Behavioral Finance Essay

3722 Words Oct 3rd, 2013 15 Pages
People are rational and seek to maximize their expected utility
Markets are efficient, with no arbitrage opportunities

These are not confirmed in real life, so we study the reason behind the anomalies in the models using:
Field data
Lab experiments
Computer simulations
Brain scans

Alternatives to Expected Utility Theory
Time Preferences
Predicting Human Behavior in Strategic Situations
Cognitive Biases & Consequences
Using Experiments to Test Finance Theories

Saint Petersburg Paradox
Coin-flipping; payoff for the first heads that appears; payoff doubles for every coin flip.
How much are you willing to pay to play this game?
Expected utility is ∞, but people
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Gamble A: bet on red draw
Gamble B: bet on green draw
Gamble C: bet on red or blue draw
Gamble D: bet on green or blue draw
Most people prefer Gamble A to B and D to C. Why?
People are risk averse.
Betting on red is the “safe” bet, since there might be zero green balls and 60 blue balls.
Betting on green or blue is guaranteed to have a 60/90 (66,6%) chance, since there might be zero blue balls and 60 green balls.
Even though this is reasonable, the choice of bets is contradictory, since they are based on opposite rationalizations (fear of having zero green balls, fear of having zero blue balls)

Explanation: when people have too little information (or ambiguous information), they take the worst-case scenario (minimum expected utility) in the set when evaluating a bet.

Bad news affects decisions more than good news; shocks to information quality. People don’t like poor information quality. Shocks to information quality (9/11, for example) have persisting negative effects on prices.

Allais’ Paradox
Set 1: Choose between
(a) certain amount of 1 million
(b) lottery that pays 5 million with 10% chance, 1 million with 89% chance or zero with 1% chance
Set 2: Choose between
(c) 1 million with 11% chance or zero with 89% chance
(d) 5

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