Behavioural Finance Topic 10 – Psychology of Money
Recap from last week on CPT
• Key anomalies in EU theory that prospect theory must accommodate
▪ Asymmetry between how people regard gains and losses (loss aversion): people
weigh losses much more than gains. In expected utility theory, there is a symmetry.
▪ People tend to judge things relative to a reference point rather than in absolute terms
as ‘expected utility theory’. Expected utility is defined in terms of absolute wealth and
prospect theory is defined in terms of gains and losses (relative to a reference point).
▪ Overweighting of low probabilities in decision making and underweighting of high
probabilities relative to certainty. People tend to act in ways that are risk adverse
when gains are involved. In terms of losses, people prefer to take a gamble, even if
the expected losses are greater than the expected gains.
▪ Framing: the way problems are framed affects people’s decisions and choices.
People behave differently depending on how things are framed.
Gains Losses
People tend to be risk-averse: People tend to be risk-seeking:
prefer certain gains to gamble to avoid certain losses
uncertain ones with higher ER (take gamble with worse ER)
Low probabilities People may switch to People may switch to
risk-seeking behaviour (e.g. risk-aversion: e.g. buy
buy lottery tickets where cost of insurance where cost of
ticket is greater than ‘expected’ insurance is greater than value
winnings) of expected losses (claim)
• Cumulative Prospect Theory
▪ Prospect Theory (value function): replaces expected utility function.
▪ Decision weighting function: translates objective probabilities into ones that people
act on.
, ▪ Integration and segregation
For numerical questions on prospect theory in the exam (like Thomas question of previous week)
Look at Q3 from 2016 exam paper.
Today
Psychological aspects of money
• Social versus market norms
• Pay, motivation and performance
• Money, honesty and cheating
Recap from last week on CPT
• Key anomalies in EU theory that prospect theory must accommodate
▪ Asymmetry between how people regard gains and losses (loss aversion): people
weigh losses much more than gains. In expected utility theory, there is a symmetry.
▪ People tend to judge things relative to a reference point rather than in absolute terms
as ‘expected utility theory’. Expected utility is defined in terms of absolute wealth and
prospect theory is defined in terms of gains and losses (relative to a reference point).
▪ Overweighting of low probabilities in decision making and underweighting of high
probabilities relative to certainty. People tend to act in ways that are risk adverse
when gains are involved. In terms of losses, people prefer to take a gamble, even if
the expected losses are greater than the expected gains.
▪ Framing: the way problems are framed affects people’s decisions and choices.
People behave differently depending on how things are framed.
Gains Losses
People tend to be risk-averse: People tend to be risk-seeking:
prefer certain gains to gamble to avoid certain losses
uncertain ones with higher ER (take gamble with worse ER)
Low probabilities People may switch to People may switch to
risk-seeking behaviour (e.g. risk-aversion: e.g. buy
buy lottery tickets where cost of insurance where cost of
ticket is greater than ‘expected’ insurance is greater than value
winnings) of expected losses (claim)
• Cumulative Prospect Theory
▪ Prospect Theory (value function): replaces expected utility function.
▪ Decision weighting function: translates objective probabilities into ones that people
act on.
, ▪ Integration and segregation
For numerical questions on prospect theory in the exam (like Thomas question of previous week)
Look at Q3 from 2016 exam paper.
Today
Psychological aspects of money
• Social versus market norms
• Pay, motivation and performance
• Money, honesty and cheating
