on investor behavior objective define and discuss the concept of rational behavior
TRANSCRIPT
On Investor BehaviorOn Investor Behavior
ObjectiveObjective
Define and discuss the concept of rational behaviorDefine and discuss the concept of rational behavior
OutlineOutline
• Definition
• On utility functions
• The axioms of utility
• Implications
Investment behaviorInvestment behavior
The “rules” that govern our approach to making investment choices
Risk:
Probability of loss
Probability distribution known
Uncertainty:
Probability of loss anywhere between 0 and 100%
Probability distribution unknown
Investment behavior: Why is it important?Investment behavior: Why is it important?
• Theories in finance
• Design of financial institutions
• Design of investment strategies
• Performance evaluation
Investment choice under certaintyInvestment choice under certainty
Choice A: 10% return with a probability of 100%
Choice B: 16% return with a probability of 100%
Decision rule: Maximum return
Investor behavior under uncertainty & riskInvestor behavior under uncertainty & risk
Rational or irrational?
Rational behaviorRational behavior
Determined by the utility functionDetermined by the utility function
Utility function:
A theoretical construction describing how individuals relate wealth (money) and personal satisfaction (utility)
Utility functions axioms that describe investor behavior under Utility functions axioms that describe investor behavior under uncertaintyuncertainty
• Greed (nonsatiation)
• Decreasing marginal utility
• Comparability
• Consistency
• Measurability
Do individuals are aware of their utility functions?Do individuals are aware of their utility functions?
That’s beside the point
What matters:
If behavior can be described by a utility function
Observed behavior: Observed behavior: GreedGreed
Individuals prefer more over less.
Observed behavior: Observed behavior: Comparability & measurabilityComparability & measurability
Individuals can compare various choices
Individuals can measure the performance of each choice
Observed behavior: Observed behavior: Decreasing marginal utilityDecreasing marginal utility
Choose between options A and B:• A: do nothing• B: toss a coin; gain $5,000 if heads, lose $5,000 if tails
Your choice is consistent with a concave utility function
More on observed behaviorMore on observed behavior
Toss a coin. You receive:
• $1 if heads appears on the first throw
• $2 if heads first appears on the second throw
• $4 if heads first appears on the third throw
• $8 if heads first appears on the fourth throw
• etc.
How much are you willing to you payare you willing to you pay to be allowed to play this game?
Should the admission ticket reflect the expected payoff of the game?
More on observed behavior:More on observed behavior:
Expected game payoff: E(x)
E(x) = (1/2)($1) + (1/4)($2) + (1/8)($4) + …+ (1/2n)($2n-1) +...
E(x) = 1/2 + 1/2 + 1/2 +….+ =……infinity
In theory, one should be willing to pay an infinite amount to be allowed to play this game!
More on observed behaviorMore on observed behavior
Under uncertainty and risk, individuals do not simply maximize expected return.
What then?
More on observed behaviorMore on observed behavior
Do individuals maximize expected utility?
EU(x) = (1/2)U($1) + (1/4)U($2) + (1/8)U($4) + …+ (1/2n)U($2n-1) +… = ??
If U(x) = square root(x)
EU(x) = (1/2)($1) + (1/4)($2)1/2 + (1/8)($4)1/2 + …+ (1/2n)($2n-1)1/2 +…
EU(x) = $2.914
More on observed behavior: More on observed behavior: Decreasing marginal utilityDecreasing marginal utility
Individuals maximize expected utility in a way that appears consistent with concave utility functions.
More on investment choice under risk and uncertaintyMore on investment choice under risk and uncertainty
How do individuals choose among A, B, and C?
Why do individuals buy insurance?
Why do individuals gamble?
A B CReturn Probability Return Probability Return Probability
-8% 0.25 -4% 0.25 -20% 0.116% 0.5 8% 0.5 0 0.624% 0.25 12% 0.25 50% 0.3
How do individuals choose among A, B, and C?How do individuals choose among A, B, and C?
If utility functions are concave (rational behavior):
maximizing expected utility =
maximizing expected return while minimizing risk
Individuals want as much Individuals want as much return return as possible with as little risk as possibleas possible with as little risk as possible
Implication of rational behaviorImplication of rational behavior
Individuals:
• produce the best estimates of future cash flows and risk, given the available information
• optimize their portfolios
• accommodate their risk preferences by choosing an optimum mix of cash and risky securities
…always
SummarySummary
Rational behavior is describing how we make investment decisions.
Rational behavior is a a view that has shaped our financial markets and institutions
Rational behavior is a belief widely held by many financial professionals and regulators