Behavioral Finance

Flashcards covering key vocabulary and concepts from the lecture notes on Behavioral Finance - EMH, Rationality & Prospect Theory, Heuristics & Biases, Portfolios & Corporate Behavior, Neurofinance & Adaptive Markets.

Efficient Market Hypothesis (EMH)

Proposes that asset prices accurately reflect all available information at any given time.

Weak Form (EMH)

Prices reflect PAST data.

Semi-Strong Form (EMH)

Prices reflect PUBLIC data.

Strong Form (EMH)

Prices reflect all information INCLUDING INSIDER information.

Noise Trader Risk

Irrational traders can push prices further from fair value and cause losses for arbitrageurs.

Horizon Risk

Even if a mispricing will eventually correct, you might not be able to wait it out due to client capital pulls or potential bankruptcy.

Model Risk

If your idea of fair value is wrong due to a faulty model, you could misprice the asset yourself.

Implementation Costs

Even perfect trades have costs, such as fees eating profits or trading large volumes moving the market.

Principle-Agent Problem

Fund managers may care more about beating their peers than beating the market, leading them to avoid risky trades to protect their job.

Expected Utility Theory (EUT)

We make decisions by weighing each outcome by its probability and utility, then choosing the highest score.

Transitivity Axiom

If you prefer A to B, and B to C, then you must prefer A to C.

Independence Axiom

If you prefer A over B, then you must prefer A + X over B + X.

Completeness Axiom

You can rank any two outcomes; you’re never indifferent forever.

Sure-Thing Principle

If you’d choose A whether X happens or not, you should still choose A even if you don’t know whether X happens.

Reference Dependence

People judge gains and losses relative to a reference point (usually current wealth or expectation), not in absolute terms.

Loss Aversion

Losses hurt twice as much as equivalent gains feel good.

Diminishing Sensitivity

The further you move from the reference point, the less each gain or loss matters.

Probability Weighting

People overweigh small probabilities and underweight large probabilities.

Framing Effects

People choose differently depending on how options are described.

Mental Accounting

People keep money in mental buckets and treat it differently, which leads to suboptimal decisions.

Disposition Effect

Investors sell winners too early to lock in gains and hold losers too long to avoid defeat.

Realization Utility

People enjoy the act of realizing a gain, even if it hurts long-term performance.

Heuristics

Mental shortcuts we use to make decisions when faced with uncertainty; efficient, but not always accurate.

Representativeness

We judge probabilities based on how much something resembles a stereotype, not on actual statistical likelihood.

Availability

We judge something based on how easily it comes to mind, not how likely it actually is.

Anchoring

We rely too heavily on the first piece of information (the anchor) when making decisions, even if it's irrelevant.

Cognitive Biases

Systematic decision errors, the behavioral consequences of heuristics.

Overconfidence

Belief that one’s skills or predictions are better than they are.

Confirmation Bias

Tendency to seek information that supports your beliefs.

Disposition Effect

Holding losers too long, selling winners too early, driven by realization utility & loss aversion.

Psychological Barriers

Non-fundamental price points – like round numbers – that traders treat as important, even if they aren’t.

Modern Portfolio Theory (MPT)

Assumes that investors are rational; they optimize a single portfolio by balancing expected return vs risk (variance); preferences are stable and mathematically consistent.

Behavioral Portfolio Theory (BPT)

Investors mentally divide their wealth into layers, each tied to a specific goal.

Safety Layer (BPT)

Capital preservation (e.g bonds, cash).

Aspiration Layer (BPT)

Big wins and risk-taking (e.g. stocks, crypto).

Market Time Approach

Managers are rational, but markets are irrational.

Managerial Bias Approach

Managers themselves are biased.

Behavioral Game Theory (BGT)

Brings behavioral insights into strategic interactions. e.g., ULTIMATUM GAME.

Neurofinance

Explores how brain chemistry, hormones, and neural systems influence financial decision making.

Cortisol

Stress hormone; rises during market crashes or volatility, linked to increased risk aversion.

Testosterone

Dominance hormone; linked to overconfidence, risk-