Question
1.One criticism that is levied against traditional economic and finance models is that they are often formulated as if the typical decision maker were an
1.One criticism that is levied against traditional economic and finance models is that they are often formulated as if the typical decision maker were an individual with unlimited cerebral RAM. Such a decision maker would consider all the relevant information and come up with the best choice. However, we know from this course that normal human beings are imperfect. And the information requirements for these models are totally egregious. Consider CAPM for a moment. This model assumes that investors are capable of studying the universe of securities in order to come up with all required model inputs. These inputs include expected returns and variances for all securities, as well as the co-variances among all securities. My question to you is why do we do that in finance? Why do we create models that people really cannot follow? Why do we assume people can do these calculations? Why does assume we are so rational? Indeed, I mentioned the example of Harry Markowitz, the founder of Modern Portfolio Theory, who uses regret theory than his own modern portfolio theory to come with his allocations in his retirement portfolio.
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