Prospect Theory - alternative to utility theory, value is assigned to changes in net wealth instead of total wealth and probabilities are replaced by decision weights. Decisions weights are lower than probabilities apart from low probability events in which case it is reversed. (explain why people buy insurance and lottery tickets) Prospect theory points out also that people are not risk averse but loss averse i.e. their losses matter more than the gains.
Bounded Rationality - assumes investors are rational but are subject to limitations of knowledge and cognitive error. Limitation in knowledge and cognitive error lead to satisficing eg rule of thumb decision making
Rational Economic Man = assumes key traditional finance assumption that people have perfect informatio, are perfectly self interested and are fully rational
Utility Theory = traditional finance theory that people maximize their utility subject to a budget constraint.
Utility Theory Axioms = continuiting (if a>b>c then b can be expressed as a combination of a and c), completeness (a is either = or > or < b) , transitivity (if a>b and b>c then a>c), independence (if c is mutually exclusive from a and b, then a>b implies a+c>b+c)
Decision Theory - concerned with identifying probabilities, values and uncertainties of outcomes relevant for a given decision with a goal of using infomation to identify an optimal decision (normative = ideal decision)
Behavioural Portfolio Theory - as compared to the modern portfolio theory under BPT investors construct portfolios in layers and expectations of return and risk profile vary between these layers.
Life Cycle Theory - people are assumed to save and spend money rationally over their lifetime in line with their short term and long term plans.
Behavioural Life Cycle Theory - life cycle theory that incorporates self control, mental accounting and framing biases
Traditional finance theory - assumes rational economic man, that investors are risk averse utility maximizers
Friedman-Savage Double Inflection Utility Function - investors are risk averse at low wealth levels, risk seeking at middle wealth levels and risk averse at high level of wealth.
Adaptive Market Hypothesis - applying theories of competition, adaptation and natural selection to reconcile the efficient market hypothesis. e.g. LTCM used arbitrage strategies that became more popular which led to more competition and LTCM's inability to adapt led to its failure.
Behavioral Asset Pricing - suggests to add a sentiment risk factor to the discount rate i.e. not only account for time value of money and fundamental asset risk
Bounded Rationality - assumes investors are rational but are subject to limitations of knowledge and cognitive error. Limitation in knowledge and cognitive error lead to satisficing eg rule of thumb decision making
Rational Economic Man = assumes key traditional finance assumption that people have perfect informatio, are perfectly self interested and are fully rational
Utility Theory = traditional finance theory that people maximize their utility subject to a budget constraint.
Utility Theory Axioms = continuiting (if a>b>c then b can be expressed as a combination of a and c), completeness (a is either = or > or < b) , transitivity (if a>b and b>c then a>c), independence (if c is mutually exclusive from a and b, then a>b implies a+c>b+c)
Decision Theory - concerned with identifying probabilities, values and uncertainties of outcomes relevant for a given decision with a goal of using infomation to identify an optimal decision (normative = ideal decision)
Behavioural Portfolio Theory - as compared to the modern portfolio theory under BPT investors construct portfolios in layers and expectations of return and risk profile vary between these layers.
Life Cycle Theory - people are assumed to save and spend money rationally over their lifetime in line with their short term and long term plans.
Behavioural Life Cycle Theory - life cycle theory that incorporates self control, mental accounting and framing biases
Traditional finance theory - assumes rational economic man, that investors are risk averse utility maximizers
Friedman-Savage Double Inflection Utility Function - investors are risk averse at low wealth levels, risk seeking at middle wealth levels and risk averse at high level of wealth.
Adaptive Market Hypothesis - applying theories of competition, adaptation and natural selection to reconcile the efficient market hypothesis. e.g. LTCM used arbitrage strategies that became more popular which led to more competition and LTCM's inability to adapt led to its failure.
Behavioral Asset Pricing - suggests to add a sentiment risk factor to the discount rate i.e. not only account for time value of money and fundamental asset risk
Shefrin suggested that in behavioral asset pricing the discount rate should include three factors: time value of money, fundamental risk and sentiment risk. The first two correspond to efficient asset pricing while the third to subjective beliefs
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