Behavioral Finance Flashcards

Vocabulary flashcards for review.

Efficient Market Hypothesis (EMH)

Asset prices at any given time fully reflect all available information.

Weak-form Efficiency

Prices reflect all past trading information (e.g., historical prices).

Semi-strong-form Efficiency

Prices reflect all publicly available information (e.g., earnings announcements, macroeconomic data).

Strong-form Efficiency

Prices reflect all information, both public and private (including insider knowledge).

Arbitrage (Traditional Finance)

Riskless exploitation of price differences for profit.

Noise Trader Risk

Risk arising when irrational market participants trade on sentiment rather than fundamentals, causing prices to deviate from intrinsic value.

Horizon Risk

Risk that a mispricing will not correct itself within the arbitrageur’s investment horizon.

Model Risk

Risk that an arbitrage strategy is based on a flawed valuation model.

Implementation Costs

Costs such as bid-ask spreads, trading fees, and short-sale constraints that reduce arbitrage profitability.

Principal–Agent Problem

Fund managers (agents) avoid trades that increase risk or deviate from benchmarks due to career concerns.

Expected Utility Theory (EUT)

Traditional model for decision-making under uncertainty; assumes agents maximize expected utility.

Prospect Theory (PT)

Describes how people evaluate outcomes relative to a reference point, exhibiting loss aversion and diminishing sensitivity.

Reference Dependence

Evaluating outcomes relative to a reference point (usually the status quo or expected outcome).

Loss Aversion

Losses hurt about twice as much as equivalent gains please.

Diminishing Sensitivity

The psychological value of each additional unit of gain or loss decreases.

Probability Weighting

Overweighing small probabilities and underweighing large ones.

Mental Accounting

Compartmentalizing money into separate mental accounts, leading to suboptimal financial decisions.

Realisation Utility

Satisfaction derived from selling an asset at a gain.

Heuristics

Mental shortcuts or rules of thumb used to simplify decision-making under uncertainty.

Representativeness

Judging the probability of an event based on its similarity to a prototype or stereotype.

Availability

Estimating likelihood based on how easily instances come to mind.

Anchoring

Relying too heavily on an initial piece of information when making decisions.

Overconfidence

Believing one's own forecasts or skills are more accurate than they actually are.

Confirmation Bias

Seeking out information that confirms pre-existing beliefs and ignoring contradictory evidence.

Framing

The way information is presented affects decision outcomes.

Psychological Barriers

Arbitrary price levels that investors anchor to when making trading decisions.

Behavioural Portfolio Theory (BPT)

Investors structure investments in mental layers or pyramids that correspond to different goals.

Market Timing Approach

Managers are rational and capitalize on investor mispricing when issuing securities.

Managerial Bias Approach

Managers are subject to biases, such as overconfidence and optimism, which affect capital structure and investment decisions.

Behavioural Game Theory

Extends classical game theory by incorporating psychological realism.

Neurofinance

Connects neuroscience and psychology with finance, exploring how brain structures affect decision-making.

Cortisol

Stress hormone; elevated levels increase risk aversion.

Testosterone

Hormone linked to confidence and aggressive behaviour; higher levels associated with increased risk-taking.

Oxytocin

Hormone associated with trust and social bonding; elevated levels can improve cooperation and trust.

Adaptive Markets Hypothesis (AMH)

Market efficiency is conditional and evolves over time as investors adapt to changing environments.