THEORIES/FOUNDATIONS OF BEHAVIORAL FINANCE

Flashcards covering key theories and foundations of behavioral finance, including decision-making under certainty, risk, and uncertainty, neoclassical economics, rational preferences, utility maximization, expected utility theory, and different risk attitudes.

Behavioral Finance

Deals with the study of the sphere of influence of psychology on the behavior of individual investors, financial analysts, and other financial professionals, and how these behaviors affect the financial market in general, assuming investors are not always rational.

Certain Decision

A decision-making situation where the person knows for sure the consequence of each alternative, strategy, or course of action to be taken, making it possible to foresee facts and results.

Uncertain Decision

A decision-making situation where each course of action has several possible consequences, but the decision-maker does not know the probability of each, making it a scenario poor in information where past experiences cannot predict the future.

Risk Decision

A decision-making situation where each alternative, strategy, or course of action has several possible consequences, and the decision-maker knows the probability of each.

Neoclassical Economics

An economic theory that combines the cost of production theory from classical economics and the concepts of utility maximization and marginalism, explaining production, pricing, consumption, and income distribution through supply and demand.

Rational Preferences

Simply meant the option to select one thing over others.

Asymmetry of Preference

Indicates that if 'a' is strictly preferred to 'b', then 'b' is not strictly preferred to 'a' (a
on b
on a).

Symmetry of Indifference

Indicates that if a person is indifferent between 'a' and 'b', then they are also indifferent between 'b' and 'a' (a ~ b
on b ~ a).

Completeness (of preferences)

An assumption that a person can compare all possible outcomes and assess their preference or indifference, meaning for any pair of choices, a
on b or b
on a or both (a ~ b).

Transitivity (of preferences)

An assumption that if a person prefers 'a' over 'b' and 'b' over 'c', then they also prefer 'a' over 'c' (if a
on b and b
on c, then a
on c).

Utility Maximization

A theory explaining how an individual allocates and describes preferences by assigning a numeric value (utility) to possible outcomes so that preferred choices receive higher numbers, representing satisfaction.

Ordinal Utility

A measure of consumer preferences indicating the order in which consumers choose one product over another, establishing that consumers assign a higher value to the preferred product.

Relevant and Full Information

A presumption in neoclassical theory that individuals achieve maximum utility by making decisions based on all applicable details and complete information about available options.

Expected Utility Theory

An instrument for analyzing situations where an individual must make a decision without knowing the uncertain results, typically choosing actions based on the outcome that provides the highest total probability and utility of all possible outcomes.

Risk-Averse

A type of person who does not like risk, and would rather have the expected value of a prospect with certainty than actually take a gamble on an uncertain outcome.

Certainty Equivalent

The wealth level that guides a decision-maker to be indifferent between a particular prospect and a certain wealth level.

Risk-Taker (Risk Seeker)

A type of person who prefers to take on risk, choosing the chance on an uncertain outcome rather than taking the expected value of a prospect with certainty.

Risk-Neutral

A type of person who only cares about expected values, with risk not mattering at all, being indifferent between a prospect and its expected value with certainty.