Decision theory- Behavioral finance

CFA Level III Portfolio Management
#1

I have a hard time understanding Decision theory.

Schweser says that it is focussed on making the ideal decision when the decision maker is fully informed, mathematically able, and rational. This is the same as Expected utility theory right? So what is the difference then?

Also CFAI says decision theory and expected utility theory are normative. And the following paragraph states that the practical application of decision theory is prescriptive. This seems contradictory to me. Somone please explain. Thanks.

#2

Look at page 6 of book 2 Mr. Raiffa outlines the difference between Descriptive analysis , which merely explains behavior , from Prescriptive analysis , which gives practical advice , on how to get results closer to normative analysis

#3

Thanks janakisri. That clarifies my second question. Can you please clarify this - "Schweser says that it is focussed on making the ideal decision when the decision maker is fully informed, mathematically able, and rational. This is the same as Expected utility theory right? So what is the difference then?"

Thanks agian.

#4

According to normative science , It is assumed that a rational decision maker follows rules of preference consistent with the axioms and that the utility function of a rational decision maker reflects the axioms. From any set of alternatives, a rational decision maker makes decisions consistent with the axioms of utility theory and chooses the combination of decisions that maximizes expected utility.

So utility theory stands alone , while the normative decision theory applies it ( expected utility ) to attain rational objectives.

pop quiz : what are the axioms of utility theory ?

#5

Umm, I remember CTIC - let’s see -

completeness (a and b can alway be compared)

transitivity (a > b and b > c => a > c)

independence (a > b => a+xc > b+xc)

forgot the second c

#6

I always forget the completeness bit and only remember continuity . That is because continuity , independence and transitivity together give you unbroken indifference curves , but why completeness? doesn’t strike bells for me.

#7

Completness is that you have clear preferences. You like something more than something else. If no compleeness in pref then you are indifferent and no utility curve can exist because you dont give a crap about the difference btween choices.

#8

I don’t get to understand continuity entirely. Can someone explain it for me in simple terms? Thanks.

#9

Continuity means that when you combine a, b and c in varying quantities you can produce a continuous indifference curve

#10

Continuity , so if you have quantitties of a, b and c you with a>b>c then there is a combination of a and c such that you will be indifferent between that combination and b

#11

Continuity: “the middle child is never special”. If b lies between a and c then some combination of a and c has the utility as b. So who needs b?

#12

Studmuffin, .how do you find the time to study between all those retarded puns. You muffin you

#13

Thanks all. I’m gonna remember “the middle child is never special” easily! :slight_smile: