Topic 2 Behavioral Finance

Topic 2: Behavioral Finance
• Bounded Rationality
• Prospect Theory
• Framing and Mental Accounting
• Behavioral Portfolio Theory
• Behavioral Asset Pricing Theory,
• Adaptive Markets Hypothesis.
1
Bounded Rationality
• A concept proposed by Herbert Simon that
challenges the notion of human rationality as
implied by the concept of homo economicus
(rational economic man)
• Suggests that there are limits upon how rational

a decision maker can be
Bounded Rationality
• Thus, decision making is not perfectly rational; it
is boundedly rational
– Limited information processing (cannot evaluate all
potential alternatives in limited time)
– Satisficing (stop when the solution is “good enough”)
• Satisfice – combines satisfy and suffice and describes decisions, actions
and outcomes that may not be optimal but are adequate/acceptable.
– Use of judgmental heuristics (shortcuts in decision
making that save mental activity)
Bounded Rationality - Example
Ben has cash that he wishes to earn interest on, have accessible
and protect against losses. He is aware that the amount of cash
to be deposited will be fully insured by the government if it is
deposited in an eligible account at an insured member
institution. He has decided to deposit the funds in a current
account at the bank down the street. The bank clearly posts on
its door that it is a member institution and only offers eligible
accounts. The account will pay 0.25%.
Explain how this decision has violated rational behavior but is

consistent with bounded rationality (link on eLearning)
https://padlet.com/mkano/dkzbuqktss9wlawk
Prospect theory (PT)
• The most widely accepted and tested alternative to
EUT
• PT was developed by Kahneman and Tversky based on
observed actual behavior via experimental evidence
that showed that people often behave contrary to EUT.
• Expected utility theory is normative.
– What people should do
• While prospect theory is positive.
– What people do
©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
posted to a publicly available website, in whole or in part. 6
PT: Inconsistent Risk Preferences
• Prospect pair 1 -- choose between: check google classroom
– A: (0.8, 4,000)
– B: (3,000)
• Note: with certainty no need to show a probability
• Prospect pair 2 – choose between:
– A: (0.8, -4,000)
– B: (-3,000)
• Results for 1: most prefer sure Ksh3000 which is consistent
with risk aversion.
• Results for 2: most do not prefer sure -Ksh3000 –> this is
inconsistent with risk aversion.
• Implies people are risk seeking in negative domain (reflection
effect)!
PT: Loss aversion
• Prospect pair 3 -- choose between:
– A: no prospect
– B: (0.5, Ksh500, -Ksh500)
• Most choose A.
• Despite risk aversion in positive domain and risk
seeking in negative domain, losses loom larger than
gains.
– This is called loss aversion.
• These and other results led to prospect theory as an
alternative to expected utility theory.
Key aspects of prospect theory
• Key precepts:
– Value function is in terms of gains or losses
• Gains and losses (PT) vs. absolute wealth (EUT)
– Risk aversion in positive domain
– Risk seeking in negative domain
– Loss aversion
Prospect theory - value function
Prospect theory - value function
– Value function used often is:
v(z) = zα for z ≥ 0, 0<α<1
v(z) = -λ (-z)β for z < 0, l>1, 0<β<1
– 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?
• Many say about $125, which implies value of 2.5 for λ.
• Value above one reflects loss aversion.
Prospect Theory - value function
• Based on the experimental results, Kahneman and
Tversky proposed a hypothetical form for the value
function and estimated the relevant parameters
where α = 0.88; β = 0.88; λ = 2.25

Prospect Theory
Characteristics of the value function
1. Gains/losses from a reference point determine the value along
the vertical axis, rather than final wealth.
– This reference point is usually the status quo
2. It is concave down in the gains domain and concave up in the
loss domain
– People exhibit risk aversion over gains and risk seeking over losses
– Gain and loss satiation
3. The value function is steeper for losses than for gains
– since people dislike losses (loss aversion)
4. It uses decision weights as opposed to simple probabilities as
in EUT
– These decision weights are a function of probabilities and are generally
lower than the corresponding probabilities except in the range of low
probabilities
• Gain and loss satiation:
– The values of the outcomes for both positive and negative
consequences of the choice have the diminishing value
characteristic.
– The α and β terms in the value function equation capture
the marginally decreasing aspect of the function
– Empirical studies estimate that α and β are typically equal
to approximately 0.88 and always less than 1.00.
– When the exponent α < 1.00, the curve will accelerate
negatively (if α = 1.00, the function would be linear; and if
α > 1.00, it would accelerate positively).
• Loss aversion:
– The resulting value function is steeper for losses than for
gains; losing Ksh1,000 produces more pain than gaining
Ksh1,000 produces pleasure.
– The coefficient λ indexes the difference in slopes of the
positive and negative arms of the value function.
– A typical estimate of λ is 2.25, indicating that losses are
approximately twice as painful as gains are pleasurable.
– The absolute value of v(-z) is more than double the value
of v(+z).
– If λ = 1.00, the gains and losses would have equal slopes; if
λ < 1.00, gains would weigh more heavily than losses.
Prospect theory – loss aversion
Allais Paradox: Common ratio effect
– A: (0.9, Ksh2000)
– B: (0.45, Ksh4000)
– A: (0.002, Ksh2000)
– B: (0.001, Ksh4000)
• Most choose 4A and 5B, but this contradicts
expected utility.
Common ratio effect cont.
Prospect Theory - Decision weights
• Why do people who buy lottery tickets also purchase
insurance?
– In the EUT framework, this is puzzling because with a lottery
a person is seeking risk, while with insurance, the same
person may pay to reduce risk, appearing to be risk averse
• Prospect theory can account for the observation that

some people buy lottery tickets and insurance at the
same time.
– It does so by overweighting low-probability events
Lottery tickets
– A: (0.001, Ksh5,000)
– B: (Ksh5)
• Most prefer A which is inconsistent with risk
aversion.
– Lottery effect
– People seem to overweight low-probability events
(which is why people buy lottery tickets)
Insurance
– A: (0.001, -Ksh5,000)
– B: (-Ksh5)
• Most prefer B which is inconsistent with risk
seeking.
– Insurance need
– Once again, people seem to overweight low-
probability events (which is why people buy
insurance)
Prospect Theory - Certainty effect
• The certainty effect happens when people
overweight outcomes that are considered
certain over outcomes that are probable.
• In other words: We would rather get an

assured, lesser win than taking the chance at
winning more [but also risk possibly getting
nothing].
23
Prospect Theory - Certainty effect
– A: (0.2, Ksh4000)
– B: (0.25, Ksh3000)
– A: (0.8, Ksh4,000)
– B: (Ksh3000)
• Most choose 8A and 9B, but they shouldn’t.
– Use exact explanation as for common ratio effect
• Why?
– Certainty is accorded higher weight relative to near-certainty
• Definition: Overweighting outcomes that are certain
relative to those that are probable
24
PT weighting function
PT - weighting function
• Instead of using simple probabilities as in EUT, PT
uses decision weights, which differ from
probabilities.
• Kahneman and Tversky suggested a weighting
function based on their estimates
26
PT - weighting function
• Each probability, p has a decision weight,
p(pr), associated with it
– We require that p(0) = 0 and p(1) = 1
– Small probability events are generally over-
weighted
• This implies that p(pr) > p for small values of p and
p(pr) < p for high values of p
– It need not be true (and generally isn't) that p(p) +
p(1 – p) = 1
• This is known as "subcertainty."
• In their estimation they found that γ = 0.61
and χ = 0.69.
– Since these magnitudes are close, we will, for
simplicity, use the average value (0.65) in both the
gain and loss domain.
27
PT - weighting function notes
• Low probabilities are given relatively higher
weights than high probability events.
• And certainty is weighted highly vs. near-

certainty.
• Weighting function for losses can vary from

weighting function for gains.
• Using functions like this solves some earlier

puzzles.
28
posted to a publicly available website, in whole or in part.
Valuing prospects under prospect theory
• Thus, the value of a prospect is given as:
V(P) = p(pr A) * v(zA) + p(1 - prA) * v(zB)

