Hello, I'm Dr O. And I would like to welcome you to the second module of Biases and Portfolio Selection. In the last module, you learned about the efficient market hypothesis and limits of arbitrage. It is really hard to beat the market consistently. But that does not mean that prices sometimes do not diverge from their fundamental values. And smart money sometimes isn't sufficient to correct the way of the mispricing. In this module, we're going to dig a little deeper and talk about why we might observe these inconsistencies with the market efficiency. Or as I mentioned earlier, why people or markets appear to misbehave. The core premise of economic theory is that people choose by optimizing, right? The problem is however, economic models replace people with home economicus, right? Richard Thaler, one of the founders of the field of behavioral finance calls them econs. Given this set of all goods and services, for example, a family could buy. Economic models assume that the family chooses the best one that it can afford, right? The beliefs that econs make choices are also unbiased. Econs are never overconfident. There is no optimization problem that is too hard for an econ to solve. And econs do not have any emotions. An econ would not expect a gift on the day of the year in which it got married or was born, right? Why? Because what difference would a date make? Econs don't have any passions. So they're kind of like Mr. Spock in Star Trek, if you remember that. But the world is not made up of econs, right? And that's why it appears that people sometimes seem to misbehave, according to our models, right? So in this lecture, you're going to learn about several insights from the field of psychology, that inform economic theory. Hence the field of behavioral finance. A lot of what you're going to hear about is thanks to Tversky and Kahneman, two prominent psychologists. Kahneman was of course, awarded the Nobel prize in economics in 2002, for his recognition of the important role of emotion and intuition in people's decision making. Kahnamon uses the framework of two minds to describe the way people make decisions. Each of us behaves as if we have an intuitive mind, right which forms rapid judgments very easily with no conscious input. We often speak of intuitions as what comes to mind. And we also have a reflective mind. Which is slow, analytical, and requires conscious effort. Now, most decisions that people make are products of the intuitive mind. And they're often accepted by the reflective mind, unless they're blatantly wrong. Okay so here's an example, so if you haven't seen this before, you will immediately see that the bottom line is longer than the top line, right? Look at them carefully, measure them, well as though some of you, right, we've seen this before might be familiar, right. In fact, the lines are of course the same length. You are the victim of an optical illusion, right? The remarkable thing about optical illusions is that even when you know the truth, right, that the lines are the same length. You still see one as being larger than the other. And in the framework of two minds, basically, your reflective mind knows the lines are the same length but your intuitive mind sees them as being different. And the output of your intuitive mind is saying, strongly, that it overrides your reflective mind's efforts. So Kahneman's contribution is that humans are sometimes as susceptible to cognitive illusions as optical illusions. These illusions are biases, mental shortcuts, right? And under certain circumstances intuition, or these biases, can lead to incorrect decisions and judgments. All right, here we go, this will be fun, enjoy.
