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The Evolution of Behavioural Finance (Coursework Sample)


The Evolution of Behavioural Finance
1. How does Prospect Theory (Behavioural Finance, Chapter 3) differ from Expected Utility Theory (Rational Finance, Chapter 2)? 
What are the implications of these differences on how these two theories explain financial decision-making?
2. Let's discuss the differences between subjective risk (Behavioural Finance, Chapter 3) and objective risk (Rational Finance, Chapter 2). What role does framing and mental accounting play in subjective risk assessment?

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Differences between prospective theory and expected utility theory
According to the expected utility theory, choices are consistently and coherently made by weighing the gains or losses of the adopted actions or their alternatives by their probabilities. These probabilities are usually payoffs which are presumed to be independent of probabilities. In other words, a decision maker in the expected utility theory chooses between risky prospects by comparing the value of the expected utility. The alternative with the most utility is selected. The expected utility theory is based on three major beliefs about the processes that take place during decision making under uncertainty or risk; linearity in assigning weights to decisions to alternatives, consistency of preferences for substitutes and judgment in reference to a fixed asset position.
On the other hand, the prospect theory is mainly used to describe decisions between choices involving risk. In other words, prospect theory is used to describe alternatives with undefined results where the probabilities are known. Unlike in the expected utility theory, decision makers in the prospect theory consider choices as adjustments to their present wealth from an individual reference point. They mainly seem to be risk averse regarding adjustments perceived as gains, and risk seeking towards adjustments perceived as losses. Moreover, decision makers using the prospect theory usually overweight improbable events and underweight probable events.
Implications of these differences
The top management in any given organization enjoys the power to determine the course of action that best suited to help then organization achieve its goals. In other words, organizations are reflections of their top management and the decision that they make. The decision made my top managers is largely influenced by the prevailing motive (opportunity or problem) and the category (opportunity or threat) at the start of the decision making process. Decision biases affect the manner in which decision makers obtain, process and appraise information on whose basis they make decisions. Differences between prospect and expected utility theories help strategic managers make more informed decisions. For example, organizational strategists are mainly concerned with implementing a current strategy as effectively as possible. However, prospect theory points out a warning to decision makers in this area. Supposing the strategy is adopted and pursued because it is successful, the decision will portray aversion of risk, and also the failure to identify more risky and potentially bigger profits.
Differences between subjective risk and objective risk
Subjective risk refers to a type of risk that an individual perceives to be a likely unwanted occurrence. For example, a person who has invested in stock exchange and made money will feel less risk investing in the market compared to a person who has lost money in the market. Subjective, risk has the potential to change the behavior of the risk taker especiall...
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