1. TF it is assumed that people are rational and risk-averse and that they act to maximize their own utility. In particular, the latter point means that individuals do not consider items like social values, unless these values can contribute to increase their own personal utility, that is
2. Rational Economic Man (REM). The traits that characterize an REM are:
- possessing perfect information, and
- acting in a perfectly rational manner .
3. The behavior of an REM leads to efficient markets, i.e., markets in which prices reflect all the relevant information available.
3. Behavioral Finance (BF), unlike TF, does not assume that:
- individuals are always risk-averse;
- individuals use Bayes' formula;
- individuals have perfect information;
- individuals act to maximize only their personal utility
4. This does not mean that individuals cannot be REM, but they need not be all the time. Instead, the key assumptions of BF:
- individuals may not have access to full information;
- individuals may lack the mathematical ability to incorporate full or partial information in their decision making process;
- individuals may not be able to attain the highest utility because they are more interested in short-term goals as opposed to overall goals.
- individuals may consider philanthropy or just simple acts of kindness as useful while these have no place/value in the world of TF, which is ruled by self-interest.
- individuals' utility functions that are not always concave. Utility functions can be concave, convex (risk-seeker) or a mix of concave and convex.
5. TF is based on utility theory and in particular concave utility functions (i.e., diminishing marginal utility).
6. BF allows for more complex types of utility functions since it allows individuals to be both risk averse and risk seekers.
7. Prospect theory
- Prospect theory goes one step further and replaces the assumption that individuals are risk averse with another assumption according to which individuals exhibit loss aversion instead.
- In particular, individuals fear losses more than they enjoy gains. In other words, investors focus on change in wealth rather than on wealth per se, and given a potential loss and gain of equal amounts, the increase in utility associated with the gain is smaller than the disutility associated with the potential loss.
- Note the subtle points: It is not just that economic agents have positive or negative change in values of utility from gain or losses; respectively, the change in the case of losses are larger than the changes associated with gains.
8.
8. Table 1: Summary of the Differences between TF vs. Bounded Rationality and Prospect Theory
| Traditional Finance | Bounded Rationality+Prospect Theory |
|---|---|
| Perfect knowledge | Limited knowledge |
| Utility is maximized | Satisfice |
| Decision making is fully rational | Limitations on cognitive ability when making decisions |
| Risk aversion | Loss aversion |
8. Cognitive Biases
| Type of bias | Description of bias |
|---|---|
| conservatism | information used to make the original decision/forecast is considered more relevant than new information |
| confirmation | looking for data that support one's beliefs and discounting information that contradicts one's beliefs |
| anchoring | reluctance to modify opinions or decisions, even when the information makes those conclusions unlikely. The individual is locked on certain ideas. |
| illusion of control | individual feels that they have control over outcomes when in reality they have little or none at all |
| hindsight | selective memory; i.e. individual remembers past events where she was right but forgets instances where she was wrong |
| framing | information is treated differently depending on how it is presented or obtained. |
| representativeness | assuming that an original classification and methodology works in all cases. Sometimes it is described as deducing too much from small samples of new information. |
| mental accounting | considering multiple investments as separate entities and not as an overall portfolio. |
| availability | memorable events are given more weight in changing the probability of events than less memorable ones. |
| Type of bias | Description of bias |
|---|---|
| loss aversion | assigning more (negative) value to losses than (positive) value to gains of same amount |
| overconfidence | illusion of having better information than others or a superior ability to "read the markets" |
| self-control | lack of discipline, favoring short-term goals over long-term ones |
| self-attribution | belief that one's successes are due to their own character and abilities, rather than luck or situational factors |
| status quo | preferring one's environment and/or situation to new ones, described also as reluctance to change(s). |
| endowment | valuing what one has more than something they do not own |
| regret aversion | doing nothing for fear that decisions could turn out to be wrong |