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Chapter 9

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Administrative Studies
ADMS 3531
Dale Domian

Chapter 9: Behavioural Finance and the Psychology of Investing 9.1 Introduction to Behavioural Finance - behavioural finance: the area of finance dealing with the implications of investor reasoning errors on investment decisions and market prices - much of research done in area of behavioural finance stems from work in the area of cognitive psychology, which is a study of how people, including investors, think, reason, and make decisions - errors in reasoning are those often called cognitive errors - some proponents of behavioural finance believe that cognitive errors by investors will cause market inefficiencies - three economic conditions that lead to market efficiency: 1) investor rationality, 2) independent deviations from rationality, 3) arbitrage - for a market to be inefficient, all three of these conditions must be ABSENT 9.2 Prospect Theory - prospect theory: an alternative theory to classical, rational economic decision making, which emphasizes, among other things, that investors tend to behave differently when they face prospective gains and losses - foundation of prospect theory rests on the idea that investors are much more distressed by prospective losses than they are happy about prospective gains - typical investor considers the pain of a $1 loss to be about twice as great as the pleasure received from the gain of $1 - if an investor has the choice between a sure gain and a gamble that could increase or decrease the sure gain, the investor is likely to choose the sure gain (choosing a sure gain over a gamble is called risk-averse behaviour) - if the same investor is faced with a sure loss and a gamble that could increase or decrease the sure loss, the investor is likely to take the gamble (choosing the gamble over the sure loss is called risk-taking behaviour) - in terms of gains and losses, investors tend to be risk-adverse with gains, but risk-taking with losses - fully rational investors (in an economic sense) is presumed to care only about his or her overall wealth and not the gains and losses associated with individual pieces of that wealth Frame Dependence Scenario One. Suppose we give you $1,000. Then, you have the following choice to make: A. You can receive another $500 for sure. B. B. You can flip a fair coin. If the coin-flip comes up “heads,” you get another $1,000, but if it comes up “tails,” you get nothing. Scenario Two. Suppose we give you $2,000. Then, you have the following choice to make. A. You can lose $500 for sure. B. You can flip a fair coin. If the coin-flip comes up “heads,” you lose another $1,000, but if it comes up “tails,” you lose nothing. In conclusion, if you chose option A in scenario one and option B in scenario two, you are guilty of focusing on gains and losses, and not paying attention to what really matters (such as the impact on your wealth). About 85% of people who are presented with first scenario choose option A. 70% of people who are presented with second scenario choose option B. - if you pick option A, you end up with $1,500 for sure - or you end up with a 50-50 chance of either $1,000 or $2,000 if you pick option B - you should pick the same option in both scenarios - whichever option you pick is up to you, but you should never pick option A in one scenario and option B in another - this phenomenon is known as frame-dependence - an investor can always frame a decision problem in broad terms (like wealth) or in narrow terms (like gains and losses) - broad and barrow frames often lead the investor to make different choices - using a narrow frame (gains and losses) is human nature; doing so can lead to irrational decisions - using broad frames (like overall wealth) results in better investment decisions Loss Aversion - when stocks are added to your portfolio, you unknowingly create a personal relationship with each of your stocks - as a result, selling one of them becomes more difficult - as with personal relationships, these “stock relationships” can be complicated and make selling stocks difficult at times and is often referred to as the status quo bias, or the endowment effect - you may have particular difficulty selling a stock at a price lower than your purchase price - if you sell a stock at a loss, you may have a hard time thinking that purchasing the stock in the first place was correct - you will also think that if you can just somehow “get even,” you will be able to sell the stock without any hard feelings, this is referred to as loss aversion, which is the reluctance to sell investments such as shares of stock after they have fallen in value - loss aversion is also called the “break-even” or “disposition effect,” and those suffering from it are sometimes said to have “get-evenitis” - legendary investor Warren Buffett offers the following advice: “The stock doesn’t know you own it. You have feelings about it, but it has no feelings about you. The stock doesn’t know what you paid. People shouldn’t get emotionally involved with their stocks.” Mental Accounting and House Money - mental accounting: the tendency to segment money into mental “buckets” - spending regular income differently from bonuses and investing prudently in one’s retirement account while taking wild risks with a separate stock account are two examples of mental accounting - Casinos in Las Vegas (and elsewhere) know about a concept called “playing with house money” where casinos have found gamblers are far more likely to take big risks with money that they have won from the casino (i.e., the “house money”) - gamblers are not as upset about losing house