BEHAVIORAL FINANCE
LECTURE 1
1. INTRODUCTION
Behavioral finance= it uses insights from psychology to understand how human behavior influences
the decisions of investors, markets and managers. Behavioural Finance is a subfield of Behavioural
economics, so they share foundations.
Finance: Financial markets, corporate finance: individual decisions are the heart of the field.
Traditional finance models have a basis in economics.
- Neoclassical economics is the dominant paradigm. Under this paradigm individuals and firms
are self-interested agents who maximize their utility/ profits in the face of constrained resources.
- In Finance, utilities can be defined over security return, portfolio return. We use discounted
utility models to derive expected returns , to value assets etc..
Traditional Finance started by centering valuations on rational economic behavior. Rational
economic behavior is modeled through Expected utility maximization.
• Behavioural finance emerged as a reaction to some market anomalies that traditional theory -
particularly Efficient Market Hypothesis (EMH) and models based on investors rationality- failed
to explain.
• Bubbles and financial crises are examples of such anomalies.
• A deeper understanding of those anomalies and the limits of traditional theory was needed.
In traditional economic model Agents are self-interested , well informed and have distinct
preferences, they make decisions consistent with utility maximation (we will see later the formalism
of such theory . i.e axioms).
Expected utility theory and Finance :
Expected utility theory(EUT): faced with uncertainty, an individual would maximize the expected
utility across possible state of the world. Applicable to individual decision making (investor
decision making)
Financial asset can have innumerable possible future outcomes, EUT as it is , is difficult to apply
Asset pricing framework provides a framework to quantify the tradeoff between risk and return.
Portfolio framework
Asset pricing , portfolio theory have some common assumptions with the Neoclassical model
,Standard Economic Model
The neo-classical economic model is the way most economists think about consumer
welfare and firm profits. This unified vision of the economy is based on some common
rationality assumptions.
Agents are assumed to:
maximize their utility.
to have complete information, and to be able to process such information.
be fully rational, and driven purely by their self-interest
People act with full information => Full external knowledge
People have known preferences => Full internal knowledge
People choose the best option Rational choices
available=>
Behavioral insights:
People often tend to satisfice rather than to maximize.
Information is not generally available (information about the existence of information may
also not be available). Where information is available, people may not obtain it.
Systematic deviations from the self-interested rational agent model exist not only for
individuals, but also for firms.Ultimately: Perceptions count for much more than facts.
Standard Economic model
Theories are usually normative and descriptive at the same time. This may lead to tensions if
they fail descriptively.
Normative theories: tell us how we should behave to obtain a certain
goal (usually utility maximization)
Descriptive theories: How people do really behave, and may or may not be the
same as the normative theory
,2. EXPECTED VALUE
NOTATION
Risk= problems in which probabilities are objectively known, observed.
Uncertainty= when probabilities are unknown, not observed.
A probability is a number between 0 and 1 that indicates a likelihood that a particular outcome will
occur. 0 means the event is impossible, 1 means it is certain. The probability of all events must sum
to 1.
Example: P(Heads) = 0.50 |P(Tails) = 0.50 |P(Heads)+P(Tails) = 1|
Please note that risk for financial assets is assessed differently (variance, downside risk etc..).
We focus mostly on binary prospects (i.e. lotteries), with 2 outcomes x > y and probability p, we can
write this as (x, p;y). Choices can be represented using decision trees.
We are then interested in preference relations between such prospects; ∼ indicates indifference
and ≻ strict preference (do not confuse this with inequalities >).
EXPECTED VALUE
Historically, the first theory used to model decision making under risk was expected value theory
(EVT). Under EVT the value of a prospect is simply taken to be its mathematical expectation:
The expected value of a gamble is the value of each possible outcome times the probability of that
outcome.
In general for i outcomes:
EXAMPLE
Consider a proposed investment action x considered by an investor. Buying some shares cheaply at initial issue
of IPO , then resell them at higher price. Assume one share costs 30p. Assume there are three outcomes :
Shares close at flotation cost : 30p investor gets nothing
Shares close at 60 p investor gets 30p payoff
Shares close at 90 investor gets 60p payoff
Outcomes have equal probabilities of happening p=0.3
Expected value of the lottery: 0.3x30 + 0.3x60 +0.3x90 =30p This is a “fair bet” : the cost is equal to the
expected value.
, Example:
The probability of rain tomorrow is 0.30 and thus the probability of no rain is 0.70.
Suppose you will make €500 if it does not rain, but only €100 if it rains.
EV = (0.70) *(500) + (0.30)*(100) = €380
LIMITS OF EVT: ST PETERSBURG PARADOX
Consider the following prospect. A fair coin is flipped with an equal chance of heads (H) or tails(T).
The player receives a prize everytime the flip comes up H. The game stops when the flip comes up T.
But you would not be willing to pay an infinite amount of money to play this gamble.
EXPECTED UTILITY
The expected utility theory was proposed as a solution to the St. Petersburg paradox by
Daniel Bernoulli in 1738. The paradox is the discrepancy between wat people seem to be
willing to pay to enter the game and the infinite expected value.
The idea is that one’s willingness to pay (WTP) for that bet does not need to be equal to
infinity if one subjectively transforms outcomes. The determination of the value of an item
must not be based on the price, but rather on the utility it yields.
Increase in wealth does not increase utility in equal proportion beyond certain
point=> diminishing marginal utility of expected wealth=> this results in a concave
utility function.
Marginal utility of money decreasing: after a certain wealth level any additional € will be
worth less in utility terms.
