# Lecture3 - Behavioral Finance Lecture 3 Florian Peters UvA...

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Behavioral Finance Lecture 3 Florian Peters UvA November 13, 2012

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Announcements Popular books about Psychology and Economics: Dan Ariely “Predictably Irrational”, “The Upside of Irrationality” Richard Thaler “The Winner’s Curse”, “Nudge” Florian Peters Behavioral Finance November 13, 2012 1
Topic today: Non-Standard Beliefs Recall the standard economist conception of human behavior: max w W X s S p ( s ) u ( x | s , w ) ... where under the standard specification beliefs are rational (=objective) Today we will focus on deviations from rational beliefs. Two main characterizations Overconfidence: d Var [ x ] < Var [ x ] Optimism: ˆ E [ x ] > E [ x ] Florian Peters Behavioral Finance November 13, 2012 2

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A Note: Bayes’ Rule for Probabilities Prob [ A | B ] = Prob [ B | A ] · Prob [ A ] Prob [ B ] Prob [ A ] is called “Prior” Prob [ A | B ] is called “Posterior” Example: Event “A” means that the economy is in a good state Event “B” means that an indicator for the economy is positive Prob [ B | A ] is the reliability of the indicator Florian Peters Behavioral Finance November 13, 2012 3
A Note: Bayes’ Rule for Normal Distributions Assume the return of security will be R in t = 2 with R N ( μ, σ 2 ). In t = 1 you acquire new information, call it signal “s”, where s = R + ε with ε N (0 , σ 2 ε ). This new information is, eg, based on your own research. Call τ = 1 2 the precision of the prior and τ ε = 1 2 ε the precision of the signal Then we can update the mean by μ Posterior = E [ R | s ] = μ |{z} prior · τ τ + τ ε | {z } weight on prior + s |{z} signal · τ ε τ + τ ε | {z } weight on signal And we can update the variance by σ 2 Posterior = 1 1 σ 2 + 1 σ 2 ε Florian Peters Behavioral Finance November 13, 2012 4

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Outline 1 Origins and Evidence of Distorted Beliefs 2 Overconfidence in Corporate Finance The Winner’s Curse in M&A CEO Overconfidence and Corporate Policies 3 Overconfidence in Trading & Asset Pricing Excessive Trading Predictability and Momentum of Asset Returns Florian Peters Behavioral Finance November 13, 2012 5
Outline 1 Origins and Evidence of Distorted Beliefs 2 Overconfidence in Corporate Finance The Winner’s Curse in M&A CEO Overconfidence and Corporate Policies 3 Overconfidence in Trading & Asset Pricing Excessive Trading Predictability and Momentum of Asset Returns Florian Peters Behavioral Finance November 13, 2012 6

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How Do Distorted Beliefs Arise? 1 People become overconfident due to biased self-attribution You have a prior, and you obtain a signal (your own research) Then there is a second, public signal, s publ . . This information is, eg, the disclosure of company results When your own signal is confirmed, your confidence increases. When your own research is not confirmed, your confidence does not decrease (or not by as much as it would rise were it confirmed).
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