WEEK 1 HC 1 - INTRODUCTION
What this course is about
● BF: the study of how psychological phenomena impact financial behavior and markets
● RE: the study of the many aspects of land and the buildings on it
Traditional Finance Theory
Standard assumptions:
● Investors and Managers resemble the homo economicus
● Markets are perfect and informationally
Three views on market efficiency
Efficient market Fanatic:
● Security prices are always equal to intrinsic value
● It is impossible to accurately predict (risk-adjusted) returns
Behavioral finance fanatic:
● Stock prices only depend on market psychology
● It is easy to predict stock price movements
Sensible middle ground:
● Security prices are highly correlated with intrinsic value, but sometimes diverge to a significant
degree
● It is possible to predict (risk-adjusted) returns, but not with great precision
The Homo Economicus:
➢ Self-regarding maximizer with unlimited and costless information processing capacity and
unbreakable willpower
Decision making:
Important building blocks of decisions:
● Beliefs (outcomes, probabilities, alternatives, etcetera)
● Preferences
Traditional approach:
● Beliefs are “rational”
● Preferences are “normatively acceptable”
Problem: people deviate systematically from rational norms
, ➢ Many phenomena are NOT understood in the traditional framework→ heuristics
Heuristics
Heuristic: experience-based rule of thumb or “mental shortcut”
Why do we use heuristics?
● Limited information
● Limited memory
● Limited information processing ability
● Limited time
Heuristics are often ok! But not always…
How we think: Two systems:
Distinction between to types of thinking:
● System 1: intuitive and automatic
● System 2: reflective and deliberate
What you see
➔ What you “see” is what your brain predicts the reality to be, given the imperfect information it gets
Homo sapiens
A “wise man”, but with…
● Bounded rationality
● Bounded awareness
● Bounded willpower
● Bounded self-interest
Behavior Finance
BF = is the study of how psychological phenomena impact financial behavior and markets
Behavioral Finance approach:
, ● Examine systematic deviations from rational behavior
● Relax assumptions of rationality and perfect capital markets
● Find ways to improve decisions and markets
BF extends finance, does not replace it
Insights apply to many areas, including:
● Corporate finance
● Investments
● Real estate
WEEK 1 HC 2 - JUDGEMENTAL BIASES Pt.1
Two kinds of Error: Bias and Noise
● Bias = predictable error
● Noise = not predictable error
The beliefs of the Homo Economicus
● Uses all relevant available information
○ (if marginal benefits > marginal costs)
● Cognitively processes information correctly
○ (according to rules of logic statistics)
● Holds rational expectations
○ (no systematic error)
, Biases in Beliefs
● Overconfidence and Optimism
● Anchoring Bias
● Base Rate Neglect
● Gambler’s Fallacy Representativeness Biases
● Hot hand Fallacy
● Confirmation Bias
● Availability Biases
● Bounded Awareness
Overconfidence and Optimism
Overconfidence =
Bias in which subjective confidence in judgements is greater than their objective accuracy.
→ Regardless of how much we know, we overestimate how well we know our limits
Optimism =
Bias in which the likelihood of positive outcomes of action is overestimated and the likelihood of negative
outcomes is underestimated.
Overconfident people are often surprised
Optimistic people are often disappointed
What this course is about
● BF: the study of how psychological phenomena impact financial behavior and markets
● RE: the study of the many aspects of land and the buildings on it
Traditional Finance Theory
Standard assumptions:
● Investors and Managers resemble the homo economicus
● Markets are perfect and informationally
Three views on market efficiency
Efficient market Fanatic:
● Security prices are always equal to intrinsic value
● It is impossible to accurately predict (risk-adjusted) returns
Behavioral finance fanatic:
● Stock prices only depend on market psychology
● It is easy to predict stock price movements
Sensible middle ground:
● Security prices are highly correlated with intrinsic value, but sometimes diverge to a significant
degree
● It is possible to predict (risk-adjusted) returns, but not with great precision
The Homo Economicus:
➢ Self-regarding maximizer with unlimited and costless information processing capacity and
unbreakable willpower
Decision making:
Important building blocks of decisions:
● Beliefs (outcomes, probabilities, alternatives, etcetera)
● Preferences
Traditional approach:
● Beliefs are “rational”
● Preferences are “normatively acceptable”
Problem: people deviate systematically from rational norms
, ➢ Many phenomena are NOT understood in the traditional framework→ heuristics
Heuristics
Heuristic: experience-based rule of thumb or “mental shortcut”
Why do we use heuristics?
● Limited information
● Limited memory
● Limited information processing ability
● Limited time
Heuristics are often ok! But not always…
How we think: Two systems:
Distinction between to types of thinking:
● System 1: intuitive and automatic
● System 2: reflective and deliberate
What you see
➔ What you “see” is what your brain predicts the reality to be, given the imperfect information it gets
Homo sapiens
A “wise man”, but with…
● Bounded rationality
● Bounded awareness
● Bounded willpower
● Bounded self-interest
Behavior Finance
BF = is the study of how psychological phenomena impact financial behavior and markets
Behavioral Finance approach:
, ● Examine systematic deviations from rational behavior
● Relax assumptions of rationality and perfect capital markets
● Find ways to improve decisions and markets
BF extends finance, does not replace it
Insights apply to many areas, including:
● Corporate finance
● Investments
● Real estate
WEEK 1 HC 2 - JUDGEMENTAL BIASES Pt.1
Two kinds of Error: Bias and Noise
● Bias = predictable error
● Noise = not predictable error
The beliefs of the Homo Economicus
● Uses all relevant available information
○ (if marginal benefits > marginal costs)
● Cognitively processes information correctly
○ (according to rules of logic statistics)
● Holds rational expectations
○ (no systematic error)
, Biases in Beliefs
● Overconfidence and Optimism
● Anchoring Bias
● Base Rate Neglect
● Gambler’s Fallacy Representativeness Biases
● Hot hand Fallacy
● Confirmation Bias
● Availability Biases
● Bounded Awareness
Overconfidence and Optimism
Overconfidence =
Bias in which subjective confidence in judgements is greater than their objective accuracy.
→ Regardless of how much we know, we overestimate how well we know our limits
Optimism =
Bias in which the likelihood of positive outcomes of action is overestimated and the likelihood of negative
outcomes is underestimated.
Overconfident people are often surprised
Optimistic people are often disappointed
