Vrije Universiteit Amsterdam
Behavioral Finance
Summary
October 2025
,1 Chapter 1
Lack of understanding of our thoughts and behaviour − > Unable to recognize when cognitive
processes that usually serve us are likely to lead us astray.
Judgment
• • Cognitive aspects of our decision-making process
Dominance
1. Define the problem − > to correctly identify and define the problem, accurate judgment is needed.
• Managers make errors by defining the problem in terms of a proposed solution
• Or, by missing the bigger problem
• Or, by diagnosing the problem in terms of its symptoms.
2. Identify the criteria − > most decisions require you to accomplish more than one objective
3. Weigh the criteria
4. Generate alternatives − > search continues until the cost of the search outweighs the value of the
added information
5. Rate each alternative on each criterion − > requires us to forecast future events potential conse-
quences of selecting each alternative on each of the criterion
6. Multiply the ratings (step 5) by the weight of each criterion − > adding up the weighted ratings
across all of the criteria for each alternative − > choose the solution with the highest sum of the
weighted ratings
System 1: Cognitive functioning
• Intuitive system fast, automatic, effortless, implicit and emotional
• Sufficient
• More likely that errors will occur
System 2: Cognitive functioning
• Rational decision-making process
• Slower, conscious, effortful, explicit, logical
• Most important decisions
Rationality
• Decision-making process that is logically expected to lead to the optimal result, given an accurate
assessment of the decision maker’s values and risk preferences
Two schools of thought
• Decision making can be divided in two parts − > study of prescriptive models and the study of
descriptive models
• Prescriptive models − > develop methods for making optimal decisions
• v(a(s1 )) is the outcome of action a if state 1 happens.
1
,Why descriptive approach?
• Understanding our own decision-making process helps clarify where we are likely to make mistakes
and therefore when better decision strategies are needed
• Optimal decision often depends on behaviour of others
• Plenty of good advice about decisions is available but not followed by people
Attempt at making rational decisions fails
• Often lack important information that would help define the problem
• Time and cost constraints − > limit quantity and quality of available information
• Decision makers retain a small amount of information in usable memory
• Intelligence limitations and perceptual errors − > constrain ability to accurately calculate optimal
choice
Satisfice − > search until a satisfactory solution is found instead of examining all possible alterna-
tives.
Heuristics
• Number of simplifying strategies people rely on when making decisions
• Mechanism for coping with complex environment surrounding decisions
• Helpful but lead to severe errors − > people are unaware that they rely on heuristics − > misap-
plying heuristics to inappropriate situations
• Benefit − > time saved outweighs the costs of any potential reduction in the quality of the decision
• Simple way of dealing with a complex world
Decision-making bounded
• Willpower is bounded− > give greater weight to present concerns than future concerns
• Self-interest is bounded − > care about the outcomes of others
Type of heuristics applied across population
1. Availability heuristic
2. Representativeness heuristic
3. Confirmation heuristic
4. Affect heuristic
Availability heuristic
• People assess the probability of an event by the degree to which occurrences of that event are readily
“available” in memory
• Useful managerial decision-making strategy − > Often leads to accurate judgments
• Error − > Availability of information is often affected by factors unrelated to the objective frequency
of the event
Representativeness heuristic
2
, • Individuals − > Tend to look for traits that correspond with previously formed stereotypes
• Managers − > predict person’s performance based on an established category of people
• Good first-cut approximation − > drawing attention to the best options
• Work on unconscious level
• Error − > People tend to rely on representative information when the information is insufficient or
less obviously representative information is available.
Confirmation heuristic
• Four separate situations to consider when assessing the association between 2 events − > Everyday
decision making commonly neglects this
• Lack of evidence to the contrary − > People assume a given hypothesis/ statement is true − >
Confirmation bias
• Good first-cut approximation − > drawing attention to the best options
• Work on unconscious level
• Error − > People tend to rely on representative information when the information is insufficient or
less obviously representative information is available.
Anchoring − > Irrelevant initial hypothesis/ starting point holds undue sway over our judgment
Hindsight bias − > Too quickly dismiss, in hindsight, the possibility that things could have turned out
differently than they did
Affect heuristic
• Often unconscious
• System 1 thinking − > Used when people are busy or under time constraint
3
Behavioral Finance
Summary
October 2025
,1 Chapter 1
Lack of understanding of our thoughts and behaviour − > Unable to recognize when cognitive
processes that usually serve us are likely to lead us astray.
Judgment
• • Cognitive aspects of our decision-making process
Dominance
1. Define the problem − > to correctly identify and define the problem, accurate judgment is needed.
• Managers make errors by defining the problem in terms of a proposed solution
• Or, by missing the bigger problem
• Or, by diagnosing the problem in terms of its symptoms.
2. Identify the criteria − > most decisions require you to accomplish more than one objective
3. Weigh the criteria
4. Generate alternatives − > search continues until the cost of the search outweighs the value of the
added information
5. Rate each alternative on each criterion − > requires us to forecast future events potential conse-
quences of selecting each alternative on each of the criterion
6. Multiply the ratings (step 5) by the weight of each criterion − > adding up the weighted ratings
across all of the criteria for each alternative − > choose the solution with the highest sum of the
weighted ratings
System 1: Cognitive functioning
• Intuitive system fast, automatic, effortless, implicit and emotional
• Sufficient
• More likely that errors will occur
System 2: Cognitive functioning
• Rational decision-making process
• Slower, conscious, effortful, explicit, logical
• Most important decisions
Rationality
• Decision-making process that is logically expected to lead to the optimal result, given an accurate
assessment of the decision maker’s values and risk preferences
Two schools of thought
• Decision making can be divided in two parts − > study of prescriptive models and the study of
descriptive models
• Prescriptive models − > develop methods for making optimal decisions
• v(a(s1 )) is the outcome of action a if state 1 happens.
1
,Why descriptive approach?
• Understanding our own decision-making process helps clarify where we are likely to make mistakes
and therefore when better decision strategies are needed
• Optimal decision often depends on behaviour of others
• Plenty of good advice about decisions is available but not followed by people
Attempt at making rational decisions fails
• Often lack important information that would help define the problem
• Time and cost constraints − > limit quantity and quality of available information
• Decision makers retain a small amount of information in usable memory
• Intelligence limitations and perceptual errors − > constrain ability to accurately calculate optimal
choice
Satisfice − > search until a satisfactory solution is found instead of examining all possible alterna-
tives.
Heuristics
• Number of simplifying strategies people rely on when making decisions
• Mechanism for coping with complex environment surrounding decisions
• Helpful but lead to severe errors − > people are unaware that they rely on heuristics − > misap-
plying heuristics to inappropriate situations
• Benefit − > time saved outweighs the costs of any potential reduction in the quality of the decision
• Simple way of dealing with a complex world
Decision-making bounded
• Willpower is bounded− > give greater weight to present concerns than future concerns
• Self-interest is bounded − > care about the outcomes of others
Type of heuristics applied across population
1. Availability heuristic
2. Representativeness heuristic
3. Confirmation heuristic
4. Affect heuristic
Availability heuristic
• People assess the probability of an event by the degree to which occurrences of that event are readily
“available” in memory
• Useful managerial decision-making strategy − > Often leads to accurate judgments
• Error − > Availability of information is often affected by factors unrelated to the objective frequency
of the event
Representativeness heuristic
2
, • Individuals − > Tend to look for traits that correspond with previously formed stereotypes
• Managers − > predict person’s performance based on an established category of people
• Good first-cut approximation − > drawing attention to the best options
• Work on unconscious level
• Error − > People tend to rely on representative information when the information is insufficient or
less obviously representative information is available.
Confirmation heuristic
• Four separate situations to consider when assessing the association between 2 events − > Everyday
decision making commonly neglects this
• Lack of evidence to the contrary − > People assume a given hypothesis/ statement is true − >
Confirmation bias
• Good first-cut approximation − > drawing attention to the best options
• Work on unconscious level
• Error − > People tend to rely on representative information when the information is insufficient or
less obviously representative information is available.
Anchoring − > Irrelevant initial hypothesis/ starting point holds undue sway over our judgment
Hindsight bias − > Too quickly dismiss, in hindsight, the possibility that things could have turned out
differently than they did
Affect heuristic
• Often unconscious
• System 1 thinking − > Used when people are busy or under time constraint
3
