(Source - The Behavioral Finance Perspective - Michael M. Pompian)
The Behavioral Finance Perspective
1. Meir Statman - "Standard finance people are modeled as 'rational', whereas behavioral finance people are modeled as 'normal'
2. At its core, Behavioral finance is about understanding how people make decision , both individually and collectively
3. Normative analysis - concerned with the rational solution to the problem at hand
4. Descriptive analysis - concerned with the manner in which real people actually make decisions
5. Prescriptive analysis - practical advice and tools that might help people achieve results more closely approximating those of normative analysis
Standard Finance
6. Standard finance is the body of knowledge built on the pillars of the arbitrage principles of Miller and Modigliani, the portfolio principles of Markowitz, the capital asset pricing theory of Sharpe, Linter, and Black, and the option pricing theory of Black, Scholes and Merton.
7. Standard finance is designed to provide mathematically elegant explanations for financial questions that, when posed in real life, are often complicated by imprecise conditions. The traditional finance theory is designed to provide mathematically elegant explanations for financial questions that, when posed in real life, are often complicated by imprecise conditions. The traditional finance relies on assumptions that tned to oversimplify reality and are challenged by behavioral finance.
8. Traditional finance concepts may be thought of as normative, indicating how people and markets should behave.
9. Individual's decision making satisifies the four axioms (Completeness, Transitiviy, Independence and Continuity), the individual is said to be rational.
Rational Economic Man
10. The notion of rational economic was developed in the late 19th century as a simple model of human economic behavior
11. REM tries to achieve discretly specified goals to the most comprehensive, consistent extent possible while minimizing economic costs.
12. Principles of perfect rationlaity, perfect self-interest and perfect information govern REM's economic decisions.
13. Perfect self-interest is the idea that humans are perfectly selfish. For every economic decision, REM ensures that he is getting the highest possible utility and will never concede anything to his opponent in a transaction.
14. Perfect information -
Risk Aversion
15. Certainity equivalent - is the maximum sum of money a person would pay to participate or the minimum sum of money a person would accept to not participate in the opportunity,
16. The difference between the certanity equivalent and the expected value is called the risk premium. Certanity equivalents are used in evaluating attitudes toward risk.
17. Certanity equivalent is used in evaluating attitudes towards risk
Behavioral Finance Perspectives on Individual Behavior
18. Investors do not necessarily make decisions consistent with utility theory and revise expectation (update beliefs) consistent with Bayes' formula
19. Investors do not have access to perfect information and may not process all available information
Utility Maximization and Counterpoint
20. The indifference curve shows the marginal rate of substitution, or the rate which a person is willing to