Behavioral Finance

Quantitative Business and Economic Research Institute

Prof. Dr. Alexander Klos
alexander.klos@qber.uni-kiel.de

Behavioral Finance – Chapter 2 1

Behavioral Finance
Structure of the lecture

1. Motivation / Basic concepts of

Behavioral Finance
Behavior of
2. Syst. errors in ind. decision making
individual investors
3. Investor behavior
- in general
- in the context of retirement savings
Implications for
financial markets
4. Behavioral Finance and markets
- Limits of Arbitrage

Behavioral Finance – Chapter 2 – April 2020 2

2 – Systematic errors in individual decision making

Structure of the chapter

Chapter 2: Systematic errors in individual decision making

2.1 Important normative concepts khái niệm quy phạm

2.1.1 Information updating according to Bayes’ law

2.1.2 Evaluation of uncertain alternatives: EU
2.2 Heuristics and biases
2.2.1 Judgment biases
2.2.2 Evaluation biases
2.3 Prospect Theory

Behavioral Finance – Chapter 2 – April 2020 3

2 – Systematic errors in individual decision making

Normative concepts

What is the rational benchmark?

… with respect to the

processing of information … with respect to the
evaluation of alternatives
(How to integrate pieces of information with uncertain outcomes
and how to update probabilities …)

Expected Utility
Bayesian Updating
Theory (EU) Một lý thuyết chuẩn tắc cho rằng các cá
nhân nên hành động theo một cách cụ thể
khi thực hiện việc ra quyết định trong điều
Bayes‘ Rule Expected Utility Theory kiện không chắc chắn
A formula that tells you how A normative theory contending that it does not design to tell us how
sửa đổi to revise initially assumed individuals should act in a particular people actually act
(“prior”) probabilities in the way when undertaking decision-
light of new data. making under uncertainty.
Eisenführ/Weber/Langer (2010), page 187 Ackert/Deaves (2009), page 361

Behavioral Finance – Chapter 2 – April 2020 4

2 – Systematic errors in individual decision making

Information updating according to Bayes

A (simple but) typical problem:

You wonder whether a certain company (e. g. a bank) is a good or a bad one. You can
observe some signals (e. g. they need public money during the 2008/2009 credit
crisis), which are all somewhat related to, but are not perfect predictors of the quality
of the company.

How should you change your original judgment (i.e. your subjective probability that
you face a high quality firm) as a reaction to the observed signals (e. g. the use of
public money)?

Another famous example (Dawes, 1988): cắt cụt vú trước

According to a newspaper report, a US doctor performed pre-emptive breast

amputations on 90 women belonging to a “high-risk group.” The reasoning behind the
amputations was that 93% of all breast cancer cases belonged to the high-risk group.
The frequency of breast cancer for the basic population considered the doctor to be
7.5% and the fraction belonging to the high-risk group to be 57%.

Determine the probability that a women belonging to the high-risk group indeed gets
breast cancer.

Behavioral Finance – Chapter 2 – April 2020 5

2 – Systematic errors in individual decision making

Bayes‘ theorem – General derivation

i is the event we are interested in

(is it a good bank?)

xj is the signal (they need public money)

xác suất tiên nghiệm, đc đưa từ các quan sát

Given: • a priori probabilities p(i)
T. Bayes (1702-1761)
• likelihoods p(xj|i)
Wanted: • a posteriori probabilities p(i|xj) Tells you how
noisy the signal is
That‘s the probability we are looking for
Given we observed some signal xj, how likely is the event i?

Behavioral Finance – Chapter 2 – April 2020 6

2 – Systematic errors in individual decision making

Bayes‘ theorem – General derivation

Given: • a priori probabilities p(i) i is the event we are

• likelihoods p(xj|i) interested in

Wanted: • a posteriori probabilities p(i|xj) xj is the signal

We know (multiplication rule) that 𝑝 𝜇𝑖 , 𝑥𝑗 = 𝑝 𝑥𝑗 𝑝 𝜇𝑖 𝑥𝑗

and 𝑝 𝜇𝑖 , 𝑥𝑗 = 𝑝 𝜇𝑖 𝑝 𝑥𝑗 𝜇𝑖 .

