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Behavioral Finance summary articles and lectures
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Behavioral FinanceLecture 1 Beliefs & Preferences
15-05-2023
Reading for this week:
Traditional Framework
There are two key assumptions about individual psychology:
1. Rational beliefs: when new information arrives, they immediately update their beliefs
about future outcomes, and do so correctly, as prescribed by Bayes’ rule.
2. Preferences, Expected Utility Theory: given their beliefs, they choose the action with the
highest expected utility for a utility function that is defined over consumption outcomes
and that is increasing concave.
Example of the ball and the bat: a bat and a ball cost $1.10 in total, the bat costs $1 more than
the ball. How much does the ball cost?
- There are different systems in answering this. There is the immediate urge to go for
$0.10 (system 1). But when you think longer, you know it should be $0.05 (system 2).
o System 1: operates automatically and quickly, with little or no effort and no
sense of voluntary control.
o System 2: allocates attention to the effortful mental activities that demand it,
including complex computations. The operations of system 2 are often
associated with the subjective experience of agency, choice and concentration.
- These two systems can run together, system 1 is more a gut feeling, and system 2 will
think a bit longer. But we often see, that the suggestion from system 1 is just taken over
by system 2, causing a biased belief.
Research in behavioral finance has tried to improve the psychological realism of the traditional
model.
Heuristics beliefs
- A rule of thumb used to arrive at a judgement or make a decision.
- Defined as cognitive shortcuts or rules of thumb that simplify decisions, especially under
conditions of uncertainty.
- They represent a process of substituting a difficult question with an easier one.
There are different types of heuristics:
- Representativeness:
Linda is 31 years old, single, outspoken and very bright. She majored in
philosophy. As a student, she was deeply concerned with issues of discrimination
and social justice and participated in antinuclear demonstrations.
Which of the following is the most likely?
o Linda is a feminist, active in the women’s movement
o Linda is a psychiatric social worker
o Linda is a bank teller
, There is no right or wrong, but most of the people choose A or B. People are
arriving at this judgement because people see the three options as categories with
stereotypes in which they fit the characteristics of Linda.
- Gambler’s Fallacy (in Finance):
Suppose a coin is flipped 5 times and the result of each event was ‘heads’.
What would you bet for the next coin flip?
o Your gut feeling tells you it should be tails, because you feel it should change at
some point, since you know it normally is 50/50.
o But, looking at past results, heads would be logical.
It is always 50/50, so individuals have a poor understanding of the random
process. People, think that the reversal point will occur more often than it does.
People think past performance can predict what will happen in the future.
- Availability:
People overweight information that is readily available and intuitive relative to
information that is less salient and more abstract, thereby biasing judgement.
Which one is more likely?
o A massive flood occurs somewhere in North America
o A massive flood happens because of an earthquake in California
Most people think that the second one is more likely, because they associate
California with earthquakes and floods, which makes it easier to imagine. However,
since California is in North America, if the second would happen, the first would
happen as well.
- Anchoring and Adjustment
People form an estimate by beginning with an initial number and adjusting to
reflect new information or circumstances. However, they tend to make
insufficient adjustments relative to that number, thereby leading to anchoring
bias. This happens a lot in pricing products or services. Something is never too
expensive, it is all relative. E.g. stating something was before $9.99, but is now
sold for $2. This gives an anchor to which it is now relatively cheap.
Example: two groups of students estimated, within 5 seconds, a numerical
expression that was written on the blackboard.
o Group 1 estimates the following equation: 8x7x6x5x4x3x2x1
o Group 2 estimates the other equation: 1x2x3x4x5x6x7x8
The result it the same, but the first one was estimated larger than the second
one, since the first has the higher number at the beginning, already anchoring
judgement to it.
Prospect Theory; preferences
- A general psychological approach that describes the way people make choices among
risky alternatives.
- Prospect theory is the most popular and widespread one.
- But before we go into the details, we have a recap of the Expected Utility Theory.
,Expected Utility Preference
- Prospect:
o A prospect is a contract that yields outcome Xi with probability Pi, where P1+P2+
…+Pn = 1
o A prospect is to be understood as a list of outcomes with associated
probabilities.
- Expected Utility:
o The expected utility preferences over the prospect f can be represented as
where u(.) is typically an increasing and concave function/
o An example: St. Petersburg Paradox
A casino offers a game of chance for a single player in which a fair coin is tossed
at each stage. The initial stake starts at 2 dollars and is doubles every time heads
appears; the first-time tails appears, the game ends and the player wins
whatever is in the pot.
What would be a fair price to pay the casino for entering the game?
the expected payoff of the gamble is ½*2 + ¼*4 + 1/8*8 + … = infinity
Yet, in reality, it would be hard to find anyone willing to pay even $25 to
participate in this gamble.
This is the St. Petersburg Paradox, the solution to this paradox is the Expected
Utility Paradox.
- People’s ‘utility’, or the subjective, internal value they attach to an additional unit of
money is determined by how much money they already have. People are risk averse,
so they consider how much winning or losing the extra money is worth to them.
- Example: Insurance
Suppose you have a house worth of $200,000. There is a small chance (0.2%)
that a fire will damage your house and will generate $75,000 in loss. You
decide to add a fire detection/prevention system to your house at a cost of
$50. Knowing that: you are risk averse and have a utility function of u(x) =
ln(x).
o Is such behavior consistent with the expected utility theory?
o The expected utility to not purchase the security system is:
V1 = 0.2% X ln(200,000-75,000) + (1-0.2%) X ln(200,000) = 12.197
o The expected utility to buy the security system is:
V2 = ln(200,000-50) = 12.206
Based on our assumptions, an expected utility maximizing individual will buy
this security system.
Prospect Theory
Designed to explain a common pattern of choice. It looks at two parts of decision making: the
framing phase and the evaluation phase.
, Decision Frame: the decision-maker’s conception of the acts, outcomes, and contingencies
associated with a particular choice. It is often possible to frame a given decision problem in
more than one way.
Framing; an example
Imagine that the U.S. is preparing for the outbreak of an unusual Asian disease, which is
expected to kill 600 people. Two alternative programs to combat the disease have been
proposed. Assume that the exact scientific estimate of the consequences of the program are as
follows:
- Program A: 200 people will be saved
- Program B: there is a 1/3 probability that 600 people will be saved and a 2/3
probability that no one will be saved.
- Program C: 400 people will die
- Program D: there is a 1/3 probability that nobody will die and a 2/3 probability that
600 people will die
Which policy would you choose?
- There are multiple ways to choose and your mind will prefer B over D and A over C,
even though the facts are the same, this is caused by framing,
The Fourfold Pattern:
The fourfold pattern is associated with decision tasks in which the risks involve either gains only
or losses only.
- Pattern 1: suppose that you face a choice between two risks. Which of the two
would you choose?
o 90% chance of winning €2000 and 10% chance of zero
o 45% change of winning €4000 and 55% chance of zero
- Pattern 2: suppose that you face a choice between two risks. Which of the two
would you choose?
o 0.2% chance of winning €2000 and 99.8% chance of zero
o 0.1% chance of winning €4000 and 99.9% chance of zero
- Pattern 3: suppose that you face a choice between two risks. Which of the two
would you choose?
o 90% chance of losing €2000 and 10% chance of zero
o 45% chance of losing €4000 and 55% chance of zero
- Pattern 4: suppose that you face a choice between two risks. Which of the two
would you choose?
o 0.2% chance of losing €2000 and 99.8% chance of zero
o 0.1% chance of losing €4000 and 99.9% chance of zero
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