Behavioural Finance
Welcome Homo Economicus….
On a journey to make you’ll Homo Sapiens!
Introduction
Rational framework Update beliefs for new information –
Bayes Make normatively acceptable choices
What works, what doesn’t? 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 Linda’s
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 Maker–Part 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 Maker–Part 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 Linda’s
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 Don’t over-emphasize any knowledge Keep an open mind Your finance classes ARE IMPORTANT
but don’t take everything at face value
THANK YOU!
For your patience and the opportunity to interact with you..
Contact [email protected]
98193 90450