Behavioral Finance. Utility of Money

the probability of car crashes?
 Why is it significant that the recent credit crisis, the worst economic recession
that the US has seen since the 1930’s, took place 75 years after the Great
Depression?
Behavioral finance is a relatively new school of thought that addresses and
provides insight into questions like these. All of us have innate psychological biases
that can lead to predictable “errors” in how we make important financial decisions.
Behavioral finance catalogues these errors and helps us to anticipate, and hopefully
avoid, these decision-making “traps.”
As you work through this course, be prepared to make mistakes…
3
Rational Expected Utility
In this section, we look at the “traditional” economic model of consumer choice, which
seeks to describe how people are expected to behave when making financial decisions.
This traditional model assumes that individuals are rational, and that they make
decisions in ways that maximize their expected “utility” (or “happiness”) from money
made or lost.
We will specify various axioms (assumptions about behavior that traditional
economists view as self-evident), and show under what circumstances we frequently
and reliably violate those very assumptions.
When you have completed this section, you will understand:
• What economists mean when they talk about risk aversion
• Budget constraints, indifference curves, and how we utilize both to optimize our
“consumption”
• Some rational utility axioms, and under what circumstances these axioms fail to
describe the way most people behave.
4
Implications of the graph:
• More money is undoubtedly better than less: U(10) > U(5), BUT
• The incremental (marginal) value of an additional dollar gets smaller as our
wealth increases: U(5) – U(0) > U(10) – U(5)
Utility of Money
Wealth
Utility
U(10)
U(5)
U(0)
0 5 10
“Utility” = happiness
See the Lecture:
Utility of Money
5
The Utility of a Gamble: Risk Aversion
• Ask yourself what is the most you would pay to play the following game:
Toss a fair coin.
If it lands heads, you get $15
If it lands tails, you get $5
• The fair (or “expected”) value of the game is...

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