Behavioral FINA V2

Prospect

A probability distribution of wealth outcomes, written as P(pr, w1, w2), where pr is the probability of the first wealth level (w1), and the second outcome (w2) is 0 if omitted. Alternatively, a gamble with probability pr of obtaining x and 1-pr of obtaining y.

Probability distribution

Defines the set of possible outcomes and their associated probabilities.

Risk

Situations where probabilities are known objectively or subjectively.

Uncertainty

Situations where the probabilities are unknown.

Utility function

A function that describes a decision maker's satisfaction with outcomes by assigning a numerical value based on preferences.

Expected utility

The probability-weighted expected value of different possible utility levels; individuals should act to maximize expected utility.

Risk aversion

Preference for the expected value of a prospect over the prospect itself; associated with a concave utility function.

Risk seeking

Preference for a prospect over its expected value; associated with a convex utility function.

Risk neutrality

Indifference between a prospect and its expected value; associated with a linear utility function.

Certainty equivalent (CEW)

The wealth level at which a decision-maker is indifferent between a gamble and a certain outcome.

Risk Premium (RP)

The difference between a prospect’s expected value and its certainty equivalent; compensation for bearing risk.

Markowitz Risk Premium

RP = E(W) - CEW.

CER (Certainty Equivalent Rate)

The risk-free rate of return that provides the same utility as a given risky asset.

Framing

The way a decision problem is presented can affect choices, even if the underlying facts are the same.

Prospect Theory

A descriptive model of decision-making under risk that better explains observed behavior than Expected Utility Theory.

Value Function

In Prospect Theory, describes subjective value relative to a reference point; S-shaped, concave for gains, convex for losses, steeper for losses.

Weighting Function

Transforms objective probabilities into subjective decision weights; typically overweights small probabilities and underweights large ones.

Loss Aversion

Tendency to feel losses more strongly than equivalent gains; central to Prospect Theory.

Riskless Loss Aversion

Experiencing loss aversion even when outcomes are certain, relative to a reference point.

Fourfold Pattern of Risk Attitudes

In Prospect Theory, risk attitudes vary by domain (gains/losses) and probability (high/low): e.g., risk-averse for gains with high probability.

Mental Accounting

Cognitive framing and budgeting of financial outcomes; often suboptimal; includes account assignment and evaluation frequency.

Integration

Combining multiple outcomes or decisions into one frame or evaluation.

Segregation

Treating outcomes or decisions separately in mental accounting.

Heuristics

Cognitive shortcuts for decision-making under complexity or uncertainty; can lead to bias.

Representativeness

Heuristic where probability is judged based on similarity to known categories; leads to base rate neglect.

Anchoring

Overreliance on initial values or information when making judgments; insufficient adjustment from anchor.

Base Rate Neglect

Failure to incorporate base rates (true statistical frequencies) into probabilistic judgment.

Familiarity

Preference for what is known or recognizable; can bias choices.

Information Overload

Decision paralysis caused by excessive or complex information.

Bounded Rationality

Idea that individuals make the best decisions possible given cognitive and informational constraints.

Market Efficiency

A condition where prices reflect all relevant information, preventing consistent outperformance.

Efficient Markets Hypothesis (EMH)

The theory that asset prices reflect all available information.

Weak Form EMH

Prices reflect all past market data (prices, volume).

Semi-Strong Form EMH

Prices reflect all publicly available information.

Strong Form EMH

Prices reflect all information, both public and private.

Anomalies

Empirical patterns that contradict EMH, such as momentum or size effects.

Momentum

Positive return correlation over the medium term; past winners tend to keep winning.

Reversal

Negative return correlation over the long term; past losers tend to rebound.

Value Stocks

Stocks trading at low prices relative to fundamentals like earnings or book value.

Growth (Glamour) Stocks

Stocks with high price-to-fundamental ratios, often due to high growth expectations.

Size Factor

Tendency for small-cap stocks to earn higher returns than large-cap stocks.

Book-to-Market Factor

Stocks with high book-to-market ratios (value stocks) earn higher returns.

Risk-Based Explanations for Anomalies

Anomalies reflect compensation for unmodeled or non-traditional risks.

Behavioral Explanations for Anomalies

Anomalies arise from systematic biases and limits to arbitrage.

Limits to Arbitrage

Barriers that prevent rational investors from correcting mispricing, such as noise-trader risk and fundamental risk.

Noise-Traders

Investors who trade on irrational or irrelevant information.

Disposition Effect

Tendency to sell winners too early and hold losers too long.

House Money Effect

More risk-taking with recent gains, treating them as “free money.”

Break-Even Effect

Increased risk-taking after losses, motivated by the desire to break even.

Overconfidence

Overestimation of one’s abilities, knowledge, or precision of beliefs; includes miscalibration and optimism.

Miscalibration

Overestimating the precision or accuracy of one's knowledge.

Self-attribution bias

Attributing success to skill and failure to external factors.

Confirmation bias

Seeking or interpreting evidence that supports existing beliefs while ignoring contradictory evidence.

Emotional Foundations

Emotions like fear, regret, or anger influence financial decisions.

Emotion-Based Decision Making

Decisions influenced by emotion rather than pure logic or rational analysis.

Rational Decision Making

Decision-making that maximizes utility based on logical evaluation of all relevant information.

Completeness (of preferences)

Individuals can rank all possible alternatives consistently.

Transitivity (of preferences)

If A is preferred to B and B to C, then A is preferred to C.

Good Company vs. Good Stock

A good company has strong fundamentals, but a good stock is undervalued; representativeness can lead investors to conflate the two.

Joint Hypothesis Problem

The issue that EMH cannot be tested independently of an asset pricing model. A test of market efficiency is also a joint test of whether the pricing model is correct.

Ambiguity Aversion

Preference for known risks over unknown risks (ambiguity). Investors often avoid choices with unknown probabilities, even if they may offer higher expected returns.

Path Dependence

Decisions are influenced by the sequence of prior gains or losses. Related to mental accounting — past outcomes are integrated into current risk-taking behavior.

Deal or No Deal Study (Path Dependence & Mental Accounting)

Contestants take more risks after losses (Break-Even Effect) or gains (House Money Effect), showing integration of outcomes over time — evidence of path dependence.

Overreaction vs. Underreaction

Overreaction leads to reversal (long-term correction), while underreaction leads to momentum (short-term persistence in returns).

BSV Model (Behavioral Source of Momentum & Reversal)

The Barberis-Shleifer-Vishny model explains anomalies by combining conservatism (slow belief updating → momentum) and representativeness (trend chasing → reversal).

Noise-Trader Risk

Risk that irrational traders will push prices further away from fundamentals in the short run, making arbitrage risky. A limit to arbitrage.

Fundamental Risk

The risk that even correct arbitrage bets may lose money due to unexpected news or firm-specific events. A key reason why arbitrage is limited.