Lecture1 - The Foundations of Behavioral Finance AEM 4230...

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1 AEM 4230 Copyright © by Vicki Bogan The Foundations of Behavioral Finance Traditional Finance { Assumes all agents (people) are rational { Choices are consistent with expected utility { Correctly update based on new information z Bayesian updating { Some agents (people) are not fully rational z Make systematic mistakes based on psychological phenomena { Biases { Heuristics { Framing effects VS. Behavioral Finance
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2 Behavioral Finance { Kahneman, D., & Tversky, A. (1979). “Prospect Theory: An Analysis of Decision Under Risk.” Econometrica, 47 (2), 263- 291 { Psychological phenomena affect decision making and must be incorporated into financial models z z Framing Effects Biases { Predisposition toward error { Primary types z Excessive optimism z Overconfidence z Confirmation bias z Illusion of control
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3 Excessive Optimism { Overestimate how frequently experience favorable outcomes { Underestimate how frequently experience unfavorable outcomes Overconfidence { Make mistakes more frequently than you believe { View yourself as better than average { Ability { Knowledge
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This note was uploaded on 09/03/2009 for the course AEM 4230 taught by Professor Bogan,v. during the Fall '08 term at Cornell.

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Lecture1 - The Foundations of Behavioral Finance AEM 4230...

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