LECTURE 1
1. INTRODUCTION
Behavioral finance= it uses insights from psychology to understand how human behavior influences
the decisions of investors, markets and managers. Behavioural Finance is a subfield of Behavioural
economics, so they share foundations.
Finance: Financial markets, corporate finance: individual decisions are the heart of the field.
Traditional finance models have a basis in economics.
- Neoclassical economics is the dominant paradigm. Under this paradigm individuals and firms
are self-interested agents who maximize their utility/ profits in the face of constrained resources.
- In Finance, utilities can be defined over security return, portfolio return. We use discounted
utility models to derive expected returns , to value assets etc..
Traditional Finance started by centering valuations on rational economic behavior. Rational
economic behavior is modeled through Expected utility maximization.
• Behavioural finance emerged as a reaction to some market anomalies that traditional theory -
particularly Efficient Market Hypothesis (EMH) and models based on investors rationality- failed
to explain.
• Bubbles and financial crises are examples of such anomalies.
• A deeper understanding of those anomalies and the limits of traditional theory was needed.
In traditional economic model Agents are self-interested , well informed and have distinct
preferences, they make decisions consistent with utility maximation (we will see later the formalism
of such theory . i.e axioms).
Expected utility theory and Finance :
Expected utility theory(EUT): faced with uncertainty, an individual would maximize the expected
utility across possible state of the world. Applicable to individual decision making (investor
decision making)
Financial asset can have innumerable possible future outcomes, EUT as it is , is difficult to apply
Asset pricing framework provides a framework to quantify the tradeoff between risk and return.
Portfolio framework
Asset pricing , portfolio theory have some common assumptions with the Neoclassical model
,Standard Economic Model
The neo-classical economic model is the way most economists think about consumer
welfare and firm profits. This unified vision of the economy is based on some common
rationality assumptions.
Agents are assumed to:
maximize their utility.
to have complete information, and to be able to process such information.
be fully rational, and driven purely by their self-interest
People act with full information => Full external knowledge
People have known preferences => Full internal knowledge
People choose the best option Rational choices
available=>
Behavioral insights:
People often tend to satisfice rather than to maximize.
Information is not generally available (information about the existence of information may
also not be available). Where information is available, people may not obtain it.
Systematic deviations from the self-interested rational agent model exist not only for
individuals, but also for firms.Ultimately: Perceptions count for much more than facts.
Standard Economic model
Theories are usually normative and descriptive at the same time. This may lead to tensions if
they fail descriptively.
Normative theories: tell us how we should behave to obtain a certain
goal (usually utility maximization)
Descriptive theories: How people do really behave, and may or may not be the
same as the normative theory
,2. EXPECTED VALUE
NOTATION
Risk= problems in which probabilities are objectively known, observed.
Uncertainty= when probabilities are unknown, not observed.
A probability is a number between 0 and 1 that indicates a likelihood that a particular outcome will
occur. 0 means the event is impossible, 1 means it is certain. The probability of all events must sum
to 1.
Example: P(Heads) = 0.50 |P(Tails) = 0.50 |P(Heads)+P(Tails) = 1|
Please note that risk for financial assets is assessed differently (variance, downside risk etc..).
We focus mostly on binary prospects (i.e. lotteries), with 2 outcomes x > y and probability p, we can
write this as (x, p;y). Choices can be represented using decision trees.
We are then interested in preference relations between such prospects; ∼ indicates indifference
and ≻ strict preference (do not confuse this with inequalities >).
EXPECTED VALUE
Historically, the first theory used to model decision making under risk was expected value theory
(EVT). Under EVT the value of a prospect is simply taken to be its mathematical expectation:
The expected value of a gamble is the value of each possible outcome times the probability of that
outcome.
In general for i outcomes:
EXAMPLE
Consider a proposed investment action x considered by an investor. Buying some shares cheaply at initial issue
of IPO , then resell them at higher price. Assume one share costs 30p. Assume there are three outcomes :
Shares close at flotation cost : 30p investor gets nothing
Shares close at 60 p investor gets 30p payoff
Shares close at 90 investor gets 60p payoff
Outcomes have equal probabilities of happening p=0.3
Expected value of the lottery: 0.3x30 + 0.3x60 +0.3x90 =30p This is a “fair bet” : the cost is equal to the
expected value.
, Example:
The probability of rain tomorrow is 0.30 and thus the probability of no rain is 0.70.
Suppose you will make €500 if it does not rain, but only €100 if it rains.
EV = (0.70) *(500) + (0.30)*(100) = €380
LIMITS OF EVT: ST PETERSBURG PARADOX
Consider the following prospect. A fair coin is flipped with an equal chance of heads (H) or tails(T).
The player receives a prize everytime the flip comes up H. The game stops when the flip comes up T.
But you would not be willing to pay an infinite amount of money to play this gamble.
EXPECTED UTILITY
The expected utility theory was proposed as a solution to the St. Petersburg paradox by
Daniel Bernoulli in 1738. The paradox is the discrepancy between wat people seem to be
willing to pay to enter the game and the infinite expected value.
The idea is that one’s willingness to pay (WTP) for that bet does not need to be equal to
infinity if one subjectively transforms outcomes. The determination of the value of an item
must not be based on the price, but rather on the utility it yields.
Increase in wealth does not increase utility in equal proportion beyond certain
point=> diminishing marginal utility of expected wealth=> this results in a concave
utility function.
Marginal utility of money decreasing: after a certain wealth level any additional € will be
worth less in utility terms.
