best (optimal) solution Decision makers may choose to "SATISFICE" rather than "OPTIMIZE" because the COST & TIME of finding the optimal solution can be very high Studies suggests that consumers, employees, and business people typically SATISFICE rather than optimize. The reason behind this is BOUNDED RATIONALITY

2.1. TRADITIONAL FINANCE PERSPECTIVE ON INDIVIDUAL BEHAVIOR Investors are assumed to be... 1. 2. 3. Further they are assumed to be... 1. 2. 3. 4.

Traditional finance concepts may be thought of as NORMATIVE, indicating how people and markets SHOULD behave. Investors are assumed to be: 1. Rational 2. Investors make decisions consistent with utility theory 3. Revise expectations consistent with Bayes' formula They are further assumed to be: 1. Self-interested 2. Risk-averse 3. Have access to perfect information 4. Process all available information in an unbiased way

2.1.1. Utility Theory and Bayes Formula What is utility?

Utility = level of relative satisfaction received from the consumption of goods and services

4.1. TRADITIONAL PERSPECTIVE ON MARKET BEHAVIOR WEAK FORM MARKET EFFICIENCY

WEAK-form market efficiency assumes that ALL PAST MARKET PRICE and VOLUME data are fully reflected in securities' prices If a market is weak-form efficient: * TECHNICAL analysis will not generate excess returns*

2. BEHAVIORAL VERSUS TRADITIONAL FINANCE PERSPECTIVE Behavioral BF MICRO Vs BF MACRO Distinguish BF Micro vs BF Macro?

o BF macro: Considers MARKET ANOMALIES that distinguish MARKETS from the EFFICIENT markets of traditional finance BFMA questions the efficiency of markets o BFMA suggests that MARKETS are subject to BEHAVIORAL effects o These behavioral effects may cause markets to deviate from the efficient markets of traditional finance

2. BEHAVIORAL VERSUS TRADITIONAL FINANCE PERSPECTIVE BF MICRO Distinguish BF Micro vs BF Macro?

o BF micro: Examines behaviors or biases that distinguish INDIVIDUAL INVESTORS from the RATIONAL actors envisioned in Neo-Classical economic theory BFMI questions the perfect rationality and decision-making process of individual investors o BFMI suggests that BEHAVIORAL BIAS biases impact the financial decisions of individual investors o BEHAVIORAL BIAS can be categorized as: 1. cognitive errors 2. emotional biases

2.2.2. Utility Maximization and Counter Point Counter Points to Utility Maximization: It fails to look at EXOGENOUS factors It does not account for RISKS It I decide between work and leasure and decide that i prefer to leasure 8 hrs a day, I might lose my job.

• Are individuals likely to calculate math equations to determine the trade-off between work and leisure on an ongoing basis? Some might, but many would not • The failure to consider EXOGENOUS factors • RISKS needs to be accounted for. - What is this individual's risk of job loss if he does not work eight hours a day? - Risk plays an important part in making utility-maximizing decisions - Risk aversion is an assumption underlying actions taken by REM

REM will: Does REM care about other people preferences to make his own decisions?

• Base his choices only ON HIS OWN UTILITY Not considering the well-being of others except to the extent this impacts REM's utility

2.1.1. Utility Theory and Bayes Formula How decision makers choose between alternatives?

• Decision makers choose between uncertain choice by comparing their EXPECTED UTILITY VALUES • They maximize their expected utility: Weighted sum of the utility values of outcomes x Their probabilities *Subject to their budget constraints*

2.1.1. Utility Theory and Bayes Formula

• In utility theory, people maximize the PV of UTILITY subject to a PV BUDGET constraint

2.2. BEHAVIORAL FINANCE PERSPECTIVE ON INDIVIDUAL BEHAVIOR 2.2.3. Attitudes Toward Risk

• It is not true that an individual's UTILITY FUNCTION has the same curvature consistently • There may be levels of wealth, at which an investor is a RISK -SEEKER and levels of wealth where the investor is RISK -NEUTRAL Also, circumstances may vary: o Double inflection utility function, u(z), is CONCAVE up to inflection point B, then becomes CONVEX until inflection point C, after which it becomes CONCAVE again PROSPECT theory has been proposed as an alternative to expected UTILITY theory

2.1.3. Perfect Rationality, Self-Interest and Information Explain the concept of perfect information? What is this not true? in competitive markets, all relevant information is already reflected in price

• Perfect information would mean that: "all consumers know all things about all products at all times" Therefore, they would always make the best decision regarding their purchases Is that true? o In competitive market, perfect competition does not require that agents have complete knowledge about the actions of others o Rather, in competitive markets, it is assumed that all relevant information is reflected in prices

2.1.3. Perfect Rationality, Self-Interest and Information Explain the concept of perfect rationality? What is this not true? Rationality is not the only driver of HUMAN behavior

• Perfect rationality assumes that REM is a perfectly rational thinker and has the ability to reason & make beneficial judgments at all times Is that true? 1. RATIONALITY is not the only driver of HUMAN BEHAVIOR It is observed that the human INTELLECT is submissive to such human emotions as FEAR, LOVE, HATE, PLEASURE, and PAIN 2. People often use their intellects to achieve or avoid these emotional outcomes

2.1.3. Perfect Rationality, Self-Interest and Information Explain the concept of self-interest? What is this not true? not true, otherwise charity would not exist

• Perfect self-interest is the idea that humans are *perfectly SELFISH* Is that true? o Studies have shown that people are not perfectly self-interested. If they were, charity would not exist

REM will: Does the REM care about SOCIAL VALUES

• REM ignores SOCIAL VALUES Unless adhering to them will give him PLEASURE (i.e., provide utility) or Failing to adhere to them will cause him PAIN (i.e., create disutility)

REM will:

• REM will construct curves of consumption bundles amongst which he is INDIFFERENT because each bundle gives the SAME UTILITY • The curve that is within budget constraints and FURTHEST from the ORIGIN gives the HIGHEST utility Choices made by REM will fall on that curve

REM will: Utility: High or Low

• Try to obtain the highest possible economic utility given budget constraints & the available info about opportunities

REM will:

• Using indifference curve analysis: REM will determine the choices that will combine to give him the HIGHEST UTILITY

2.1.1. Utility Theory and Bayes Formula Talk about the price of the item versus the utility of the item for different investors

• Value of an item is not based on its price, but rather on the utility it yields • The price of an item is dependent only on the characteristics of the item and is equal for everyone • The utility is dependent on the particular circumstances and preferences of the person making the estimate of utility