Behavioral Economcis Introduction

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u n i v e r s i t y o f c o p e n h a g e n

Behavioral Economics and Finance

Frederik vlisenUniversity of Copenhagen

Lecture 1

September 2014 Slide 1/25


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Today

Introduction to behavioral economics and behavioralfinance

What are the topics of the course?

Prerequisites and organization of the course

Behavioral Economics and Finance September 2014 Slide 2/25


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Introduction

Behavioral economics and Behavioral finance studyhuman, social and cognitive factors that influenceeconomic decisions by consumers, borrowers, investors,and how these e.g. affect market prices, returns andportfolio choices

Behavioral finance is a branch of behavioral economics

Economic models are always based on assumptionsabout human preferences and behavior

Traditional economic models assume e.g.

People are selfish

People are rational



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What does rationality mean?

Rationality means two things:

When agents receive new information, they update theirbeliefs correctly according to by Bayes rule

Given their beliefs, agents make choices that are

normatively acceptable maximization of utility

Behavioral models typically integrate insights frompsychology with neo-classical economic theory

Hence: behavioral models try to use more realisticmodels of human behavior to better understandeconomic decisions



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Behavioral finance argues that some financial

phenomena can be better understood using models inwhich agents are not fully rational bounded rationality

It analyzes what happens when we relax one, or both, ofthe two tenets that underlie individual rationality

In some behavioral finance models, agents fail to updatetheir beliefs correctly

In other models, agents apply Bayes law properly but

make choices that are normatively questionable, i.e.they are incompatible with expected utility theory



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One of the most prominent examples:

Peoples choices under risk and uncertainty seem todiverge from our classical assumptions about humanbehavior: e.g. people are not only risk, but alsoloss averse

This course will review this as well as other recent topics

in the field of behavioral economics and behavioralfinance:

(i) We will study the behavioral evidence that is the basisfor the new behavioral economic and behavioral financemodels

(ii) We will study how this behavioral evidence is formalized(iii) We will study the implications e.g. for strategic

interactions and financial decision making




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To phrase the course content in questions:

What are the shortcomings of traditional theories ineconomics and finance?

How do the new concepts / theories in behavioralfinance and behavioral economics address these

shortcomings?

How do these new theories relate to the traditionaltheories and what are their strengths and limitations?

How do the new behavioral presumptions in behavioralfinance and economics change the predictions ofclassical economic theories?




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Syllabus

Papers: List available on Absalon

Free No book - easy download (use e.g.

scholar.google.com ) while at KUs network

Great! Reseach based teaching!

Now a long story about the evolution as a student of

economics...




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Organization

Contact: [email protected]

Day and Time: Wed 13-15 CSS 35.01.44 and/or

Thursday 15-17 CSS 35.01.06

Teaching Method: Lectures and one assignment

One Course, 2 lecturers Alexander Sebald will lecture

from November(-ish) onwards



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At the end of the course: closing lecture and afinal exam

Assessment:

The final grade will be based on the final exam (2 hours,closed book, English). The final exam covers the contentof the lectures as well as the mandatory reading list




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Assignment:

Individual exercise that should help you to even betterunderstand the functioning of the different behavioral

models discussed during the course Assignment has to be uploaded on Absalon

Important: the assignment must be approved forstudents to be able to sit the exam




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Course Homepage:

To register for the course, please log on to Absalon viawww.punkt.ku.dk and search for the course in the

Course catalogue.

Teaching and assessment language: English




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Topics

Topic 1: Experimental Economics - Methodology

A lot of the psychological phenomena used in behavioral

models in finance were found/tested in experiments

The first lecture will give you an introduction/overviewto experiments in economics

Example: An experiment on overconfidence




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Topic 2: Overconfidence

Extensive evidence shows that people are overconfidentin their judgments

Judgments concerning their own abilities, the value ofstocks in a year from now, the return of investmentprojects etc

We will study the evidence for overconfidence and whatit e.g. implies for financial decisions making




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Topic 3: Conservatism

A conservatism bias means that e.g. investors are tooslow in updating their beliefs in response to recentevidence. This implies e.g. initial underreaction to newsabout firms

Topic 4: Heuristics

People use heuristics to judge e.g. the likelihood ofuncertain events

We will explore what kind of heuristics people use andwhat they imply for financial decisions




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Topic 5: Prospect Theory

An essential ingredient of any model trying tounderstand asset prices or trading behavior is anassumption about how investors evaluate risky gambles

Vast majority of models assume that investors evaluategambles according to expected utility framework

Experiments have shown that this is not true in manyrespects

A more realistic theory: Prospect Theory




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Topic 6: Myopic Loss Aversion

It has experimentally been shown that people dislikelosses much more than they like equivalent gains

Loss aversion is an essential part of prospect theory andmyopic loss aversion can explain the equity premium

puzzle Topic 7 Disposition Effect

The disposition effect relates to the tendency ofinvestors to sell shares whose price has increased, while

keeping assets that have dropped in value. Investors areunwilling to recognize losses, but are more willing torecognize gains




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Topic 8: Ambiguity Aversion

In reality, probabilities associated with gambles are rarelyobjectively known

Experiments suggest that people do not like situationswhere they are uncertain about the probabilitydistribution of a gamble (ambiguity aversion)

We will study this phenomenon and its implications forfinancial decision making




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Topic 9: Self-control problems

It has experimentally been shown that people havepreferences for immediate gratification

This means: they value the present much more than thefuture (ex. Buying of a car vs. savings for retirement)

We will study how this has been formalized and whatimpact it has on investment / savings decisions




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Topic 10-13: Social Preferences - Distributional

concerns, Guilt aversion, Reciprocity and Proceduralconcerns

These topics concentrate on the finding that people arenot only concerned about their own monetary payoff,

but also have social preferences and exhibit emotionsWe look at social preferences like inequality aversion andbelief-dependent emotions and analyze how theyinfluence economic behavior

Furthermore, we analyze how belief-dependentpreferences can lead to procedural concerns




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1. Experimental Economics

2. Overconfidence

3. Conservatism

4. Heuristics

5. Prospect Theory

6. Myopic Loss Aversion

7. Disposition Effect

8. Ambiguity Aversion

9. Self Control Problems

10. Distributional Preferences

11. Guilt Aversion

12. Reciprocity

13. Procedual Concerns

Individual Decision Making

Strategic Interaction




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Finally

Requirements:

A level of microeconomics as e.g. in:

Hal R. Varian, Intermediate Microeconomics - AModern Approach

or equivalent books, is a sufficient prerequisite for thecourse




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Questions?


Documents

Behavioral Economcis Introduction