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Behavioral Finance perspective (Traditional vs behavioral finance…
Behavioral Finance perspective
Traditional vs behavioral finance
Traditional
normative (ideal)
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
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
Behavioral
descriptive (actual)
grounded in psychology
neither assumes rationality nor efficient markets
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
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
Market focus
detects and describes market anomalies
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)