Decision Theory

How should we decide? And how

do

we decide? These are the two central questions of Decision Theory: in the

prescriptive

(

rational

) approach we ask how rational decisions should be made, and in the

descriptive

(

behavioral

) approach we model the actual decisions made by individuals. Whereas the study of rational decisions is classical, behavioral theories have been introduced only in the late 1970s, and the presentation of some very recent results in this area will be the main topic for us. In later chapters we will see that both approaches can sometimes be used hand in hand, for instance, market anomalies can be explained by a descriptive, behavioral approach, and these anomalies can then be exploited by hedge fund strategies which are based on rational decision criteria.