Behavioral Finance 1 Flashcards
Are markets rational?
No, in our theories we make assumptions about the availability and interpretation of information
Name three subjective expectation models.
Extrapolative beliefs
Diagnostic expectations
Experience effect
What happens in extrapolative thinking about the market?
Good recent returns increase expectations about future returns.
Describe the relationship between degree of extrapolation and memory
Higher degree of extrapolation leads to shorter memory
What is cash flow extrapolation?
Good past growth increases expectations about future growth
Compare the relationship between cashflow extrapolation and memory with that of normal extrapolation.
Higher degree of cash flow extrapolation leads to larger memory than with normal extrapolation.
What could be a reason for the fact that cashflow extrapolation leads to longer memory than normal extrapolation?
Investors see cashflows, earnings etc. as more fundamental in their lifetime and that is why they remember it better.
To which phenomenon can extrapolation lead?
Herding behavior
What are diagnostic expectations?
Investors overweight recent information and exaggerate patterns they believe signal future outcomes, leading to overly optimistic or pessimistic forecasts.
What is the cause of extrapolation and diagnostic expectations and name the two sorts.
Heuristics (intuitive thinking vs rational thinking)
Representativeness –> good returns are representative for good times
Availability –> good earnings are easier to retrieve than other kind of returns
Next to extrapolation and diagnostic expectations, name two other biases that lead to irrational market behavior.
Overconfidence and optimism bias
Name three assumptions we hold in traditional finance.
Investors interpret information correctly.
Investors use all of the available information.
Investors make the best possible guess about future expectations.
