Can someone explain the purpose of having the 4 axioms of TF ?
Sure…the 4 axioms you describe above include: (1) Completeness - we have well defined preferences when it comes to choices we face (cookies over brownies) and we decide between those two alternatives, (2) Transitivity - we decide consistently (I still love cookies more than brownies) between our choices, (3) Independence - if we have a preference for cookies more than brownies and we add a glass of milk to both we still like cookies more than we like brownies and lastly, (4) Continuity - we face smooth indifference curves…meaning we are indifferent along all points on our indifference curve (exhibit 3 Trade-Off between Work and Leisure).
Ok…so with those 4 axioms we are in the realm/framework of Traditional Finance (TF) where in “decision theory” we must adhere to all of these in order to draw smooth indifference curves, we then layer on a budget constraint (your on a diet and you can only have one cookie) where then you can determine your optimal choice. So if you will go to your candidate reading #5, section 2.1.1 (page 11 in hard bound book or below exhibit 1 in electronic version) you’ll see the 4 things people do when making rational decisions under uncertainty (is your spouse going to catch you eating cookies) in a perfect world the first being they adhere to the 4 axioms of expected utility theory.
Of course all of these four elements must adhere in the world of traditional finance for the math, models and theories to work. Alternatively, Behavioral Finance (BF) relaxes these four assumptions and recognizes we are not utility maximizers (4 axioms), we don’t hold perfect information and we are not perfectly selfish (we give to charity) in making our decisions (cookies or brownies).
Its all about comparing and contrasting TF with BF and how we make decisions in the realm of uncertainty. We need the 4 axioms in TF to make the decision work under utility theory and we need to contrast them with BF (Prospect Theory) to see where humans don’t always adhere to the 4 axioms when making their decisions.
I’m hungry and going to get a glass of milk and cookies…yum!
Marc A. LeFebvre, CFA
Thanks a lot. Your explanation is really helpful!!!
I believe that you’ve mischaracterized transitivity. It’s more like this: I love cookies more than brownies, and brownies more than broccoli, so I must love cookies more than broccoli.
But I like broccoli more than both cookies and brownies, I’m vegan…now I’m all messed up:-))! Thanks for the contribution Bill, always great to give it a collaborative effort.
Marc: you’re hilarious.
My wife loves broccoli, cauliflower, and liver; I cannot stand any of them. (That’s an exaggeration: broccoli that’s lightly steamed or lightly fried (so that it’s still crunchy) is good; cauliflower and liver are awful, unconditionally.)
It’s good to see you here answering questions. The candidates cannot help but benefit from your wisdom and insight.
Were you born vegan, or did you suffer some trauma along the way?
Great analogies thanks guys! Of course now I’m going to be hungry during the exam if this subject shows up.