behaviourl finance Flashcards
(39 cards)
What is the key principle of Expected Utility Theory (EUT)?
People make decisions by maximizing the expected value of utility over all possible outcomes.
What is the formula for Expected Utility?
E[U] = Σ p_i * u(w_i), where p_i is the probability and u(w_i) is the utility of outcome i.
Define Certainty Equivalent (CE).
The guaranteed amount a person finds equally desirable to a risky prospect.
What is the Risk Premium?
The difference between the expected value of a gamble and its certainty equivalent: RP = E[w] - CE.
How does risk aversion appear graphically in utility functions?
As a concave utility function: u’‘(w) < 0.
What are the key features of the Prospect Theory value function?
Defined over gains/losses, concave for gains, convex for losses, steeper for losses (loss aversion).
What is loss aversion?
Losses hurt about twice as much as gains feel good; a core concept in Prospect Theory.
What is the Certainty Effect?
People overweight certain outcomes over probabilistic ones, even when the latter have better expected values.
What is the Reflection Effect?
Risk attitudes reverse when outcomes are framed as losses versus gains.
What is probability weighting?
People overweigh small probabilities and underweigh large ones.
What is mental accounting?
The tendency to treat money differently depending on its source or intended use.
What is payment decoupling?
Reducing the ‘pain of paying’ by separating payment from consumption.
Define the representativeness heuristic.
Judging probabilities based on similarity to stereotypes or past patterns.
Define the anchoring heuristic.
Relying too heavily on an initial value (anchor) and adjusting insufficiently.
Define the availability heuristic.
Estimating likelihood based on how easily examples come to mind.
What is overconfidence in finance?
The tendency to overestimate one’s knowledge or predictive accuracy.
How does overconfidence affect trading?
It leads to excessive trading and under-diversification.
What is the evidence for overconfidence in trading?
Barber & Odean (2000): high trading volume → lower returns, especially among men.
What is home bias?
Investors overweight domestic assets despite benefits of international diversification.
What is familiarity bias?
Preferring investments one knows or understands, even if they’re not better.
What is the ‘Good Company ≠ Good Stock’ fallacy?
Assuming a well-run or popular company must be a good investment (representativeness bias).
What are limits to arbitrage?
Barriers that prevent rational investors from correcting mispricing.
Give examples of limits to arbitrage.
Fundamental risk, noise-trader risk, short horizons, and short-sale constraints.
What is noise-trader risk?
The risk that irrational traders move prices further from fundamentals.
