Expected Utility Theory

Foundations of Finance I: Expected Utility Theory

• Neoclassical economics posits individuals and firms optimize within resource constraints.
• Rationality, utility maximization, and independent decision-making, with all available information assumed.
• Rational preferences are complete, choices are comparable, and transitive.
• To get optimal choice, an individual considers all possible bundles of goods that satisfy her optimal budget (wealth) constraint, and then choose maximum utility (gets flatter as wealth increases).
• Maximizing utility involves attaining satisfaction from goods, with utility functions using ordinal ranking.
• Relevant information: People use full information, acknowledging costs to acquire and process data.
• Expected Utility Theory: Defines rational behavior under uncertainty.
• Prospect: a series of wealth outcomes, each of which is associated with a probability
• It deals with risk by assessing probabilities and possible outcomes.
• Risk requires compensation with higher expected returns

Defining Risk Preferences

• Risk-averse individuals prefer the expected value, while risk-seekers favor the prospect itself.
• Risk-neutrality yields equal utility from gambles and expected values.
• Certainty equivalent determines indifference between prospects and wealth levels. Risk-neutral individuals equate it to the prospect's expected value.
• Allais Paradox: Contradicts expected utility theory.
• Presenting questions clearly reduces violations of expected utility.
• Context Independence: Indifference between prospects remains when combined with another.
• Decision Framing: Frames are influenced by presentation, perception, and personal traits. Changes impact choices, violating expected utility theory.

Asset Pricing, Market Efficiency, and Agency Relationships

• The modern portfolio theory uses risk aversion, mean, and return variance assumptions.
• Investors prefer assets with certain outcomes or less uncertainty.
• Uncertainty is measured using variance from the mean, with variance and standard deviation for risk ranking.
• Historical data aids risk-return trade-offs.
• Diversification reduces portfolio risk by combining non-correlated assets, but it can't eliminate it.
• Positive covariance and correlation occurs when variables move in the same direction; negative when opposite.
• Diversifiable or nonsystematic risk can be eliminated
• Nondiversifiable or systematic risk is hard to get rid of
• The efficient frontier curve represents portfolios optimizing expected return for given risk levels.
• Adding a risk-free asset leads to two-fund separation, where utility is maximized by optimizing the risk-free asset combined with a risky asset fund.
• Return and risk for a portfolio is a function of the returns and risks.
• The tangency portfolio is the market portfolio, including all risky assets weighted by their value
• The capital market line (CML) charts risk-free assets and market portfolio combinations.
• CAPM insights: Only risk linked to market movements is priced.
• Beta measures systematic, non-diversifiable risk, reflecting asset sensitivity to the market.
• With positive beta comes more asset returns, more market risk premium, and expected return over the risk-free rate.

Understanding Market Efficiency

• Efficient markets allocate capital effectively through accurate pricing.
• Market efficiency requires quick price reflection of information and zero information generation costs.
• Marginal benefits should not exceed costs for investors for EMH.
• Asset prices match expected fundamental value and prices reflect reasonable expectations.
• Asset prices equal expected fundamental value.
• Random walks mean the next step is unpredictable.
• Techincal and fundemential analysis are unable to generate excess returns
• Joint Hypothesis Problem: Market efficiency tests also test risk-adjustment models.
• Value Premium: Investing in value stocks has historically been a winning strategy.

Agency Theory Fundamentals

• The principal hires agents, where interests may diverge and agency problems arise.
• Agency costs stem from misaligned incentives impacting firm value.
• Optimal contracts align shareholder and manager interests using incentives.
• Carrots and sticks: rewards and penalities are use to motivate agents

Prospect Theory, Framing and Mental Accounting

• Prospect theory outlines how individuals choose in risky situations.
• Major features include risk attitudes and wealth changes from a reference point.
• Expected utility struggles with risk attitude shifts. Prospect theory offers flexibility depending on the nature of the prospect
• Prospect theory allows for risk attitude shifts based on nature.
• Loss Aversion: Losses loom larger than gains.
• A reference point is usually the status quo
• Replaces the expected utility utility function. While utility is usually measured in wealth, value is defined by loss or gains relative to a reference pt.
• Decision weights account for probability in prospect evaluation.
• Prospect Thory incorporates the overwighting of low-probability events
• Fourfold pattern: risk aversion for gains and risk seeking for losses when the outcome probability is high, and risk seeking for gains and risk aversion for losses when the outcome probability is low.
• Cumulative prospect theory has more decision weights that reflect different weight for losses and gains

Decision-Making Nuances

• People value certain outcomes over probable, causing the certainty effect.
• Weighting is greatest for unlikely events.
• Endowment Effect: Ownership increases value.
• Consistency of choices is expected in expected utility theory Integration groups outcomes, while segregation views situations independently.

