Behavioral Finance: The Role of Psychology
CLASS NOTES:
Newer revolution of finance
Behavioral finance = Reaction against to 1) Mathematical
finance 2) Efficient market
Over confidence
Kahneman + Tversky
Prospect Theory (1979)
How people make choices
Replaces Expected Utility Theory
Weighting Function
Distort probability
SUMMARY:
Expected Util Theory çà Prospect Theory
Mental Compartment
SUMMARY:
If coin is head – you get $200
If coin is tail – you pay $100
Probability 50% Gain > Loss
Would people buy the rotary ticket?
Today’s topic was behavioral finance.
The theory is replacing the previously presented theories such as 1) Math modeling of expected returns 2) Efficient market hypothesis – information based random algorithms
Behavioral finance theory in another word, prospect theory (Daniel Kahneman et all won Nobel Prize) claims that market behavior (decision making of buy-sell) is heavily incorporated with individual physiologic effect between returns and probability and then it can be modeled as a curve with a reference point. Figure 1 has the reference point in probability so the returns becomes flat after the point.
Cumulative prospect theory
This is also by Kahneman. For the 2nd figure, buyers’ decision depends on prospect of probability/risk (individual feeling you might win or not) and return is not linear but discrete as shown. The figure shows people seemed to over react for 2 extreme cases of probability but does not change reaction much for mid probabilities.
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