EC4024 Lecture 17: Behavioural FinanceDr Stephen Kinsella: www.stephenkinsella.net

This Time

EMH/AMH

Expected Utility Theory

Behavioural Finance

Prospect Theory

Recap

Efficient Markets HypothesisAdaptive Markets HypothesisExpected Utility Theory

Efficient Markets Hypothesis

• Arbitrage theorem holds always.

• Pricing fundamentals are mean-reverting, markets are informationally efficient.

• Believe that Pt* = Pt + Ut where Ut is a forecast error. Ut must be uncorrelated with any other information.

• cf Pilbeam, cht 10, Shiller (2002)

Adaptive Markets Hypothesis

EMH+Behav.Finance

Markets adapt over time via financial interactions

Implies no stable relationships over time

Arbitrage can exist

Only survival matters

Expected Utility Theory www.xkvd.com

Prospect Theory

Kahneman & Tversky (1979)Theory is: people treat losses differently to gains.

Implications of Prospect theory

Biases1. Representativeness2. Availability3. Anchoring

Loss Aversion

Endowment Effect: I place a higher value on a good I own than on an identical good that I don’t own

Applications & Anomalies

January Effect

Anomalies

“On the basis of history, the only profitable time to hold small

stocks is the month of January."http://www.investmentu.com/

The Winner’s Curse

Risk Aversion

Next TimeNeuroFinance & Behavioural Economics in GovernmentRead Liebowitz & Thaler (2008)