It follows: 𝑝 𝑥𝑗 𝑝 𝜇𝑖 𝑥𝑗 = 𝑝 𝜇𝑖 𝑝 𝑥𝑗 𝜇𝑖

𝑝 𝜇𝑖 𝑝 𝑥𝑗 𝜇𝑖 𝑝 𝜇𝑖 𝑝 𝑥𝑗 𝜇𝑖
Bayes‘ rule: 𝑝 𝜇𝑖 𝑥𝑗 =
𝑝 𝑥𝑗
=
σ𝑖 𝑝(𝜇𝑖 )𝑝 𝑥𝑗 |𝜇𝑖

Behavioral Finance – Chapter 2 – April 2020 7

2 – Systematic errors in individual decision making

Bayes‘ theorem – Example

Suppose I have a jar of coins in which 99% are fair coins and 1% are double headed
coins. I take a coin at random and toss it 3 times and observe 3 heads.

What is the probability that this is a double headed coin?

1 : This is a double headed coin

2 : This is a fair coin
x : 3 heads in a row

𝑝 𝜇1 𝑝 𝑥 𝜇1 𝑝 𝜇1 𝑝 𝑥 𝜇1
𝑝 𝜇1 𝑥 = =
𝑝 𝑥 𝑝 𝜇1 𝑝 𝑥 𝜇1 + 𝑝 𝜇2 𝑝 𝑥 𝜇2

0.01 ∙ 1
𝑝 𝜇1 𝑥 = ≈ 0.075
0.01 ∙ 1 + 0.99 ∙ 0.53

𝑝 𝜇2 𝑥 = 1 − 𝑝 𝜇1 𝑥 ≈ 0.925

Behavioral Finance – Chapter 2 8

2 – Systematic errors in individual decision making

Bayes‘ theorem

𝑝 𝜇𝑖 𝑝 𝑥𝑗 𝜇𝑖
We can also write Bayes’ rule 𝑝 𝜇𝑖 𝑥𝑗 = 𝑝 𝑥𝑗
as

Bayes‘ rule: 𝑝 𝜇𝑖 𝑥𝑗 ∝ 𝑝 𝜇𝑖 𝑝 𝑥𝑗 𝜇𝑖

tương xứng 1
∝ means “proportional to.” The constant of proportionality is 𝑝 . The constant ensures
𝑥𝑗
that the 𝑝 𝜇𝑖 𝑥𝑗 sum up to 1 if we sum over all i.

Example:
𝑝 𝜇1 𝑝 𝑥 𝜇1 = 0.01 ∙ 1 = 0.01

𝑝 𝜇2 𝑝 𝑥 𝜇2 = 0.99 ∙ 0.53 = 0.99 ∙ 0.125 = 0.12375

0.01 0.12375
𝑝 𝜇1 𝑥 and 𝑝 𝜇2 𝑥 must sum up to 1. We can find 𝑝(𝑥) by solving + = 1.
𝑝 𝑥 𝑝 𝑥

Behavioral Finance – Chapter 2 – April 2020 9

2 – Systematic errors in individual decision making

Bayes‘ theorem – Continuous variables

𝑓 𝜇 𝑓 𝑥𝜇 𝑓 𝜇 𝑓 𝑥𝜇
Bayes‘ rule: 𝑓 𝜇𝑥 =
𝑓 𝑥
= ∞
‫׬‬−∞ 𝑓 𝜇 𝑓 𝑥|𝜇 𝑑𝜇

or: 𝑓 𝜇𝑥 ∝𝑓 𝜇 𝑓 𝑥𝜇

Example:

Assume 𝑥~𝑁(𝜇, 𝜎 2 ). 𝜎 2 is known. Suppose that we have an unknown parameter 𝜇.

Prior beliefs about the unknown parameter 𝜇 can be express in terms of a normal
distribution, so that 𝜇~𝑁(𝜇0 , 𝜎02 ) and 𝜇0 and 𝜎02 are known. (Note that 𝜎 2 ≠ 𝜎02 .)

