“Behavioral finance doesn’t assume that investors are risk averse, that they adhere to Bayes’ formula, that they act in their own self interest or that they have perfect informtion”.
“Baye’s formula is useful tool for reducing behavioral biases when incorporating new information.”
Basically the first sentence states Bayes’ formula is not good for Behavioral bias while the second one explicitly indicates it is useful. Any thoughts?
Thank you!
Rational investor is assumed to incorporate all new conditional information into their decision making. Behavioral finance says that, in reality, the average investor does not have the ability or understanding to do this consistently (the first point).
The second point says that just because investors don’t automatically incorporate Bayes formula in practice doesn’t mean it can’t be a useful tool for educating investors and getting them to think in a more rational manner (which would in turn lead to decisions that more closely match traditional finance theory).
Bayes fomula is part of traditional finance/ rational thinking. Not Behavioral Finance.
The second part just says that one way to mitigate the effects of behavioral biases in our decision making is to incorporate Bayes formula when looking at new information. Hope this helps.
Great to know! Thank you both for the help!