Behavioral Finance Lecture 1

BMME115 Behavioral Finance
Lecture 1
Beliefs and Preferences
Dr. Li He
Rotterdam School of Management
MScFI program
Beliefs: Heuristics Preferences: Prospect Theory References
Traditional Framework
Two assumptions about individual psychology:
Dr. Li He Beliefs and Preferences 1 / 33


I Rational beliefs
I When new information arrives, they immediately update their
beliefs about future outcomes, and do so correctly, as prescribed
by Bayes’ rule.


I Rational beliefs
I When new information arrives, they immediately update their
beliefs about future outcomes, and do so correctly, as prescribed
by Bayes’ rule.
I Preferences: Expected utility theory
I Given their beliefs, they choose the action with the highest
Expected Utility for a utility function that is defined over
consumption outcomes and that is increasing and concave.

The Architecture of Cognition: An Illustrative Example
Bat and Ball
I A bat and a ball cost $1.10 in total.
I The bat costs $1 more than the ball.
How much does the ball cost?
A $0.10
B $0.05
C $0.55

The Architecture of Cognition: Two Systems
System 1
I Operates automatically and quickly, with little or no effort and
no sense of voluntary control.
System 2
I Allocates attention to the effortful mental activities that
demand it, including complex computations. The operations of
System 2 are often associated with the subjective experience of
agency, choice, and concentration.

Behavioral Finance
Research in behavioral finance has tried to improve the

psychological realism of the traditional model

Behavioral Finance

I Beliefs: heuristics
I A rule of thumb used to arrive at a judgment or make a decision.

Behavioral Finance

I Preferences: Prospect theory
I A general psychological approach that describes the way people
make choices among risky alternatives.

Behavioral Finance


Heuristics
Definition
I Heuristics are defined as cognitive shortcuts or rules of thumb
that simplify decisions, especially under conditions of
uncertainty.
I They represent a process of substituting a difficult question
with an easier one.
References
I Tversky, A. and Kahneman, D. (1974). Judgment under uncertainty:

Heuristics and biases. Science, 185(4157):1124–1131

Representativeness
Definition
People make judgements based on stereotypic thinking, asking how

representative an object or idea it belongs.

Representativeness: An Illustrative Example
Consider an individual who has been described by a friend as follows:
“ Linda is 31 years old, single, outspoken and very bright. She majored in
philosophy. As a student she was deeply concerned with issues of discrimination
and social justice and also participated in antinuclear demonstrations.”
Which of the following is the most likely?
A Linda is a feminist, active in the women’s movement.

B Linda is a psychiatric social worker.
C Linda is a bank teller.

In Finance: Gambler’s Fallacy
The Coin Toss

Suppose a coin is flipped 5 times and the result of each event was “Heads”.
What would you bet for the next coin flip?

In Finance: Gambler’s Fallacy
The Coin Toss

Suppose a coin is flipped 5 times and the result of each event was “Heads”.
What would you bet for the next coin flip?
Reklaitis, V. (August 24, 2018) Market Watch
“When stocks hit an all-time high in any one month, they have a 90% chance
of achieving another record within four months.”
“If you have this ‘Gambler’s Fallacy,’ where you see a new high and your
immediate reaction is, ‘Well, that’s the top,’ it literally works in the opposite
direction.”
— Ritholtz Wealth Management

Availability
Definition
People overweight information that is readily available and intuitive

relative to information that is less salient and more abstract,
thereby biasing judgment.

Availability: An Illustrative Example

Anchoring and Adjustment
Definition
People form an estimate by beginning with an initial number and

adjusting to reflect new information or circumstances. However,
they tend to make insufficient adjustments relative to that number,
thereby leading to anchoring bias.

