1. Behavioral Finance
Economics 437

2. 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

3. 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

4. Utility Function
Utility
Gains
A reference point
Losses

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

6. 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

7. 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

8. 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

9. The End