"We have an irrational tendency to be less willing to gamble with profits than with losses.."
––Tvede (1999)
In these lectures, we'll build on the insights of the Efficient and Adaptive Markets hypotheses developed in earlier lectures (here and here), and have a go at puling them down at the same time. This might sound contradictory, but it's not. All science (even a pseudo-science like modern economics) advances through sustained and successful criticism. It's ok to tear down the existing theory, but if you do, make sure there's something to replace it with.
Stated baldly, Behavioural Finance is the study of the inefficiency of real world markets. Most of the time, behavioural finance theorists will borrow concepts from psychology or sociology to make their claims more realistic. The behavioural economics movement is closely aligned with the Neuroeconomics movement currently en vogue in academic economic circles. Dr. Liam Delaney of UCD's Geary institute retains a bibliography of neuroeconomics readings, if you're interested.
To the theory-proper. In previous lectures, we worked on the Efficient Markets Hypothesis: markets price traded assets to remove the possibility of arbitrage, making risk-less profits harder and harder to come by.
Nobellist Daniel Kahneman and his colleague Amos Tversky studied decision making under uncertainty over a long period of time (their most famous article is here). They found three heuristics people use to help them make judgements under uncertainty:
1. Representativeness. When possibly erroneous commonality between objects of similar appearance is assumed.
2. Availability. We base our predictions of the frequency of events or the proportion within a population based on how easily an example can be brought to mind.
3. Anchoring and Adjustment. We overly rely, on specific information or a specific value and then adjust to that value to account for other elements of the circumstance. Usually once the anchor is set, there is a bias toward that value.
In this lecture, we'll look at Prospect theory and asset pricing, and compare Kahneman's and Tversky's theory to the data. We'll also see how various famous behavioural economists (Profs. Shiller, Thaler, and Camerer).
In lecture 19, we'll move on to consider Thaler's 'Anomalies', holes he's found in the existing body of theory, as they apply to Financial Economics.
Slides
[Update] These links should work now.EC4024Lecture19.pdf
EC4024_Lecture1819_behaviouralFin.pdf
Links
Thaler's Anomalies page, get the papers here.