Behavioral Finance
Chapter 1
x>y means that x is the preferred choice if a person was offered these two choices.
x~y means indifference, the person values the two outcomes the same.
x≥y means that there is a weak preference. Prefers x or is indifferent between x and y.
Utility function u(●): utility is satisfaction received from a particular outcome.
(example of u goods= u(2 bread, 1 water) > u(1bread, 2 water))
(example of u money= u(w2) > u(w1))
Neoclassical economics: assumes that people maximize their utility using full information of the
choice set.
The more wealth a person has, the less the utility increases.
Expected utility theory: individuals should act in a particular way when confronted with decision-
making under uncertainty. The decision is made based on risk, a risky situation is one which you
know what the outcomes could be and can assign a probability to each outcome.
(uncertainty is when you cannot assign probabilities or even come up with possible outcomes.)
People are likely to chose the less risky option:
U(P1)= 0.40u(50.000) + 0.60u(1.000.000) = 3.4069
U(P2)= 0.50u(50.000) + 0.50u(1.000.000) =3.4539
The outcome on P2 is bigger, but people prefer P1 over P2 because the risk of the lower outcome
(50.000) is less.
Risk:
U(P1)= 0.40u(50.000) + 0.60u(1.000.000)
U(P2)= 1.00u(620.000)
Risk averse: the person will most likely choose P2 because the outcome is certain.
Risk seekers: does the opposite of the risk averse person
Risk neutral: people who only care about the values, the risk does not affect their choice.
Risk averse Risk seeker Risk neutral
,Chapter 2
Expected value of returns = E(Ri)
Expectation = E(●)
Variance of returns = Ơi2
Standard deviation = Ơi
Number of observations = n
Return = i
n
1
Mean return = Ŕ i= ∑ Ri , t
n t=1
Ri ,t− Ŕ i¿ 2
¿
Sample variance = n
2 1
S =
i n−1 t =1
∑ ¿
Sample standard deviation = Si= S
√
3−2¿ 2
2
i
¿
Standard deviation = 2−2 ¿2 +¿
1−2 ¿2 +¿
¿
¿
Variance = (weight A x variance A) + (weight B x variance B) + (weight C x var C)
Systematic risk = risk of the market, you cannot reduce this risk
Unique risk = this kind of risk is reducible
Modern portfolio theory: to diversify risk, you should mix the stocks to minimize the unique risk. If
the stocks move identical there is no possibility to reduce the risk.
CAPM: rational investors hold the market portfolio in combination with the risk-free asset. The
investors will not be compensated for taking on diversable risk unrelated to market movements. The
measure of risk is the Beta (β). The Betais the covariance of stock i’s returns with the market.
Expected return on asset i = E ( Ri )=Rf + β i( E ( Rm )−Rf )
E(Rm) = expected return for the market
Ơ (Ri , Rm)
Beta for stock i = βi = 2
Ơ m
Market efficiency: most things that occur are random. Stocks move random too. The prices are
reflecting all information available.
Weak = prices reflect all information contained in historical returns.
Semi-strong = prices reflect all publicly available information, incl. past earnings and forecast.
Strong = prices reflect information that is not publicly available, insiders information.
Efficient market:
, - security prices should respond quickly and accurately to new information.
- professional investors should not outperform net of all fees.
- simulated trading strategies should fail.
Joint hypothesis problem: you cannot determine which of the theories are right.
Example: calculated with CAPM 20% on returns, he stocks say there is 21% on the returns. You should
buy the stock because the return is actually higher than expected OR the calculations with CAPM are
wrong and the market is not efficient.
Agency theory: and agency relationship exists whenever someone (the principal) contracts with
someone else (the agent) to take actions on behalf of the principal and represent the principal’s
interest.
Example: the agent of the company wants the employees to work hard for the owner for the lowest
salary possible. The employees want to work as less as possible for a high salary.
Align the interests:
- Make the employees part of the company so they would want to work hard for it themselves.
- Pay the management in stocks so they have the same interests.
- Make agents principals.
Agency costs: are incurred because managers incentives are not consistent with maximizing the value
of the firm.
Direct costs: include expenditures that benefit the manager but not the firm. (luxury jet)
Indirect costs: difficult to measure and are a result from lost opportunities. Example: managers of a
firm that is an acquisition target may resist the takeover attempt because of concern about keeping
their jobs, even if the shareholders would benefit from merger.
