Expected utility theory, Prospect Theory, Disposition effect , Heuristics and biases

Defined Expected utility theory,
Defined Prospect Theory,
Defined Disposition effect
Defined Heuristics and biases
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1. Prospect theory expected utility theory Heuristics Disposition effect Strategic finance Course Instructor :Sir GM Qasmi Presented by: KangoRehan

2. Content Expected utility theory Prospect theory Heuristics Disposition effect

3. Expected Utility theory Developed by Von Neuman and Morgenstern in 1944 (VNM) It is Normative theory of behavior which means it describes how people should rationally behave. Individuals should act in a particular way when they do decision making under the uncertainty. Excepted utility theory deals with the risk not the uncertainty. In risky situations you know that what outcomes will result and you assign them a probability and in uncertainty you don’t even know the possible outcomes so you cant assign them any probability

4. Expected Utility theory All rational decision makers should be able to compare any two alternatives, or at least choose the choice that is different from them. Weakly dominant Strongly dominant

5. Prospect theory Theory formulated in 1979 and developed in 1992 by amos tversky and Daniel kahnemen . Belongs to behavioral economic subgroup Describing how individual make a choice between probabilistic alternatives where risk is involved and the probability of different outcomes are unknown. Also known as the loss aversion theory

6. Perceived gains and Perceived loss Losses causes greater emotional impact on the individual then does equivalent amount of a gain SO it’s the matter of presenting, An opportunity with equal yield can be presented in two ways 1-In terms of potential gains 2- in terms of potential losses According to the Prospect theory individual will select the option with potential gains Example :50$ with loss and 25$ straight

7. Disposition Effect Prospect theory Explains the occurrence of the disposition Effect Tendency for the investor to hold on to the losing stocks for long and sell the winning stock soon. But logic explains that investor should hold the winning stocks in order to win more And sell the loosing stocks in order to avoid the further loss

8. Disposition Effect Disposition Effect can be minimized by: Framing the mental approach of the investor Example Loosing $100 versus loosing $50 twice from two place Loosing 100 would create less negativity than loosing 50 timely

9. Heuristics Derived from Greek word which means “to discover” problem-solving method that uses short cuts to produce good-enough solutions given In a limited time frame or deadline. Heuristics provide for flexibility in making quick decisions, especially when working with complex data. Decisions made using a heuristic approach may not necessarily be optimal.

10. Heuristics Decision need to be made Even if the environment is of the Limited attention Limited Information Limited Processing capacity So shortcuts are necessary. Heuristics is a decision rule that utilize a subset of the information set.

11. Types of Heuristics Type 1 Are appropriate when a very quick decision must be made OR when the stakes are low Example: Burger or pizza Type 2 Are more effortful and are appropriate when stakes are high

12. Cognitive heuristics Familiarity People are more likely to accept a gamble if they feel they have a better understanding of the relevant context Example: People likey to gamble more on the bases of the competency and their high confidence level. When they feel they have low competency and confidence on particular situation they would like to go for the alternatives Ambiguity Aversion When the judged probability was at lowest, clear tendency was to prefer the random bet this is because of ambiguity aversion Diversification heuristic: People like to try all the things when they are not mutually exclusive Example: Buffet dinner