This document summarizes key concepts in behavioral finance including: 1. The efficient markets hypothesis and adaptive markets hypothesis which extends EMH to incorporate behavioral finance insights. 2. Expected utility theory and prospect theory which challenges expected utility theory by showing people treat losses differently than gains. 3. Behavioral biases like representativeness, availability, and anchoring that influence investor decisions. Applications of behavioral finance concepts to anomalies like the January effect are also discussed.

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

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

3. Recap
Efficient Markets Hypothesis
Adaptive Markets Hypothesis
Expected Utility Theory

4. 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)

5. 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

6. Expected Utility Theory www.xkvd.com

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

8. Implications of
Prospect theory
Biases
1. Representativeness
2. Availability
3. Anchoring

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

10. Applications &
Anomalies

11. Anomalies
January Effect

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

13. The Winner’s Curse

14. Risk Aversion

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