money as they are about losing the money they brought with them to gamble - money is less precious when it comes to you as a windfall, whereas money is precious when you earn it through hard work, sweat and sacrifice - there are no “paper profits”, the profits are yours - all your money is your money – that is, you should not separate your money into bundles labeled “house money” and “my money” - myopic loss aversion: this behavior is the tendency to focus on avoiding short-term losses, even at the expense of long- term gains (for example, you might fail to invest “retirement” money into stocks because you have a fear of loss in the near term - regret aversion: this aversion is the tendency to avoid making a decision because you fear that, in hindsight, the decision would have been less than optimal. Regret aversion relates to myopic loss aversion - sunk cost fallacy: this mistake is the tendency to “throw good money after bad.” An example is to keep buying a stock or mutual fund in the face of unfavourable developments - endowment effect: this effect is the tendency to consider something that you own to be worth more than it would be if you did not own it. Because of the endowment effect, people sometimes demand more money to give up something than they would be willing to pay to acquire it - money illusion: if you suffer from a money illusion, you are confused between real buying power and nominal buying power (i.e., you do not account for the effects of inflation) 9.3 Overconfidence - a serious error in judgment you can make as an investor is to be overconfident - we are all overconfident about our abilities in many areas - concerning investment behaviour, overconfidence appears in several ways (for example, diversification, or the lack of it. Investors tend to invest too heavily in the company for which they work. This loyalty can be very bad financially because both your earning power (your income) and your retirement nest egg depend on one company - other examples of lack of diversification include investing too heavily in the stocks of local companies Overconfidence and Trading Frequency - if you are overconfident about your investment skill, you are likely to trade too much - investors who make relatively more trades have lower returns than investors who trade less frequently - average household earned an annual return of 16.4 percent - those households that traded the most earned an annual return of only 11.4 percent Overtrading and Gender: “It’s (basically) a guy thing” - two possible effects of overconfidence are that it leads to more trading and more trading leads to lower returns - men are more overconfident than women in the area of finance - young and single people held portfolios that displayed more return volatility and contained higher percentage of stocks in small companies What is Diversified Portfolio to the Everyday Investor? - average number of stocks in a household portfolio is about four and the median is about three - about 43% of households outperformed the market Illusion of Knowledge - overconfident investors tend to underestimate the risk of individual stocks and their overall portfolios - overconfidence typically stems from a belief that information you hold is superior to information held by other investors - you believe, therefore, you make better judgments (this is referred to as illusion of knowledge) Snakebite Effect - unwillingness of investors to take a risk following a loss - opposite influence of overconfidence - makes people less confident in the investment process following a loss 9.4 Misperceiving Randomness and Overreacting to Chance Events - cognitive psychologists have discovered that the human mind is a pattern-seeking device - we conclude that casual factors or patterns are at work behind sequence of events even when the events are truly random - in behavioural finance, this is known as representativeness heuristic The “Hot-Hand” Fallacy - suppose we look at recent performance of two basketball players named LeBron and Shaquille > both players make half their shots > suppose LeBron made two shots in a row while Shaquille just missed two shots in a row > researchers have found that if they ask 100 basketball fans which player has the better chance of making the next shot, 91 of them will say LeBron while 9 will say Shaquille. LeBron has a “hot hand” The Gambler’s Fallacy - people commit the gambler’s fallacy when they assume that a departure from what occurs on average, or in the long run, will be corrected in the short run - because an event has not happened recently, it has become “overdue” and is more likely to occur > if you draw 4 red cards in a row, you think that you will pick up a black card next - this can be thought of as a forecasting error 9.5 More on Behavioural Finance Heuristics - simplifies the decision-making process by identifying a defined set of criteria to evaluate - unfortunately, investors often choose inappropriate criteria (such as, criteria that identify good companies, but not necessarily good investment) How do we overcome bias? - we are born with biases - know all potential biases - by understanding what errors you could make, you are less likely to make them - diversifying your portfolios, avoiding situations (or media) that you know will unduly influence you, and creating objective investment criteria 9.6 Sentiment-Based Risk and Limits to Arbitrage Limits to Arbitrage - limits to arbitrage: refers to the notion that under certain circumstances, rational, well-capitalized traders may not be able to correct a mispricing, at least not quickly - strategies designed to eliminate mispricings are often risky, costly, or som
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