Price Anchoring

Adjustment and Anchoring: An Illustrative Example
Two groups of students estimated, within 5 seconds, a numerical expression

that was written on the blackboard.
One group estimated the product
8×7×6×5×4×3×2×1

Adjustment and Anchoring: An Illustrative Example
Two groups of students estimated, within 5 seconds, a numerical expression

that was written on the blackboard.
One group estimated the product
8×7×6×5×4×3×2×1
while another group estimated the product
1×2×3×4×5×6×7×8

Behavioral Finance


Recap of Expected Utility Theory
Prospect
I A prospect (x1 , p1 ; · · · ; xn , pn ) is a contract that yields outcome xi

with probability pi , where p1 + p2 + · · · + pn = 1.
I A prospect is to be understood as a list of outcomes with associated

probabilities.

Recap of Expected Utility Theory
Prospect
I A prospect (x1 , p1 ; · · · ; xn , pn ) is a contract that yields outcome xi

with probability pi , where p1 + p2 + · · · + pn = 1.
I A prospect is to be understood as a list of outcomes with associated

probabilities.
Expected Utility
I The expected utility preferences over the prospect f can be

represented as X
V (f ) = pi u(xi )
i
where u(·) is typically an increasing and concave function.

Expected Utility Theory
St. Petersburg Paradox
I A casino offers a game of chance for a single player in which a fair coin is
tossed at each stage;
I The initial stake starts at 2 dollars and is doubled every time heads appears;
I The first time tails appears, the game ends and the player wins whatever is
in the pot.
What would be a fair price to pay the casino for entering the game?

St. Petersburg Paradox

The expected payoff of the gamble is
1 1 1
× 2 + × 4 + × 8 + ··· = ∞
2 4 8
Yet, in reality, it would be hard to find anyone willing to pay even $25 to participate in
this gamble.
Solution Expected utility theory

I People’s “utility,” or the subjective, internal value they attach
to an additional unit of money is determined by how much
money they already have.

Example: Insurance
I Suppose you have a house worth $200,000;
I There is a small chance (0.2%) that a fire will damage your house and will
generate $75,000 in loss;
I You decide to add a fire detection/prevention system to your house at a
cost of $50.
Knowing that:
I You are risk averse and have a utility function u(x ) = ln(x ).
Is such behavior consistent with expected utility theory?

The expected utility to not purchase the security system is
V1 = 0.2% × ln(200, 000 − 75, 000) + (1 − 0.2%) × ln(200, 000) = 12.197
The expected utility to purchase the security system is
V2 = ln(200, 000 − 50) = 12.206
Based on our assumptions, an expected utility maximizing individual will buy this
security system.

Prospect Theory
Definition
I Prospect theory is designed to explain a common pattern of
choice.
I It looks at two parts of decision making: the framing phase and
the evaluation phase.
References
I Kahneman, D. and Tversky, A. (1979). Prospect theory: An analysis of

decision under risk. Econometrica, 47(2):263–292
I Tversky, A. and Kahneman, D. (1992). Advances in prospect theory:
Cumulative representation of uncertainty. Journal of Risk and Uncertainty,
5(4):297–323

Prospect Theory: Framing
Decision Frame
I The decision-maker’s conception of the acts, outcomes, and
contingencies associated with a particular choice.
I It is often possible to frame a given decision problem in more
than one way.

Framing: An Illustrative Example
Asian Diseases [Tversky and Kahneman, 1981]
I Imagine that the U.S. is preparing for the outbreak of an unusual Asian
disease, which is expected to kill 600 people.
I Two alternative programs to combat the disease have been proposed.
I Assume that the exact scientific estimate of the consequences of the

programs are as follows:
I If program A is adopted, 200 people will be saved;

I If program B is adopted, there is a 1/3 probability that 600 people
will be saved, and a 2/3 probability that no people will be saved.
Which policy option would you choose?

