Introduction to Behavioral Finance

Flashcards covering the definitions, key figures, and core theories of behavioral finance.

Behavioral Finance

An area of study focused on how psychological influences can affect market outcomes by analyzing investor behavior across various sectors.

Cognitive Psychology

One of the two pillars of behavioral finance that focuses on how people think.

Limits to Arbitrage

One of the two pillars of behavioral finance that explains when markets will be inefficient.

Rational vs. Normal Investors

Classical finance treats investors as rational, whereas behavioral finance views them as "normal," meaning they have limits to self-control and are influenced by biases.

Daniel Kahneman

Psychologist born in $1934$ who was awarded the Nobel Memorial Prize in Economic Sciences in $2002$ for his work on human judgment and decision-making under uncertainty.

Prospect Theory

A theory developed by Kahneman and Tversky describing how people choose between probabilistic alternatives, demonstrating that gains and losses are valued differently.

Bounded Rationality

The concept that human judgments deviate from rationality due to cognitive limitations, leading people to settle for a "good enough" decision rather than an optimal one.

System 1 (Fast Thinking)

The brain's automatic, quick, and intuitive mode of thinking, often guided by emotions and heuristics.

System 2 (Slow Thinking)

The brain's deliberate, logical, and effortful mode of thinking used for complex problem-solving and careful consideration.

Loss Aversion

A central idea in Prospect Theory stating that people experience losses more intensely than gains; for example, losing $100$ feels more painful than the pleasure of gaining $100$.

Reference Points

Benchmarks, such as current wealth levels or expected outcomes, that people use to evaluate gains and losses rather than using absolute terms.

Probability Weighting

The tendency for individuals to overestimate the likelihood of improbable events and underestimate the likelihood of more probable events.

Availability Heuristic

A mental shortcut where people judge the likelihood of an event based on how easily examples or instances come to mind.

Representativeness Heuristic

A bias where people judge the probability of an event by comparing it to an existing prototype or stereotype in their minds.

Anchoring Bias

The tendency to rely heavily on the first piece of information received (the "anchor") when making subsequent decisions or judgments.

Amos Tversky

A key figure in behavioral finance born in $1937$ who collaborated extensively with Daniel Kahneman to identify cognitive biases and develop Prospect Theory.

Cumulative Prospect Theory (CPT)

An extension of prospect theory that introduces cumulative probability weighting and handles decisions involving multiple possible outcomes.

Judgment Under Uncertainty: Heuristics and Biases

The title of a seminal $1974$ paper by Tversky and Kahneman that challenged the notion of human rationality in economic theory.

Framing

The concept explored in the $1984$ paper "Choices, Values, and Frames," describing how different ways of presenting the same decision problem can lead to different choices.

Ambiguity Aversion

The idea that people find uncertainty about probabilities (ambiguity) more discomforting than known risks.

Richard Thaler

Economist born in $1945$ who was awarded the Nobel Memorial Prize in Economic Sciences in $2017$ for his contributions to behavioral economics and nudge theory.

Nudge Theory

A concept by Richard Thaler examining how small design changes in the environment can influence behavior in predictable ways without restricting freedom of choice.

Mental Accounting

A concept that explains how people mentally separate their money into different accounts based on subjective criteria, which affects spending and saving behavior.

Misbehaving

The title of Richard Thaler's book that outlines the development of behavioral economics and emphasizes the importance of understanding real human behavior.