Reading 6 - 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 TF. 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 as a matter of procedure every time they make a decision or that the decisions of people are consistent with those that would be made on the basis of Bayesian updating.
4.2. TRADITIONAL PERSPECTIVE ON PORTFOLIO CONSTRUCTION
A "RATIONAL" portfolio is one that is MEAN¬VARIANCE efficient. The appropriate portfolio for an investor is constructed HOLISTICALLY by considering the investor's TOLERANCE for RISK, INVESTMENT OBJECTIVES, INVESTMENT CONSTRAINTS, and investor circumstances.
4.1.3.3. Calendar Anomalies What is 2 examples of a technical anomaly? Explain these.
A CALENDAR ANOMALY is an irregularity identified when patterns of trading behavior that OCCUR IN CERTAIN TIMES OF THE YEAR are considered. JANUARY EFFECT: Stocks in general—and SMALL stocks, in particular—have delivered abnormally high returns during the month of January. THE TURN OF THE MONTH EFFECT: stocks earn higher returns on the last day and first four days of each month
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?
A FUNDAMENTAL anomaly is an irregularity that emerges when one considers a stock's future performance based on a fundamental assessment of the stock's value. - performance of SMALL-capitalization companies and VALUE companies compared to LARGE-capitalization companies and GROWTH companies 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.
4.1.3. Studies Challenging the EMH: Anomalies 4.1.3.2. Technical Anomalies: What is 2 examples of a technical anomaly? Explain these.
A technical anomaly is an irregularity that emerges when one considers PAST PRICES AND VOLUME LEVELS. Technical analysis encompasses a number of techniques that attempt to forecast securities PRICES by studying PAST prices and VOLUME levels. Common technical analysis strategies are based on RELATIVE STRENGTH and MOVING AVERAGES, as well as on SUPPORT and RESISTANCE. MOVING AVERAGES: - Buy and sell signals are generated by the crossing of a short moving average with a long moving average. - When the short moving average moves above (below) the long moving average, the signal is to buy (sell). - They test long moving averages of 50, 150, and 200 days with short moving averages of 1, 2, and 5 days. TRADING RANGE BREAK (Support and Resistance): - A buy signal is generated when the price penetrates the resistance level, and a sell signal is generated when the price penetrates the support level. Brock et al. test support and resistance based on past 50, 150, and 200 days with signals generated when a maximum or minimum is violated by 1 percent. - They then compute 10-day holding period returns following the buy and sell signals.
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. • 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.
3.3. PROSPECT THEORY What is prospect theory?
ALTERNATIVE to expected UTILITY theory Prospect theory describes HOW INDIVIDUALS MAKE CHOICES in situations in which they have to decide between alternatives that involve RISK (e.g., financial decisions) and how individuals EVALUATE potential LOSSES & GAINS. Prospect theory considers how prospects (alternatives) are perceived based on their framing, how gains and losses are evaluated, and how uncertain outcomes are weighted.
4.3.2. A Behavioral Approach to Asset Pricing Describe the Behavioral Approach to Asset Pricing
An alternative to 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, which in turn is derived from systematic errors in judgment committed by investors. Sentiment causes asset prices to deviate from values determined using TF approaches Dispersion of analysts' forecasts serves as a PROXY for the SENTIMENT RISK PREMIUM in the model. Thus, 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)
What is preference anomaly?
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.
Introduction
BF is about understanding how people make decisions, both ind. and collectively. By understanding how investors & mkts behave, it may be possible to MODIFY OR ADAPT to their behaviors to improve economic outcomes. The INTEGRATION of BF and TF finance has can produce a SUPERIOR economic outcome; the resulting financial decision may produce an economic outcome closer to the OPTIMAL outcome of TF, while being EASIER for an investor to adhere to in practice.
4.3.3. Behavioral Portfolio Theory ***IMPORTANT for the EXAM***
BPT uses a probability-weighting function rather than the real probability distribution used in Markowitz's portfolio theory (1952).
Cancellation
Cancellation involves DISCARDING COMMON OUTCOMES probability pairs between choices. For example, the pairs (200, 0.2; 100, 0.5; 20, 0.3) and (200, 0.2; 300, 0.4; -50, 0.4) are reduced to (100, 0.5; 20, 0.3) and (300, 0.4; -50, 0.4).
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 relevant to a given 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. Bounded rationality theory: o Relaxes the assumptions that PERFECT INFORMATION is available and that ALL AVAILABLE INFORMATION IS PROCESSED according to expected UTILITY theory. o Acknowledges that individuals are limited in their abilities to gather and process information. Prospect theory: o Relaxes the assumptions that individuals are RISK-AVERSE and make decisions consistent with expected UTILITY theory. o Assumes that individuals are LOSS-AVERSE.
Editing Phase
Depending on the number of prospects, there may be UP TO SIX 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 risk aversion? What is the shape of the utility curve? And have ...marginal utility of wealth. Explain what it means to be risk averse, risk neutral and risk seeking?
