Behavioral Finance Economics 437

Steve Ross Lecture – Thurs Mch 31 MIT Professor, considered among the very top two or three finance economists in the world Founder of Arbitrage Price Theory (which is a generalization of CAPM and the theory behind multi-factor investment models Considered likely to win Nobel Prize in the next two to three years He is a staunch defender of EMH

Loss Aversion => Prospect Theory Loss Aversion is the idea that individuals feel more pain from losses than happiness from gains of equal dollar amounts (losing $ 100 hurts worse than gaining $ 100 feels good) A way of capturing loss aversion is prospect theory Risk aversion when thinking about gains Risk preferring when thinking about losses

Utility Function Utility Gains A reference point Losses

What about other anomalies? Over-confidence Saliency (“hot hand” effects) Reinforcement Bias Do these have predictable finance implications

Questions of Interest Booms and busts: are these the result of noise trader activity Stock market rallies – bull and bear markets – waves of optimism and pessimism Greater fool theory

Booms and Busts Periodically occur Are they a natural consequence of biases such as overconfidence, saliency, and confirmation bias? Usual explanation is the “bad actor” explanation, which often leads to regulatory overkill What if they simply occur naturally and periodically regardless of regulation? Regulation itself may be subject to the same biases

Bull and Bear Markets Why? Is fundamental news serially correlated? Do the fundamentals of companies really change that often Does the market move mostly on psychology? If so, how do fundamentals matter Buffett: “In the short run, the market is a voting machine, in the long run, the market is a weighing machine

The End