Behavioral Finance Flashcards

Vocabulary flashcards on key concepts from behavioral finance lecture notes.

Rationality

Internal consistency ensured by adhering to certain axioms, according to standard economic theory.

Subjective Expected Utility (SEU)

A framework underpinned by axioms proposed by Leonard Savage, used to define rationality in standard economic theory.

Sure-Thing Principle

The principle that individuals prefer to bet on outcomes with known probabilities over those with unknown probabilities.

Ambiguity Aversion

A preference for known probabilities over ambiguous ones.

Maxmin Expected Utility

An alternative model that relaxes Savage axioms, where the decision-maker considers a set of possible priors and optimises for the worst-case scenario.

Short-term Momentum and Long-term Reversal

Dual pattern in stock prices where past winners continue to outperform (short-term momentum) followed by prices returning toward fundamental values (long-term reversal).

Overconfidence

Overestimating the precision of one's private information.

Self-attribution Bias

Taking credit for successful outcomes and dismissing failures as bad luck.

Representativeness

Overreacting to news that confirms existing trends.

Conservatism Bias

Underreacting to new but conflicting information.

Disposition Effect

The concept that investors tend to sell winners too early and hold onto losers too long.

Mental Accounting

Framing gains and losses relative to a reference point.

Newswatchers

Agents who receive private information about fundamentals but do not use price data.

Momentum Traders

Agents who only respond to recent price trends.

Overconfidence

Overestimating the accuracy of one's own knowledge, the precision of their information, or their ability to control outcomes.

Overprecision

Overestimating the accuracy of one's beliefs.

Overplacement

Believing one is better than others.

Hubris Hypothesis

The irrational tendency of acquirers to overpay for target companies.

Market-timing/catering View

Rational managers reacting to investor sentiment.

Managerial Bias View

Executives themselves being irrational.

Traditional Portfolio Theory

Investors seeking to maximise expected utility through optimal risk–return trade-offs.

Behavioural Portfolio Theory (BPT)

Investors do not manage their portfolios as a unified whole but build "layered" portfolios that correspond to different goals

Mental Accounting

Investors separating their wealth into different "mental accounts" with different rules.

Maslowian Portfolio Theory (MaPT)

Investors build portfolios in layers corresponding to a hierarchy of needs: safety, growth, and aspiration.

Prospect Theory

Individuals evaluate outcomes relative to a reference point, exhibit loss aversion, and are risk-averse in the domain of gains but risk-seeking in the domain of losses.

Adaptive Markets Hypothesis (AMH)

Developed by Andrew Lo, seeks to reconcile the behavioural and efficient views of markets by borrowing insights from evolutionary biology.

Efficient Market Hypothesis (EMH)

Financial markets reflect all available information, leaving no room for consistent outperformance.

Representativeness Heuristic

The tendency to judge probabilities based on how closely something resembles a stereotype, rather than on actual statistical likelihood.

Availability Heuristic

Judging the likelihood of events based on how easily examples come to mind.

Anchoring Heuristic

The tendency to rely heavily on initial values or anchors when making decisions.

Framing Effects

Distorting financial decision-making by influencing how choices are presented.

Affect Heuristic

Emotional reactions to options influence decisions more than objective analysis.

Horizon Risk

The idea that arbitrageurs must act within the short timeframes expected by their clients or investors.

Noise Traders

Investors who act on sentiment rather than fundamentals.

Noise Trader Risk

The possibility that mispricing will widen in the short run before correcting.

Disposition Effect

Investors are reluctant to realise losses because doing so would trigger regret, while they are eager to realise gains to experience pride.

Realisation Utility

Investors gain direct psychological satisfaction from the act of realising a gain, or pain from realising a loss.

Loss Realisation Neutrality

This assumes that capital gains or losses are irrelevant to the utility derived from an asset

Speculative Bubble

A market scenario in which asset prices rise rapidly and substantially beyond intrinsic value, often followed by a sharp correction or crash.

Overconfidence

Investors place excessive weight on their private beliefs and underweight public information. When prices rise, these investors interpret it as confirmation of their skill, causing them to double down

Confirmation Bias

Investors selectively attend to bullish news, while dismissing signs of overvaluation or poor fundamentals

Adaptive Market Hypothesis

Market ecology includes varying agent types, rules, learning processes, and feedback loops

Herding

Investors mimic the actions of others, often ignoring their own information