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Chapter 9

CFIN501- Chapter 9- Behavioral Finance and the Psychology of Investment.docx

7 Pages

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FIN 501
Edward Blinder

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CFIN501 Chapter 9 Behavioral Finance and the Psychology of InvestmentIntroduction To Behavioral FinanceRecognize circumstances that lead to poor decisions cut down on the damage done by investment blundersBehavioral financearea of finance dealing with the implications of investor reasoning errors on investment decisions and market pricesoResearcharea of cognitive psychology how many people and make decisionsoCognitive errorerrors in reasoning Proponents of behavioral financecognitive errors by investors will cause market inefficienciesThree economic conditions that lead to market efficiencyoInvestor rationalityoIndependent deviations from rationalityoArbitrageMarket inefficientall three of these conditions must be absentoSubstantial portion of investors make irrational investment decisionsoCollective irrationality of theses investors then must lead to an overly optimistic or pessimistic market situationcannot be corrected via arbitrageProspect TheoryProspect theorydeveloped in the late 1970soCollection of ideas that provides an alternative to classical rational economic decision makingFoundationidea that investors are much more distressed by prospective losses than they are happy about prospective gainsResearches typical investors considers pain of 1 loss to be about twice as great as the pleasure received from the gain of 1oInvestors respond in different ways to identical situationsoDifferences depend on whether the situation is present in terms of losses ot in terms of gainsInvestors seem to be willing to take more risk to avoid the loss of a dollar than they are to make a dollar profitInvestor has the choice between a sure gain and a gamble choose the sure gainoRisk adversechoosing a sure gain over gambleoRisk taking behaviorchoosing gamble over the sure lossFocus on gains and losses and the tendency of investors to be risk adversewith regard to gainsrisk taking when it comes to lossesoEssence of prospect theoryFully rational investor is presumed to care about his or her overall wealthnot the gains and losses associated with individual pieces of that wealthFrame DependencyInvestment problem is present in two different waysinvestors often make inconsistent choicesHow a problem is described or framedoFrames are transparentinvestors should be able to see through the way the question is askedPhrasing or framing of the question leads people to answer the questions differentlyImportant investment lessonsoInvestor can always frame a decision problem in broad terms or in narrow termsoBroad and narrow frames often lead the investor to make differentUsing a narrow frame is human naturelead to irrational decisionsBroad framesresult in better investment decisionsLoss AversionAdd new stock to portfolioassociate stock with its purchase priceoPrice changesunrealized gains and lossesAdd stocks to your portfoliounknowingly crate a personal relationship with each of your stocksoSelling one of them becomes more difficultoStatus quo bias or the endowment effectSell a stock at a losshard time thinking that purchasing the stock in the first place was correctSomehow get evenyou will be able to sell the stock without any hard feelingsLoss aversionreluctance to sell investments after they have fallen in valuesoBreak even or disposition effectoThose suffering from itgetevenitisEffect is worse when investors hold mutual funds1
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