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MN30509 Behavioural Finance Lecture 1

Behavioural finance lecture 1 notes

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University of Bath

Academic year: 2021/2022

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MN30509 Behavioural Finance

Lecture 1: introduction  Behavioural finance looks at effects of investors’ psychological biases in financial markets  Behavioural corporate finance looks at effects of managerial psychological biases in corporate finance decisions  Social forces: herding behaviour in finance markets, looking at what other investors are doing, getting information on their thinking  Social preferences: thinking of others, not self-interested – trust, fairness, empathy  Fairness: FSA (financial services authority- changed name after financial crisis to FCA- financial conduct authority, looks over financial markets) reports / HFT paper  2 main managerial biases: overconfidence and regret  Emotional finance / emotional corporate finance looks at the effects of managers / investors’ unconscious emotions in a Freudian psychoanalytical framework  Standard finance assumes that managers and investors are fully-rational, unbiased, emotionless, self-interested maximisers of expected utility, with stable preferences (homo economicus)  Behavioural finance considers the real world: agents are boundedly rational, biased, emotional, not fully self-interested, non-EU maximisers, unstable preferences  Biases: overconfidence  Non expected utility / unstable preferences: prospect theory  Not fully self-interested: fairness, trust, empathy  Emotions: incorporating emotions (pride/regret) into prospect theory

Behavioural foundations Biases  Predisposition towards error  Excessive optimism  Overconfidence  Confirmation bias  Illusion of control

Heuristics  A rule of thumb used to make a decision  Representativeness  Availability  Anchoring  Affect

Framing effects  A person’s decisions are influenced by the manner in which the setting for the decision is described  Framing is important in prospect theory  Prospect theory: a general psychological approach that describes how people make choices among risky alternatives  Framing in prospect theory: loss aversion / aversion to a sure loss

 Economic accounting / mental accounting / sunk losses / entrapment

Expected utility theory

 Monotone increase and concave down  General shape for risk averse  The sure thing gives a higher utility than the gamble

Prospect theory

 In the negative domain, when people face with losses, people prefer the gamble, so are risk seeking  When faced with a gain, people are risk averse

Portfolio theory: Markowitz

 Most choose A  Despite risk aversion in positive domain and risk seeking in negative domain, losses loom larger than gains  This is loss aversion

Development of prospect theory  These and other results led to prospect theory as an alternative to expected utility theory  Key precepts: o Value function is in terms of gains and losses (because of the kink at the origin) o Risk aversion in positive domain o Risk seeking in negative domain o Loss aversion

Prospect theory value function

Common value function functional form  Function used often is: o In the positive domain: v(z) = zα for z≥0, 0<α< o In the negative domain: v(z) = -λ(-z)β for z<0, λ>1, 0<β< More simple: o In the positive domain: u = w1/ o In the negative domain: u = -w1/ o The higher the lambda the bigger the kink  Kink at origin is from λ  Value function (not utility) so v is used  Ask people about 50/50-coin toss where loss is $50 and gain is unknown: what gain would make people indifferent between gamble or no gamble? o Many say about $125, which implies value of 2 for λ o Value above one reflects loss aversion

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MN30509 Behavioural Finance Lecture 1

Module: Behavioural finance (MN30509)

University: University of Bath

Was this document helpful?

MN30509 Behavioural Finance

Lecture 1: introduction

Behavioural finance looks at effects of investors’ psychological biases in financial

markets

Behavioural corporate finance looks at effects of managerial psychological biases in

corporate finance decisions

Social forces: herding behaviour in finance markets, looking at what other investors

are doing, getting information on their thinking

Social preferences: thinking of others, not self-interested – trust, fairness, empathy

Fairness: FSA (financial services authority- changed name after financial crisis to FCA-

financial conduct authority, looks over financial markets) reports / HFT paper

2 main managerial biases: overconfidence and regret

Emotional finance / emotional corporate finance looks at the effects of managers /

investors’ unconscious emotions in a Freudian psychoanalytical framework

Standard finance assumes that managers and investors are fully-rational, unbiased,

emotionless, self-interested maximisers of expected utility, with stable preferences

(homo economicus)

Behavioural finance considers the real world: agents are boundedly rational, biased,

emotional, not fully self-interested, non-EU maximisers, unstable preferences

Biases: overconfidence

Non expected utility / unstable preferences: prospect theory

Not fully self-interested: fairness, trust, empathy

Emotions: incorporating emotions (pride/regret) into prospect theory

Behavioural foundations

Biases

Predisposition towards error

Excessive optimism

Overconfidence

Confirmation bias

Illusion of control

Heuristics

A rule of thumb used to make a decision

Representativeness

Availability

Anchoring

Affect

Framing effects

A person’s decisions are influenced by the manner in which the setting for the

decision is described

Framing is important in prospect theory

Prospect theory: a general psychological approach that describes how people make

choices among risky alternatives

Framing in prospect theory: loss aversion / aversion to a sure loss

MN30509 Behavioural Finance Lecture 1

Behavioural finance (MN30509)

University of Bath

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MN30509 Behavioural Finance Lecture 1

Module: Behavioural finance (MN30509)

University: University of Bath

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