– where
• V(P) refers to value of prospect, comparable to U(P).
• v(z) refers to the value of a wealth change (z is used instead of w, which
refers to a wealth level)
• π(pr) is the decision weight associated with probability, pr.
• Steps:
– Convert probabilities to decision weights
– Calculate values of gains/losses
– Use above formula
29
Valuing prospects under prospect theory
• V(P) = p(pr A) * v(zA) + p(1 - prA) * v(zB)
where α = 0.88; β = 0.88; λ = 2.25
p(pr) = prg / [prg + (1- pr)g](1/g) where g = 0.65
PT Questions
• Q1: Calculate the value for the following prospect
P1 (0.3, sh300,– sh100)
• Q2: Using prospect theory, choose between the following
two prospects
P2(0.001, sh5,000)
P3(sh5)
• Q3: According to prospect theory, which is preferred?
– Prospect A or B?
• Decision (i). Choose between:
A(0.80, sh50) and B(0.40, sh100)
– Prospect C or D?
• Decision (ii). Choose between:
C (0.00002, sh500,000) and D (0.00001, sh1,000,000)
– Are these choices consistent with expected utility theory? Why or
why not?
PT Question 4
Consider a person with the following value function under
prospect theory:
v(z) = z0.5 if z ≥ 0
= −2(−z)0.5 if z < 0
a) Is this individual loss averse? Explain.
b) Assume that this individual weights values by
probabilities, instead of using a prospect theory
weighting function. Which of the following prospects
would be preferred?
P1(0.8, 1000, −800)
P2(0.7, 1200, −600)
P3(0.5, 2000, −1000)
Expected Utility Theory Prospect Theory
Expected Utility (EU) vs. Prospect Theory (PT)
• Discuss in groups
• Post discussion notes on padlet (link on
eLearning)
• https://padlet.com/mkano/gzdpra5jrg9ij
ma9
Prospect theory vs Utility theory
Poll question
slido.com
• Which concept has struck you the most in behavioral
finance so far?
• https://app.sli.do/event/ailnjg7g/embed/polls
/f83cb190-4cc8-4b71-8dc3-4d3754ace8c5
Other Behavioral Finance Models
1. Framing and mental accounting
2. Behavioral Portfolio Theory
3. Behavioral Asset Pricing
4. Adaptive Markets Hypothesis
51
posted to a publicly available website, in whole or in part.
Framing
• Essential condition for a theory of choice is
principle of invariance:
– different representations of same problem should
yield same preference.
• Unfortunately, this sometimes does not work
out in practice:
– People have different perspectives and produce
different decisions depending on how a problem is
framed.
Framing: Example
• Prospect pair 10 – you are given Ksh1000 – then choose
between:
– A: (0.5, Ksh1000)
– B: (Ksh500)
• Prospect pair 11 – you are given Ksh2000 – then choose
between:
– A: (0.5, -Ksh1000)
– B: (-Ksh500)
• Results for 10: most prefer B.
• Results for 11: most prefer A.
• Problems are identical! People have chosen differently
because of different frames.
Mental accounting
• Refers to the way people categorize money
• According to MA, people place value based on
which category the money falls into
– Some categories are worth more than other
categories.
• This can sometimes go against logic, and often
leads to odd and suboptimal decisions.
• Related to prospect theory and framing.
Mental accounting:
Example 1: Theater ticket problems
• 1. Imagine you have decided to see a play
where admission is Ksh1000. As you enter
theater you discover that you have lost a
Ksh1,000 note. Would you still pay Ksh1,000 for
a ticket to the play?
• 2. Imagine that you have decided to see a play
and paid the admission price of Ksh1,000 per
ticket. As you enter the theater you discover
that you have lost the ticket. The seat was not
marked and the ticket cannot be recovered.
Would you pay Ksh1,000 for another ticket?
Mental accounting:
Example 1: Theater ticket problems cont.
• Nothing is different about the two problems.
• Of respondents given first question, 88% said
they would buy a ticket.
• Of respondents given second question, 54% said
they would not buy a ticket.
Mental accounting
• Example 2
– Simon has allocated a Ksh10,000 in the trip jar for
her next trip.
– Even if she is short on her rent by Ksh10,000, she
won't use it.
– This is because the value, the worth, of the money
in that trip jar is more valuable than money she
uses for her rent.
– She'd rather borrow the Ksh10,000 she is short
from someone rather than use her trip jar money.
• ©2010 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or
Mental accounting: video
Prospect theory, mental
accounting and prior outcomes
• Problem with prospect theory is that it was set
up to deal with one-shot gambles – but what
if there have been prior gains or losses?
• Do we go back to zero (segregation), or move
along curve (integration)?
• Integration occurs when positions are lumped
together, while segregation occurs when
situations are viewed one at a time.
Mental accounting:
Example 1: Theater ticket problems cont.
• In 2nd question, where the movie ticket got lost,
integration is more likely because both lost
ticket and new ticket would be from same
“account.”
– Integration might suggest that Ksh2,000 is too much for the
ticket.
Mental accounting: Opening and closing
accounts
• Once an “account” is closed, you go back