Framing: An Illustrative Example
Asian Diseases [Tversky and Kahneman, 1981]
I Imagine that the U.S. is preparing for the outbreak of an unusual Asian
disease, which is expected to kill 600 people.
I Two alternative programs to combat the disease have been proposed.
I Assume that the exact scientific estimate of the consequences of the

programs are as follows:
I If program C is adopted, 400 people will die.

I If program D is adopted, there is a 1/3 probability that nobody will
die, and a 2/3 probability that 600 people will die.
Which policy option would you choose?

The Fourfold Pattern
Pattern 1
Suppose that you face a choice between two risks. Which of the two would you
choose?
A 90% chance of winning $2,000 and 10% chance of zero.
B 45% chance of winning $4,000 and 55% chance of zero.

Pattern 1
choose?
A 90% chance of winning $2,000 and 10% chance of zero.
B 45% chance of winning $4,000 and 55% chance of zero.
Pattern 2
choose?
C 0.2% chance of winning $2,000 and 99.8% chance of zero.
D 0.1% chance of winning $4,000 and 99.9% chance of zero.

Pattern 3
choose?
E 90% chance of losing $2,000 and 10% chance of zero.
F 45% chance of losing $4,000 and 55% chance of zero.

Pattern 3
choose?
E 90% chance of losing $2,000 and 10% chance of zero.
F 45% chance of losing $4,000 and 55% chance of zero.
Pattern 4
choose?
G 0.2% chance of losing $2,000 and 99.8% chance of zero.
H 0.1% chance of losing $4,000 and 99.9% chance of zero.

Fourfold pattern associated with decision tasks in which the risks involve either gains
only or losses only
Gains Losses
Probabilities moderate Risk averse Risk seeking
Probabilities small Risk seeking Risk averse

Prospect Theory: Value Function
The figure plots the value function proposed by Tversky and Kahneman [1992] as part of their cumulative prospect
α α
theory, namely, v (x ) = x for x ≥ 0 and v (x ) = −λ(−x ) for x < 0, for α = 0.5 and λ = 2.5.

Prospect Theory: Value Function
I Reference dependence The individual derives utility not from

final wealth levels but rather from gains and losses measured
relative to some reference point.
I Diminishing sensitivity The value curve is maximally sensitive to
change nearest the origin and progressively less sensitive as it
moves away from this reference point.
I Loss aversion The value function is asymmetric: it is steeper in
the domain of losses than in that of gains. This implies that
losing hurts more than a comparable gain pleases.

Prospect Theory: Weighting Function
The figure plots the weighting function proposed by Tversky and Kahneman [1992] as part of their cumulative
δ δ δ 1/δ
prospect theory, namely, w (p) = p /(p + (1 − p) ) for three different values of δ. The dashed line
corresponds to δ = 0.4, the solid line to δ = 0.65, and the dotted line to δ = 1.

Prospect Theory: Weighting Function
I Endpoints Individuals are limited in their ability to comprehend

and evaluate extreme probabilities.
I Diminishing sensitivity People become less sensitive to changes
in probability as they move away from the two endpoints.

Prospect Theory: Functions
Tversky and Kahneman [1992] propose the functional forms:

X
V (f ) = w (pi )v (xi ),
i
I where v (·) is known as the value function and w (·) as the weighting
function.
x α,

x ≥0
v (xi ) =
−λ(−x )α , x <0
pδ
w (p) =
(p δ + (1 − p)δ )1/δ

Prospect Theory
Example: Insurance
I Suppose you have a house worth $200,000;
I There is a small chance (0.2%) that a fire will damage your house and will
generate $75,000 in loss;
I You decide to add a fire detection/prevention system to your house at a
cost of $50.
Knowing that:
I You take the case of purchasing the security system as the reference point;
I The prospect utility function over gains and losses is with α = 1, λ = 2 and
δ = 1.
Is such behavior consistent with prospect theory?

Prospect Theory
The prospect utility function is

x, x ≥0
v (x ) =
2x , x <0
The expected utility not to purchase the security system is
v = 0.2% × 2 × (−75, 000 + 50) + (1 − 0.2%) × 50 = −249.9
Based on our assumptions, an individual will buy this security system under prospect
theory.