Derive the posterior distribution of 𝜇 given that we have one observation z from the
random variable x.
Proof can be googled. Here, the ∝-representation of Bayes’ rule is helpful.

𝜇0 𝜎2 +𝑧𝜎0 ² 𝜎 2 𝜎0 ²
Solution: 𝜇|𝑧~𝑁(𝜇1 , 𝜎12 ) with 𝜇1 = and 𝜎12 =
𝜎 2 +𝜎0 ² 𝜎 2 +𝜎0 ²
In words: Updated belief about 𝜇 is a weighted average of prior belief and signal.

Behavioral Finance – Chapter 2 – April 2020 10

2 – Systematic errors in individual decision making

Structure of the chapter

Chapter 2: Systematic errors in individual decision making

2.1 Important normative concepts

2.1.1 Information updating according to Bayes’ law
2.1.2 Evaluation of uncertain alternatives: EU
2.2 Heuristics and biases
2.2.1 Judgment biases
2.2.2 Evaluation biases
2.3 Prospect Theory

Behavioral Finance – Chapter 2 – April 2020 11

2 – Systematic errors in individual decision making

Expected utility theory

Alternatives: a, b, ... a1
p1
a2
Probabilities: p1, p2, p3, ... p2
.
for the occurrence of a .
pn-1 .

pn an-1
Consequences: a1, a2, a3, ...
respectively x1, x2, x3, ... an

Idea: If certain axioms are satisfied, a so called “utility function“ is used to

assign a utility level to each consequence. Nếu 1 số tiên đề nhất định thỏa mãn, một cái gọi là "hàm tiện ích"
được sử dụng để ấn định mức tiện ích cho mỗi hệ quả.
The expected utility of each alternative is computed.
The higher the expected utility of an alternative, the
more preferred it is. 𝑛 ∞

𝐸𝑈 𝑎 = ෍ 𝑝𝑖 𝑢 𝑎𝑖 or 𝐸𝑈 𝑎 = න 𝑢 𝑥 𝑓 𝑥 𝑑𝑥
𝑖=1 −∞
Note: f(x) is the density function of the distribution of consequences of alternative a in the continuous case.

Behavioral Finance – Chapter 2 – April 2020 12

2 – Systematic errors in individual decision making

Axioms of expected utility theory

Complete Ordering Thứ tự complete

• Completeness: f.a. a, b it holds: a ≿ b or b ≿ a.
• Transitivity: from a ≿ b and b ≿ c follows a ≿ c.

Behavioral Finance – Chapter 2 – April 2020 13

2 – Systematic errors in individual decision making

Axioms of expected utility theory

Continuity
if a ≿ b ≿ c, then there exists some probability p
such that: b ~ p · a + (1 – p) · c.

If
1 1 1
a 100 € ≻ b 50 € ≻ c 10 €

Then

p 100 €
1
50 € ∼
1-p 10 €

Behavioral Finance – Chapter 2 – April 2020 14

2 – Systematic errors in individual decision making

Axioms of expected utility theory

Independence
if a ≿ b, it must hold for each lottery c and probability p:
p·a+(1–p)·c ≿ p·b+(1–p)·c.

(verbal description: A preference between two lotteries should not change

if both lotteries are connected to the same (irrelevant) lottery)

Behavioral Finance – Chapter 2 – April 2020 15

2 – Systematic errors in individual decision making

Example: Independence axiom

Assume: 60 €
70 € 0.5 0.7 60 €
0.4

a ≿ b c
0.6 30 € 0.5 30 € 0.3 10 €

a‘= 0.5·a + 0.5·c 70 €

0.4 70 €
0.2
0.5
0.6 30 € 0.35 60 €

0.3 giá trị trung bình 45.5

0.7 60 € 30 €
0.5

0.3 0.15
10 € 10 €
Independence axiom:
b‘= 0.5·b + 0.5·c If a ≿ b, then a’ ≿ b’
60 €
0.5
60 €
0.6
0.5
0.5 30 €
0.25 30 € average value: 45
0.7 60 €
0.5
0.15
0.3 10 € 10 €

