3-6 Behavioral Finance

Question 0

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Answer 0

• People are rational, risk-averse (prefer greater certainty to less certainty), selfish utility maximizers
• everyone has perfect information so results in efficient markets that reflect all available information

Question 1

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Answer 1

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Question 2

What is Behavioral Finance?

Answer 2

• Descriptive rather than prescriptive analysis on how individuals behave and make decisions
• recognizes that individuals exhibit cognitive and emotional biases that doesn’t result in risk-averse utility maximizing decisions

Question 3

Bayes’ Formula

Answer 3

represents the decision process of a rational economic man (REM), where a probability is updated for new information:

P(AIB) = P(A) X [ P(BIA) / P(B) ]

Question 4

Utility function of wealth for risk-averse, risk-neutral and risk-seeking individuals

Answer 4

people can be risk-averse (concave utility function of wealth), risk-seeking (convex) or risk-neutral (linear)

can also exhibit a combination of these

Question 5

What is Bounded Rationality?

Answer 5

• Adjustment to Traditional Finance theory and describes how people really make decisions
• removes assumption that people have perfect information, are fully rational and consistent utility maximizers
• people instead practice satisfice - they will choose less than optimal outcomes that they are satisfied with given limited information, even though the choice doesn’t optimize utility