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Prospect theory is a theory of behavioral economics, judgment and decision making that was developed by Daniel Kahneman and Amos Tversky in 1979. [1] The theory was cited in the decision to award Kahneman the 2002 Nobel Memorial Prize in Economics .
Behavioral Finance attempts to explain the reasoning patterns of investors and measures the influential power of these patterns on the investor's decision making. The central issue in behavioral finance is explaining why market participants make irrational systematic errors contrary to assumption of rational market participants. [1]
The prospect theory can explain such phenomena as people who prefer not to deposit their money in a bank, even though they would earn interest, or people who choose not to work overtime because they would have to pay higher taxes. It also plainly underlies the disposition effect.
Behavioral finance has produced several generalized expected utility theories to account for instances where people's choices deviate from those predicted by expected utility theory. These deviations are described as " irrational " because they can depend on the way the problem is presented, not on the actual costs, rewards, or probabilities ...
In cognitive science and behavioral economics, loss aversion refers to a cognitive bias in which the same situation is perceived as worse if it is framed as a loss, rather than a gain. [1] [2] It should not be confused with risk aversion, which describes the rational behavior of valuing an uncertain outcome at less than its expected value.
Hyperbolic discounting is mathematically described as = + where g(D) is the discount factor that multiplies the value of the reward, D is the delay in the reward, and k is a parameter governing the degree of discounting (for example, the interest rate).
Behavioral finance theory attributes stock market bubbles to cognitive biases that lead to groupthink and herd behavior. Bubbles occur not only in real-world markets, with their inherent uncertainty and noise, but also in highly predictable experimental markets. [1]
A behavioral portfolio bears a strong resemblance to a pyramid with distinct layers. Each layer has well defined goals. The base layer is devised in a way that it is meant to prevent financial disaster, whereas, the upper layer is devised to attempt to maximize returns, an attempt to provide a shot at becoming rich.