EC4024 Lecture 17: Behavioural Finance
Dr Stephen Kinsella: www.stephenkinsella.net

This Time
EMH/AMH
Expected Utility Theory
Behavioural Finance
Prospect Theory

Recap
Efficient Markets Hypothesis
Adaptive Markets Hypothesis
Expected 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
Biases
1. Representativeness
2. Availability
3. 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

Anomalies
January Effect

“On the basis of history, the only
profitable time to hold small http://www.investmentu.com/
stocks is the month of January.\"

The Winner’s Curse

Risk Aversion

Next Time
NeuroFinance & Behavioural
Economics in Government
Read Liebowitz & Thaler (2008)