to zero.
• Evidence that people avoid closing

accounts at a loss:
– Selling a stock at a loss is painful: disposition effect (to
be discussed later).
Behavioral Asset Pricing
• The intrinsic value of an asset is its expected
cashflows discounted at a required return (RR)
• Under traditional asset pricing models (e.g., CAPM)
RR = risk free rate + fundamental risk premium
• Behavioral asset pricing model adds a sentiment
premium to the discounting rate
– RR = risk free rate + fundamental risk premium +
sentiment premium
• Market sentiment is understood as the aggregate
error in the market
– When market sentiment is zero, prices are efficient, and
vice versa.
63
• The more widely dispersed analysts’ opinion, the
greater the sentiment premium
– The higher the discount rate applied to asset’s cash flow
the lower the asset’s prices
• Market sentiment is a stochastic process that co-

evolves with fundamentals
• The sentiment premium is referred to as a

stochastic discount factor (SDF) in the proposed
asset pricing model and is based on investor
sentiment relative to fundamental value.
64
• Reference:
– Shefrin, H. (2008). A behavioral approach to asset
pricing. Elsevier.
Behavioral Portfolio Theory
• Rather than hold well-diversified portfolios,
investors layer their portfolio according to goals
such as required return, utility, access to
information, loss aversion etc.
• The resulting overall portfolio may appear
diversified but may be suboptimal since the layers
are constructed without regard to their correlation
with each other.
• Can explain
– Holding excess cash and low risk bonds in the low risk layer and
excessively risky assets in the high risk layer (and not holding
more moderate-risk assets)
Behavioral Portfolio Theory
• Reference: Shefrin, H., & Statman, M. (2000).
Behavioral portfolio theory. Journal of financial and
quantitative analysis, 35(2), 127-151
Adaptive Markets Hypothesis (AMH)
• AMH couples the notion of bounded rationality
and satisficing with evolutionary dynamics
• Under AMH prices reflect as much information
as dictated by the combination of
environmental conditions and the number and
nature of “species” in the economy.
• “Species” means distinct groups of market
participants e.g., pension funds, retail
investors, hedge fund managers etc.
• Thus, market efficiency cannot be evaluated in
a vacuum but is highly context dependent and
dynamic.
• Success in the market is an evolutionary process
such that investors make decisions to help them
survive and satisfice.
– NOT utility maximization
• There are five basic tenets of adaptive markets
1. People act in their own self-interest.
2. People make mistakes.
3. From those mistakes, they learn, adapt, and
innovate.
4. As they experiment and fail or succeed, the
process of natural selection operates on
individuals, institutions, and markets.
5. This evolutionary process is what determines
financial market dynamics.
Practical implications
1. The risk/return relationship is unlikely to be stable
over time.
2. Contrary to EMH, arbitrage opportunities do arise
from time to time in AMH, hence providing
motivation for active portfolio management.
3. Investment strategies wax and wane, performing
well in certain environments and poorly in other
environments.
4. Innovation is the key to survival, market
participants must adapt to changing market
environments in order to survive.
5. Survival is the only objective that matters, and not
profit maximisation or utility maximisation.
71

Topic 2 Behavioral Finance

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Topic 2 Behavioral Finance

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Topic 2: Behavioral Finance

• Suggests that there are limits upon how rational

Explain how this decision has violated rational behavior but is

where α = 0.88; β = 0.88; λ = 2.25

• Prospect theory can account for the observation that

• In other words: We would rather get an

• And certainty is weighted highly vs. near-

• Weighting function for losses can vary from

• Using functions like this solves some earlier

V(P) = p(pr A) * v(zA) + p(1 - prA) * v(zB)

where α = 0.88; β = 0.88; λ = 2.25

p(pr) = prg / [prg + (1- pr)g](1/g) where g = 0.65

• Once an “account” is closed, you go back

• Evidence that people avoid closing

• Market sentiment is a stochastic process that co-

• The sentiment premium is referred to as a

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