Expected utility theory generally assumes that individuals are risk-averse. This means that: • individual may refuse a fair bet (a bet w/ an exp. value =0) • utility functions are concave & show diminishing marginal utility of wealth. Given 2 choices: 1) investing to receive an exp value w/ certainty 2) investing in an uncertain alternative that generates the same expected value: o Risk-averse (TF): Someone who prefers to invest to receive an expected value with CERTAINTY rather than invest in the UNCERTAIN alternative that generates the same expected value. o Risk-neutral: Someone who is indifferent between the two investments o Risk-seeking: Someone who prefers to invest in the uncertain alternative
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, a RATIONAL decision maker makes decisions consistent with the AXIOMS of UTILITY THEORY and chooses the combination of decisions that MAXIMIZES EXPECTED UTILITY. 1. Completeness: assumes that an individual has well-defined preferences and can decide between any two alternatives. 2. Transitivity: assumes that, as an individual decides according to the completeness axiom, an individual decides consistently. 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. 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.
2. BEHAVIORAL VERSUS TRADITIONAL FINANCE PERSPECTIVE a. Contrast TRADITIONAL and behavioral finance perspectives on investor decision making; Traditional FINANCE PERSPECTIVE
Grounded in neoclassical economics. Individuals are assumed to be: 1. Risk-averse, 2. Self-interested utility maximizers • Investors who behave in this manner are referred to as RATIONAL. At the mkt level, prices incorporate and reflect ALL available & relevant info. • Mkt that behave in this manner are referred as EFFICIENT. • The TF approach relies on assumptions that tend to OVERSIMPLIFY reality & are challenged by BF. • 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. • Attempts to understand & explain observed INVESTOR & MKT behaviors and bases its assumptions on OBSERVED financial behavior rather than on IDEALIZED financial behavior. • Neither assumes that people act rationally and consider all available information in decision-making nor that markets are efficient.
Prospect theory: What are the main phases of making a choice?
In prospect theory, based on descriptive analysis of how choices are made, there are TWO phases to making a choice: 1) an EARLY PHASE in which prospects are FRAMED(or EDITED) - consists of using heuristics to do a preliminary analysis of the prospects, often yielding a simpler representation of these prospects. - decide which outcomes they see as economically identical & then create a reference point to consider where these prospects rate. - Outcomes BELOW the reference point are viewed as LOSSES, and those ABOVE the reference point are GAINS. 2) a LATER PHASE in which prospects are EVALUATED and CHOSEN. - Edited prospects are evaluated and the prospect of HIGHEST PERCEIVED VALUE is chosen.
3.3.1. The Evaluation Phase
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(prob1)v(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 under react to mid-sized and large probabilities. * v is a function that assigns a value to an outcome o The value function (graph for gain and 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.
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 NOT FULLY RATIONAL when making decisions and DO NOT necessarily "OPTIMIZE" but rather "SATISFICE"when arriving at their decisions. People have informational, intellectual, and computational limitations. People gather SOME (BUT NOT ALL) available information, use heuristics (rules of thumb) to make the process of analyzing the information tractable, and stop when they have arrived at a satisfactory, not necessarily optimal, decision. Bounded rationality sets parameters on how much will be done in making a decision and within which decisions will be deemed as satisfactory. The term "SATISFICE" combines "satisfy" and "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 or welfare. A gain or loss is, of course, defined with respect to some REFERENCE POINT. The location of the reference point affects whether the outcomes are coded as gains or losses. Prospects are coded as (gain or loss, probability; gain or loss, probability; ...) such that the probabilities initially add to 100 percent or 1.0.
BPT: Layers In BPT investors construct their portfolios in layers and expectations of returns and attitudes toward risk vary between the layers.
Portfolio construction is primarily a function of five factors. 1. the allocation to different layers depends on investor goals and the importance assigned to each goal. 2. the allocation of funds within a layer to specific assets will depend on the goal set for the layer. If a higher goal is set, then the assets selected for the layer are likely to be riskier or more speculative in nature. 3. the n. of assets chosen for a layer depends on the shape of the investor's utility function. - Risk-averse individuals have concave utility functions, meaning that utility increases at a decreasing rate with increases in wealth (diminishing marginal utility of wealth). 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. 4. concentrated positions in some securities may occur if investors believe they have an informational advantage with respect to the securities. 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.
Simplification
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.
Combination
Prospects are simplified by COMBINING the probabilities associated with IDENTICAL GAINS or LOSSES. For example, a prospect initially coded as (250, 0.20; 200, 0.25; 200, 0.15; 150, 0.40) will be simplified to (250, 0.20; 200, 0.40; 150, 0.40).
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. • It is not necessarily true that an individual's UTILITY FUNCTION 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.
Risk attitude towards wealth Describe the utility curve for a risk averse individual, risk neutral individual and risk seeking individual?