Behavioral Finance – Chapter 2 – April 2020 16

 9. Decision making under risk and one objective
Axiomatic foundation of utility theory

• Independence axiom is suy ra thêm là có a' và a ~ b thì có thể suy ra b

often called the
substitution axiom 50% change to play ab
lottery a
– Lottery b has the same 100 250
value as lottery a in the 0,5 0,5
example if the a‘
a
50% change to play
100 ~
indifference statements 0,5 lottery c 0,5
are true 0 0

– Direct implication of the

if I have an indifference
independence axiom, 250
between a and b, then i also since with indifference 0,5
have an indifference between between a and b
a' and b'
indifference must also 0,5 0,5
hold for the combined bb‘ 0
Lottery a: Certain 100
0,5
lotteries Lottery b: (250,0.5;0,0.5)
0
a’ = p · a + (1 – p) · c and Lottery c: Certain 0
b’ = p · b + (1 – p) · c 50% change to play
p=0.5
lottery c

Rational Decision Making – Chapter 7-9 – May 2019 17

2 – Systematic errors in individual decision making

Expected utility theory (EUT)

Connection between axioms and EUT formula
a1 q1 x max

p 1-q 1 x min
1  p
1
pi qi x max
a: pi
ai ai~(xmax,qi, xmin,1-qi) a':
1-q i x min
pn qn x max
pn
an 1-q n x min


n x max
pi q i
i= 1
EUT formula
n
EU(a)   pi  u(ai ). u(ai):= qi a'':
i1
n
p (1 - qi )
i= 1 i x min

Behavioral Finance – Chapter 2 – April 2020 18

2 – Systematic errors in individual decision making

Expected utility theory (EUT)

Understanding the role of the qi is crucial in understanding the overall proof.

By the continuity axiom, each possible outcome ai corresponds to a unique

probability qi (see ). The qi’s range from 0 to 1 (qi=0 corresponds to xmin and
qi=1 corresponds to xmax) and the higher the qi the “more attractive” is the ai
(so the qi’s have the flavor of a “utility value” even though they are probabilities).

Using this property ai~(xmax,qi, xmin,1-qi), we can conclude via the independence
axiom (see ) and reduction, a simple property of probability calculus, (see )
that each alternative a is as “attractive” as an alternative a‘ with only two
outcomes xmax and xmin.
Thus the attractiveness of an arbitrary alternative must be determined by the
n

probability to receive xmax in a‘‘. This probability is  p  q and can be interpreted

i i
i1
to be the expected utility of a.

Thus alternatives have to be compared by their expected utility.

Behavioral Finance – Chapter 2 – April 2020 19

2 – Systematic errors in individual decision making

Exp. utility and normal distributions

• With CARA utility (𝑢 𝑥 = 1 − 𝑒 −𝑎𝑥 ) and normal distributions, one can show that
∞
𝑎 𝑎 2 −𝑎
𝑎
𝜇− 𝜎2
෩ ෩ ෩
𝐸 𝑢(𝑊) = න 𝑢 𝑊 𝑓 𝑊 𝑑𝑊 = 𝑢 𝐸 𝑊 − 𝑉𝑎𝑟(𝑊) = 𝑢 𝜇 − 𝜎 = 1 − 𝑒 2
2 2
−∞
𝑢′′ 𝑊
• a: Arrow-Pratt risk aversion coefficient − 𝑢′ 𝑊
• f(W): probability density function of a normal distribution

• Example:
• 𝑢 𝑊 = 1 − 𝑒 −0.02𝑊
• Calculate expected utility if wealth is normally distributed with mean 𝜇=8 CU and
standard deviation 𝜎=.3 CU
1. The “simple” way:
𝑎 0.02
෩ = 1− −0.02 𝜇−2 𝜎2 −0.02 8− 2 0.32
𝐸 𝑢(𝑊) 𝑒 =1− 𝑒 ≈ 0.148

2. The “hard” way:

∞ 𝑊−𝜇 2
1
෩ =න
𝐸 𝑢(𝑊) 1 − 𝑒 −0.02𝑊 𝑒
−
2𝜎² 𝑑𝑊 ≈ 0.148
−∞ 𝜎 2𝜋

Behavioral Finance – Chapter 2 – April 2020 20