Reference I
Kahneman, D. and Tversky, A. (1979). Prospect theory: An analysis of

decision under risk. Econometrica, 47(2):263–292.
Tversky, A. and Kahneman, D. (1974). Judgment under uncertainty: Heuristics
and biases. Science, 185(4157):1124–1131.
Tversky, A. and Kahneman, D. (1981). The framing of decisions and the
psychology of choice. Science, 211(4481):453–458.
Tversky, A. and Kahneman, D. (1992). Advances in prospect theory:
Cumulative representation of uncertainty. Journal of Risk and Uncertainty,
5(4):297–323.

Behavioral Finance Lecture 1

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BMME115 Behavioral Finance

Beliefs and Preferences

Two assumptions about individual psychology:

Dr. Li He Beliefs and Preferences 1 / 33

Two assumptions about individual psychology:

Dr. Li He Beliefs and Preferences 1 / 33

Two assumptions about individual psychology:

Dr. Li He Beliefs and Preferences 1 / 33

The Architecture of Cognition: An Illustrative Example

Bat and Ball

I A bat and a ball cost $1.10 in total.

I The bat costs $1 more than the ball.

How much does the ball cost?

Dr. Li He Beliefs and Preferences 2 / 33

The Architecture of Cognition: Two Systems

Dr. Li He Beliefs and Preferences 3 / 33

Research in behavioral finance has tried to improve the

Dr. Li He Beliefs and Preferences 4 / 33

Research in behavioral finance has tried to improve the

Dr. Li He Beliefs and Preferences 4 / 33

Research in behavioral finance has tried to improve the

Dr. Li He Beliefs and Preferences 4 / 33

Research in behavioral finance has tried to improve the

Dr. Li He Beliefs and Preferences 4 / 33

I Tversky, A. and Kahneman, D. (1974). Judgment under uncertainty:

Dr. Li He Beliefs and Preferences 5 / 33

People make judgements based on stereotypic thinking, asking how

Dr. Li He Beliefs and Preferences 6 / 33

Representativeness: An Illustrative Example

Consider an individual who has been described by a friend as follows:

Which of the following is the most likely?

A Linda is a feminist, active in the women’s movement.

Dr. Li He Beliefs and Preferences 7 / 33

In Finance: Gambler’s Fallacy

The Coin Toss

Dr. Li He Beliefs and Preferences 8 / 33

In Finance: Gambler’s Fallacy

The Coin Toss

Reklaitis, V. (August 24, 2018) Market Watch

— Ritholtz Wealth Management

Dr. Li He Beliefs and Preferences 8 / 33

People overweight information that is readily available and intuitive

Dr. Li He Beliefs and Preferences 9 / 33

Availability: An Illustrative Example

Dr. Li He Beliefs and Preferences 10 / 33

Anchoring and Adjustment

People form an estimate by beginning with an initial number and

Dr. Li He Beliefs and Preferences 11 / 33

Dr. Li He Beliefs and Preferences 12 / 33

Adjustment and Anchoring: An Illustrative Example

Two groups of students estimated, within 5 seconds, a numerical expression

Dr. Li He Beliefs and Preferences 13 / 33

Adjustment and Anchoring: An Illustrative Example

Two groups of students estimated, within 5 seconds, a numerical expression

while another group estimated the product

Dr. Li He Beliefs and Preferences 13 / 33

Research in behavioral finance has tried to improve the

Dr. Li He Beliefs and Preferences 14 / 33

Recap of Expected Utility Theory

I A prospect (x1 , p1 ; · · · ; xn , pn ) is a contract that yields outcome xi

I A prospect is to be understood as a list of outcomes with associated

Dr. Li He Beliefs and Preferences 15 / 33

Recap of Expected Utility Theory