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university of copenhagen

Behavioral Economics and Finance


Frederik vlisen
University of Copenhagen

Lecture 1

September 2014 Slide 1/25

university of copenhagen

Today
Introduction to behavioral economics and behavioral

finance
What are the topics of the course?
Prerequisites and organization of the course

Behavioral Economics and Finance September 2014 Slide 2/25

university of copenhagen

Introduction
Behavioral economics and Behavioral finance study

human, social and cognitive factors that influence


economic decisions by consumers, borrowers, investors,
and how these e.g. affect market prices, returns and
portfolio choices
Behavioral finance is a branch of behavioral economics
Economic models are always based on assumptions

about human preferences and behavior


Traditional economic models assume e.g.
People are selfish
People are rational

Behavioral Economics and Finance September 2014 Slide 3/25

university of copenhagen

What does rationality mean ?


Rationality means two things:
When agents receive new information, they update their

beliefs correctly according to by Bayes rule


Given their beliefs, agents make choices that are

normatively acceptable maximization of utility


Behavioral models typically integrate insights from

psychology with neo-classical economic theory


Hence: behavioral models try to use more realistic

models of human behavior to better understand


economic decisions

Behavioral Economics and Finance September 2014 Slide 4/25

university of copenhagen

Behavioral finance argues that some financial

phenomena can be better understood using models in


which agents are not fully rational bounded rationality
It analyzes what happens when we relax one, or both, of

the two tenets that underlie individual rationality


In some behavioral finance models, agents fail to update

their beliefs correctly


In other models, agents apply Bayes law properly but

make choices that are normatively questionable, i.e.


they are incompatible with expected utility theory

Behavioral Economics and Finance September 2014 Slide 5/25

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One of the most prominent examples:


Peoples choices under risk and uncertainty seem to

diverge from our classical assumptions about human


behavior: e.g. people are not only risk, but also
loss averse
This course will review this as well as other recent topics

in the field of behavioral economics and behavioral


finance:
(i) We will study the behavioral evidence that is the basis
for the new behavioral economic and behavioral finance
models
(ii) We will study how this behavioral evidence is formalized
(iii) We will study the implications e.g. for strategic
interactions and financial decision making

Behavioral Economics and Finance September 2014 Slide 6/25

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To phrase the course content in questions:


What are the shortcomings of traditional theories in

economics and finance?


How do the new concepts / theories in behavioral

finance and behavioral economics address these


shortcomings?
How do these new theories relate to the traditional

theories and what are their strengths and limitations?


How do the new behavioral presumptions in behavioral

finance and economics change the predictions of


classical economic theories?

Behavioral Economics and Finance September 2014 Slide 7/25

university of copenhagen

Syllabus
Papers: List available on Absalon
Free No book - easy download (use e.g.

scholar.google.com ) while at KUs network


Great! Reseach based teaching!
Now a long story about the evolution as a student of

economics...

Behavioral Economics and Finance September 2014 Slide 8/25

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Organization
Contact: frederik@oevlisen.dk
Day and Time: Wed 13-15 CSS 35.01.44 and/or

Thursday 15-17 CSS 35.01.06


Teaching Method: Lectures and one assignment
One Course, 2 lecturers Alexander Sebald will lecture

from November(-ish) onwards

Behavioral Economics and Finance September 2014 Slide 9/25

university of copenhagen

About Me
M.Sc. in Economics 2006
PhD in Behavioral and Experimental Economics 2011:
External: teach this course, CSU, kIntro, Mikk2

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university of copenhagen

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At the end of the course: closing lecture and a

final exam
Assessment:

The final grade will be based on the final exam (2 hours,


closed book, English). The final exam covers the content
of the lectures as well as the mandatory reading list

Behavioral Economics and Finance September 2014 Slide 12/25

university of copenhagen

Assignment:

Individual exercise that should help you to even better


understand the functioning of the different behavioral
models discussed during the course
Assignment has to be uploaded on Absalon

Important: the assignment must be approved for


students to be able to sit the exam

Behavioral Economics and Finance September 2014 Slide 13/25

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Course Homepage:

To register for the course, please log on to Absalon via


www.punkt.ku.dk and search for the course in the
Course catalogue.
Teaching and assessment language: English

Behavioral Economics and Finance September 2014 Slide 14/25

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Topics
Topic 1: Experimental Economics - Methodology

A lot of the psychological phenomena used in behavioral


models in finance were found/tested in experiments
The first lecture will give you an introduction/overview
to experiments in economics
Example: An experiment on overconfidence

Behavioral Economics and Finance September 2014 Slide 15/25

university of copenhagen

Topic 2: Overconfidence

Extensive evidence shows that people are overconfident


in their judgments
Judgments concerning their own abilities, the value of
stocks in a year from now, the return of investment
projects etc
We will study the evidence for overconfidence and what
it e.g. implies for financial decisions making

Behavioral Economics and Finance September 2014 Slide 16/25

university of copenhagen

Topic 3: Conservatism

A conservatism bias means that e.g. investors are too


slow in updating their beliefs in response to recent
evidence. This implies e.g. initial underreaction to news
about firms
Topic 4: Heuristics

People use heuristics to judge e.g. the likelihood of


uncertain events
We will explore what kind of heuristics people use and
what they imply for financial decisions

Behavioral Economics and Finance September 2014 Slide 17/25

university of copenhagen

Topic 5: Prospect Theory

An essential ingredient of any model trying to


understand asset prices or trading behavior is an
assumption about how investors evaluate risky gambles
Vast majority of models assume that investors evaluate
gambles according to expected utility framework
Experiments have shown that this is not true in many
respects
A more realistic theory: Prospect Theory

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university of copenhagen

Topic 6: Myopic Loss Aversion

It has experimentally been shown that people dislike


losses much more than they like equivalent gains
Loss aversion is an essential part of prospect theory and
myopic loss aversion can explain the equity premium
puzzle
Topic 7 Disposition Effect

The disposition effect relates to the tendency of


investors to sell shares whose price has increased, while
keeping assets that have dropped in value. Investors are
unwilling to recognize losses, but are more willing to
recognize gains

Behavioral Economics and Finance September 2014 Slide 19/25

university of copenhagen

Topic 8: Ambiguity Aversion

In reality, probabilities associated with gambles are rarely


objectively known
Experiments suggest that people do not like situations
where they are uncertain about the probability
distribution of a gamble (ambiguity aversion)
We will study this phenomenon and its implications for
financial decision making

Behavioral Economics and Finance September 2014 Slide 20/25

university of copenhagen

Topic 9: Self-control problems

It has experimentally been shown that people have


preferences for immediate gratification
This means: they value the present much more than the
future (ex. Buying of a car vs. savings for retirement)
We will study how this has been formalized and what
impact it has on investment / savings decisions

Behavioral Economics and Finance September 2014 Slide 21/25

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Topic 10-13: Social Preferences - Distributional

concerns, Guilt aversion, Reciprocity and Procedural


concerns
These topics concentrate on the finding that people are
not only concerned about their own monetary payoff,
but also have social preferences and exhibit emotions
We look at social preferences like inequality aversion and
belief-dependent emotions and analyze how they
influence economic behavior
Furthermore, we analyze how belief-dependent
preferences can lead to procedural concerns

Behavioral Economics and Finance September 2014 Slide 22/25

Reciprocity
Procedual Concerns
Excercise Class
Closing Lecture

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Student presentations: 1. Assignment


Exam

1. Experimental Economics
2. Overconfidence
3. Conservatism
4. Heuristics
5. Prospect Theory

Individual Decision Making

6. Myopic Loss Aversion


7. Disposition Effect
8. Ambiguity Aversion
9. Self Control Problems
10. Distributional Preferences
11. Guilt Aversion
12. Reciprocity

Strategic Interaction

13. Procedual Concerns

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Finally
Requirements:

A level of microeconomics as e.g. in:


Hal R. Varian, Intermediate Microeconomics - A
Modern Approach
or equivalent books, is a sufficient prerequisite for the
course

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Questions?

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