Mental Accounting Outlined

• The organizational method people use to make decisions more manageable.
• Key aspects include account assignment, closure, and evaluation.
• Prospect theory shows how investors will chose to avoid closing account if they know the losses will result
• Disposition effect causes investors to be incline to avoid selling losers
• Path depenedence occurs when decisions depend on the past.

Challenges to Market Efficiency

• Anomalies may arise opposing market efficiency assumptions.
• Arbitrage yields risk-free profit by simultaneously buying and selling perfect substitute securities.
• Standardized unexpected earnings, there is a tendency for a continued drift in prices, especially after unexpected earnings.
• Small-Firm Effect: Low capitalization firms may yield excess returns after accounting for market risk.
• Possible tax selling pressure can temporarily depress prices, after which they rebound
• Data snooping involves analyzing a dataset until “anomalies" are found

Contrasting Value and Growth Stocks

• Value Stocks: Low price relative to accounting.
• Growth Stocks: High price relative to accounting.
• Value Investing: Overweighting value stocks.

Understanding Noise Trading

• Noise trading is based on misinformation
• EMH relies on investor rationality, uncorrelated errors, and arbitrage.
• Investor errors correlate with market movements, with "sentiment" being the noise among traders.
• Smart-money traders trade for rational reasons.
• "noise" creates broad sentiment with noise-traders driving and lowering prices.
• Smart-money investors do not contemplate arbitraging away mispricing-they merely make space to increase demand.
• Factors that prevent foreign exchange markets from triangular arbitrage are "Limits to Arbitrage"
• Fundamental risk that rational revaluation impacts profitability.
• Noise-Trader Risk stems from irrational actions.
• Implementation costs, particularly short-sale constraints, can prevent even clear arbitrage opportunities from being exploited

Heuristics and Biases in Decision-Making

• Selective perception leads to biased information downloads.
• Cognitive dissonance causes the reduction of psychological inconsistencies to endorse self image
• Memory is reconstructive, can incorporate misleading information and is variable on emotion
• Framing: Perception and Memory respond to the frame and context .
• Ease of processing leads to faster understanding.
• Heuristics are decision rules that employ a subset of analysis with limited capacity.
• Type 1: automatic, reflex Type 2: cognitive
• Evolution requires the survivil of heuristics with environmental factors at play
• Aversion to risk and familiarity are related heuristics.
• Ambiguity aversion causes the tendancy to influence choice in risky events
• The diversification heuristic occurs when you try a little bit of everything or a variety of items
• Regret causes investors to hold, fearing future regret should action be undertake to change current state.

Cognitive Shortcuts and Errors

• Representativeness evalutes the probablility of an outcome based on A resembeling B
• The neglect of base rate information, overpaying attention to sample
• Someone with multiple good hands is due for some bad hands; gambler's fallacy
• Overestimating Predicability: Tendency to believe there is more predictability than is usually the case.
• Recency bias, term describing a easily recalled term
• Events that are easily called to mind are believed to be greater likelyhood of accurring
• Anchoring occurs when estimates are made from an insufffient initial value.

Rationality and Adaptation of Fast and Frugal Heuristics

• Adaptive choices take heuristics involving time, knowledge and computation to make decisions
• Adaptive to seek to employ the right tool at right time.
• Overconfidence leads to overestimate knowledge
• Underconfidence can arise when evidince is low and source has credability

Overconfidence

• Miscalibration: the tendency to overestimate knowledge, abilities, and the precision of their information, or to be overly sanguine of the future and their ability to control it
• Hard-easy effect: the tendency to be less overconfident on easy questions, even to the point of underconfidence
• Better-Than-Average Effect: the tendency for a person to rate himself as above average in knowledge or skills
• Illusion of Control: people think that they have more control over events than objectively can be true.
• Planning Fallacy: the tendency to think that more can be accomplished than is likely

Impediments and Implications of Overconfidence

• Factors include attribution theory, self-attribution bias, hindsight bias, and confirmation bias.
• Self-Attribution Bias: Successes are contributed to ability, wile things that go badly will not have the same effect
• Hindsight Bias: which pushes people into thinking that “they knew it all along
• People are overly optimistic when predictions occur and can use defense mechanisums to get them by

Financial Behaviours Stemming from Familiarity

• Home Bias: domestic investors overweight domestic stocks
• Local Investing and Information for markets that is either domestic or close-to-home.
• With small, leveraged firms producing goods that are not traded internationally tending to be the ones where local preference comes through strongest
• Momentum is the tendancy to purchase securies when performance is strong
• Brad barber and terranec odeann found hat information Is free based on news to generate

Explore Expected Utility Theory, which defines rational behavior under uncertainty by assessing probabilities and possible outcomes. Understand how individuals make optimal choices by considering bundles of goods within budget constraints to maximize utility. Learn about rational preferences and the role of information in decision-making.