Behavioral Finance perspective
Traditional vs behavioral finance
Traditional
- normative (ideal)
Behavioral
- descriptive (actual)
- grounded in psychology
- neither assumes rationality nor efficient markets
Individual
- rational
- decisions consistent with utility theory
- revise expectations consistent with Bayes formula
- self-interested, rise averse, access to perfect information, process all information in an unbiased way
Individual focus
- biases/errors impact financial decisions
- cognitive errors = basic statistical, information processing or memory errors
- emotional biases = stem from impulse/intuition, reasoning influenced by feelings
Market focus
- detects and describes market anomalies
Utility & Bayes formula
- max PV of utility subject to a present value budget constraint
- Basic axioms:
- completeness (well defined preferences)
- transitivity (a>b, b>c)
- independence (a>b, a + xc> b + xc)
- continuity - a>b, b>c -> some a + c > b
Rational economic man (REM)
- will obtain the highest possible economic well being (utility)
- given budget constraints, available information, will not consider the well-being
- perfect rationality, perfect self-interest, perfect information
risk-aversion
- utility functions are concave and show diminishing marginal utility of wealth
- Bounded rationality = choices may be rational but are subject to the limitation of knowledge & cognitive capacity
- Inner conflict = short term vs long term goals
- altruism = challenges perfect self-interest
- risk aversion = is reference dependent (averse or seeking)
Prospect theory
- Framing: alternative are ranked heuristically
- Evaluation
- preference for risk seeking or rise averse behavior determined by attitudes towards gains & losses
- attitudes are defined relative to a reference point and not total wealth
Bounded rationality
Decision theory
- normative, concerned with identifying the ideal decision
- assumes decision maker is fully informed, is able to make quant calculation with accuracy and perfectly rational
Bounded rationality
- gather some, but not all available information
- uses heuristics in analysis
Satistice = stop when they have arrived at satisfactory decision
Market behavior/portfolio construction
Traditional
- market level -> prices incorporated and reflect all relevant info
- Weak form
- Semi-strong form
- Strong form
- PC: mean-variance efficient (optimal portfolio given risk tolerance)
Behavioural
Asset pricing
- sentiment premiums/factors
Behavioral portfolio theory
- portfolio in layers
Adaptive market hypothesis
- applies principles of evolution to financial markets (competition, adaptation, natural selection)
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