Risk attitudes toward wealth are reflected in the curvature of the individual's utility function of wealth: 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-AVERSE individuals have: 1. CONCAVE utility functions (utility increases at a decreasing rate with increases in wealth) 2. Individual has a DIMINISHING marginal utility of wealth. 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. Thus, if a market is semi-strong-form efficient, TECHNICAL and 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. Thus, if a market is strong-form efficient, even INSIDER INFORMATION will not generate excess returns.
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?
TF assumes that after gathering information and analyzing it according to Bayes' formula, individuals will MAKES DECISIONS CONSISTENT WITH with the decisions of RATIONAL ECONOMIC MAN (REM). REM will: • Try to obtain the highest possible econ utility given budget constraints & the available info about opportunities, • Base his choices only ON his OWN utility, not considering the well-being of others except to the extent this impacts REM's utility. • Using indifference curve analysis, REM will determine the choices that will combine to give him the HIGHEST UTILITY. • 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 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). • Principles of perfect rationality, perfect self-interest, and perfect information govern REM's economic decisions.
4.3.4. Adaptive Markets Hypothesis
The AMH applies principles of evolution—such as competition, adaptation, and natural selection—to financial markets in an attempt to reconcile efficient market theories with behavioral alternatives. 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 Lo notes that 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: people are assumed to spend and save money rationally to achieve an optimal short-term and long-term consumption plan. Describe the Behavioral Approach to Consumption and Savings
The BEHAVIORAL life-cycle theory incorporates self-control, mental accounting, and framing biases. In addition: People classify their sources of wealth into three basic accounts: 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.
Bayes Formula Explain how people use Bayes Formula to make decisions?
The RATIONAL decision maker, given NEW information, is assumed to UPDATE beliefs about PROBABILITIES according to Bayes' formula. Bayes' formula is a mathematical rule explaining how EXISTING PROBABILITIES beliefs should be changed given NEW information. In order to develop the calculation, all possible events must be MUTUALLY exclusive and EXHAUSTIVE events with KNOWN probabilities. 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 they may have different utility functions or different beliefs about the probabilities of different outcomes.
Segregation
The RISK-LESS component of any prospect is separated from its RISKY component. For example, a prospect initially coded as (300, 0.8; 200, 0.2) is decomposed into a sure gain of (200, 1.0) and a risky prospect of (100, 0.8; 0, 0.20). The same process is applied for losses. o The above operations are applied to each prospect separately. The following operations are applied to two or more prospects:
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 w/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 info & may not process all available info.
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 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 of perfect information, perfect rationality, and 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 intuitively obvious that many economic decisions are made in the absence of 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
What is the main difference of prospect theory value function from expected utility function?
VALUES are attached to CHANGES rather than FINAL STATES, and the 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. Prospect theory EXPLAINS APPARENT DEVIATION in decision making from the RATIONAL decisions of TF. These deviations result from OVER WEIGHTING low probability outcomes, UNDER WEIGHTING moderate and high probability outcomes, and having a value function for changes in wealth (gains and losses) that is in general CONCAVE for gains, CONVEX for losses, and STEEPER for LOSSES than for GAINS. As a result, people are: RISK-AVERSE: - HIGH PROB. OF GAINS or a low probability of losses; RISK=SEEKING: - low probability of gains or a HIGH PROB OF LOSSES of losses.
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. Thus, 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 micro: examines behaviors or biases that distinguish INDIVIDUAL INVESTORS from the RATIONAL actors envisioned in Neo Classical economic theory. o BF macro: considers MARKET ANOMALIES that distinguish MARKETS from the EFFICIENT markets of traditional finance. BFMI questions the perfect rationality and decision-making process of individual investors, and BFMA questions the efficiency of markets. o BFMI suggests that BEHAVIORAL BIAS biases impact the financial decisions of individual investors. BEHAVIORAL BIAS can be categorized as cognitive errors or emotional biases. o BFMA suggests that MARKETS are subject to BEHAVIORAL effects. These behavioral effects may cause markets to deviate from the efficient markets of traditional finance.
2.1.1. Utility Theory and Bayes Formula What is utility theory? What is utility? How decision makers choose between alternatives?
• In utility theory, people maximize the PV of UTILITY subject to a PV BUDGET constraint (Utility= level of relative satisfaction received from the consumption of goods and services) • Decision makers choose between RISKY or UNCERTAIN prospects by comparing their expected UTILITY VALUES • They max their exp. utility (the wgt sum of the utility values of outcomes x by their prop) —subject to their budget constraints. • 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, however, is dependent on the particular circumstances and preferences of the person making the estimate of utility.
2.1.3. Perfect Rationality, Self-Interest and Information Explain the concept of perfect information? What is this not true?
• 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 purchases. Is that true? o In competitive mkt, 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?
• 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? o Rationality is not the sole driver of human behavior. o It is observed that the human INTELLECT is submissive to such human emotions as fear, love, hate, pleasure, and pain. o 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?
• 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, philanthropy would not exist.
