Behavioural Finance

Welcome Homo Economicus.

Introduction

Rational framework

Update beliefs for new information Bayes Make normatively acceptable choices

What works, what doesnt? Stretching rationality from the individual to the collective..

Efficient Markets and Arbitrage

Traditional framework

Rational agents interested in final wealth No frictions Substitute for hedge

Price = Fundamental Value What is the fundamental finance principle to derive fundamental value? Discounted cash flows!

Expectations formed based on correctly processing information

Limits to Arb - Free Lunches!?!

Prices are right No Free Lunch No free lunch Prices are right? Risks that limit arbitrage

Fundamental Risk Noise Trader Risk Implementation cost

Psychology vs Rationality

IQ of 200 means intelligent or rational? IQ = Logic = Rationality? Why then EQ? and now SQ? Do we use the rational framework?

Update beliefs for new information Bayes Make normatively acceptable choices

Behaving well or badly?

A bat and a ball together cost $1.10. The bat costs $1.00 more than the ball. How much does the ball cost? Are you an above average driver? If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets?

Lost your heart to someone?

A health survey was conducted in a sample of adult males in Bombay, of all ages and occupations. Please give your best estimates of the following values:

What percentage of the men surveyed have had one or more heart attacks? What percentage of the men surveyed are both over 55 and have had one or more heart attacks?

Card Trick

Imagine these are four playing cards laid out in front of you. Each one has a letter on one side and a number on the other. If a card has an E, it should have a 4. Which cards do you need to turn over in order to see if I am telling the truth?

Card trick

You betcha

Suppose an unbiased coin is flipped three times, and each time the coin lands on heads. If you had to bet $1000 on the next toss, what side would choose? Heads, tails or no preference?

Mr./Ms Decision Maker

Imagine that the Bombay is preparing for the outbreak of an unusual disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume the exact scientific estimates of the consequences of the programs are as follows:

Mr./Ms Decision Maker

If program A is adopted 200 people will be saved. If program B is adopted there is a 1/3 probability that 600 people will be saved, and a 2/3 probability that no one will be saved. Which program do you choose?

Choosing your friends?

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 anti-nuclear demonstrations

Choosing your friends?

Which statement is more likely?

Linda is a bank teller Linda is a bank teller and is active in the feminist movement

Would you want to be Lindas friend?

Appropriate = Right answer?

You are now going to play a game against the others sitting in this room. The game is simply this. Pick a number between 0 and 100. The winner of the game will be the person who guesses the number closest to two thirds of the average number picked. Your guess is?

Mr/Ms Decision MakerPart II

If program C is adopted 400 people will die. 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 program do you choose?

Good prospect for prospect?

In addition to what you already own, you have been give Rs. 1000. Now choose between

A A 50% chance of winning Rs. 1000 more B Winning Rs. 500 for SURE. 100%

Good prospect for prospect?

In addition to what you already own, you have been give Rs. 2000. Now choose between

A A 50% chance of LOSING Rs. 1000 B LOSING Rs. 500 for SURE. 100%

Review time!

Where in the spectrum are you?

Behaving well or badly?

A bat and a ball together cost $1.10. The bat costs $1.00 more than the ball. How much does the ball cost? Are you an above average driver? If it takes 5 machines 5 minutes to make 5 widgets, how long would it take 100 machines to make 100 widgets?

Lost your heart to someone?

A health survey was conducted in a sample of adult males in Bombay, of all ages and occupations. Please give your best estimates of the following values:

What percentage of the men surveyed have had one or more heart attacks? What percentage of the men surveyed are both over 55 and have had one or more heart attacks?

Card Trick

Imagine these are four playing cards laid out in front of you. Each one has a letter on one side and a number on the other. If a card has an E, it should have a 4. Which cards do you need to turn over in order to see if I am telling the truth?

Card trick

You betcha

Suppose an unbiased coin is flipped three times, and each time the coin lands on heads. If you had to bet $1000 on the next toss, what side would choose? Heads, tails or no preference?

Mr./Ms Decision Maker

Imagine that the Bombay is preparing for the outbreak of an unusual disease, which is expected to kill 600 people. Two alternative programs to combat the disease have been proposed. Assume the exact scientific estimates of the consequences of the programs are as follows:

Mr./Ms Decision Maker

If program A is adopted 200 people will be saved. If program B is adopted there is a 1/3 probability that 600 people will be saved, and a 2/3 probability that no one will be saved. Which program do you choose?

Mr/Ms Decision MakerPart II

If program C is adopted 400 people will die. 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 program do you choose?

Choosing your friends?

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 anti-nuclear demonstrations

Choosing your friends?

Which statement is more likely?

Linda is a bank teller Linda is a bank teller and is active in the feminist movement

Would you want to be Lindas friend?

Appropriate = Right answer?

You are now going to play a game against the others sitting in this room. The game is simply this. Pick a number between 0 and 100. The winner of the game will be the person who guesses the number closest to two thirds of the average number picked. Your guess is?

Good prospect for prospect?

In addition to what you already own, you have been give Rs. 1000. Now choose between

A 50% chance of winning Rs. 1000 more B Winning Rs. 500 for SURE. 100%

Good prospect for prospect?

In addition to what you already own, you have been give Rs. 2000. Now choose between

A A 50% chance of LOSING Rs. 1000 B LOSING Rs. 500 for SURE. 100%

Wealth or gains/losses

Why does it matter to MDA and ADA whether they lose money or make money when they already have such high wealth We like wealth or gains? NNT and the difficulty with a mental ability to take advantages of Black Swans

Take aways

We are hard wired accept it Learn and realize when our decisions may not be fully rational Dont over-emphasize any knowledge Keep an open mind Your finance classes ARE IMPORTANT but dont take everything at face value

THANK YOU!
For your patience and the opportunity to interact with you..

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