Chapter 1
x>y means that x is the preferred choice if a person was offered these two choices.
x~y means indifference, the person values the two outcomes the same.
x≥y means that there is a weak preference. Prefers x or is indifferent between x and y.
Utility function u(●): utility is satisfaction received from a particular outcome.
(example of u goods= u(2 bread, 1 water) > u(1bread, 2 water))
(example of u money= u(w2) > u(w1))
Neoclassical economics: assumes that people maximize their utility using full information of the
choice set.
The more wealth a person has, the less the utility increases.
Expected utility theory: individuals should act in a particular way when confronted with decision-
making under uncertainty. The decision is made based on risk, a risky situation is one which you
know what the outcomes could be and can assign a probability to each outcome.
(uncertainty is when you cannot assign probabilities or even come up with possible outcomes.)
People are likely to chose the less risky option:
U(P1)= 0.40u(50.000) + 0.60u(1.000.000) = 3.4069
U(P2)= 0.50u(50.000) + 0.50u(1.000.000) =3.4539
The outcome on P2 is bigger, but people prefer P1 over P2 because the risk of the lower outcome
(50.000) is less.
Risk:
U(P1)= 0.40u(50.000) + 0.60u(1.000.000)
U(P2)= 1.00u(620.000)
Risk averse: the person will most likely choose P2 because the outcome is certain.
Risk seekers: does the opposite of the risk averse person
Risk neutral: people who only care about the values, the risk does not affect their choice.
Risk averse Risk seeker Risk neutral
,Chapter 2
Expected value of returns = E(Ri)
Expectation = E(●)
Variance of returns = Ơi2
Standard deviation = Ơi
Number of observations = n
Return = i
n
1
Mean return = Ŕ i= ∑ Ri , t
n t=1
Ri ,t− Ŕ i¿ 2
¿
Sample variance = n
2 1
S =
i n−1 t =1
∑ ¿
Sample standard deviation = Si= S
√
3−2¿ 2
2
i
¿
Standard deviation = 2−2 ¿2 +¿
1−2 ¿2 +¿
¿
¿
Variance = (weight A x variance A) + (weight B x variance B) + (weight C x var C)
Systematic risk = risk of the market, you cannot reduce this risk
Unique risk = this kind of risk is reducible
Modern portfolio theory: to diversify risk, you should mix the stocks to minimize the unique risk. If
the stocks move identical there is no possibility to reduce the risk.
CAPM: rational investors hold the market portfolio in combination with the risk-free asset. The
investors will not be compensated for taking on diversable risk unrelated to market movements. The
measure of risk is the Beta (β). The Betais the covariance of stock i’s returns with the market.
Expected return on asset i = E ( Ri )=Rf + β i( E ( Rm )−Rf )
E(Rm) = expected return for the market
Ơ (Ri , Rm)
Beta for stock i = βi = 2
Ơ m
Market efficiency: most things that occur are random. Stocks move random too. The prices are
reflecting all information available.
Weak = prices reflect all information contained in historical returns.
Semi-strong = prices reflect all publicly available information, incl. past earnings and forecast.
Strong = prices reflect information that is not publicly available, insiders information.
Efficient market:
, - security prices should respond quickly and accurately to new information.
- professional investors should not outperform net of all fees.
- simulated trading strategies should fail.
Joint hypothesis problem: you cannot determine which of the theories are right.
Example: calculated with CAPM 20% on returns, he stocks say there is 21% on the returns. You should
buy the stock because the return is actually higher than expected OR the calculations with CAPM are
wrong and the market is not efficient.
Agency theory: and agency relationship exists whenever someone (the principal) contracts with
someone else (the agent) to take actions on behalf of the principal and represent the principal’s
interest.
Example: the agent of the company wants the employees to work hard for the owner for the lowest
salary possible. The employees want to work as less as possible for a high salary.
Align the interests:
- Make the employees part of the company so they would want to work hard for it themselves.
- Pay the management in stocks so they have the same interests.
- Make agents principals.
Agency costs: are incurred because managers incentives are not consistent with maximizing the value
of the firm.
Direct costs: include expenditures that benefit the manager but not the firm. (luxury jet)
Indirect costs: difficult to measure and are a result from lost opportunities. Example: managers of a
firm that is an acquisition target may resist the takeover attempt because of concern about keeping
their jobs, even if the shareholders would benefit from merger.
