Behavioral Finance Flashcards
Moving Averages
- buy stock when stock goes above moving average - Fundamentalists argue this approach is wrong - Patterns are not predictable enough - Technicians disagree saying Fundamentalists just dont know how to use them right - only way to see who is “right” is try this method out - effectiveness is different for each person
Random Walks and efficient markets
- the theory that stock price and movements are upredictable, so there is no way to know where prices are headed
Efficient Market Hypothesis
- Markets have a large number of knowledgable investors who react quickly to new information, causing securities prices to adjust quickly and accurately and since the market follows a random walk there is not way to earn an excess of market returns
Weak Form of Eff. Market
- past data on stock prices are of no use in predicting future stock price changes- so technical analysis doesn’t work, the technicians of the world are not going to outperform the market
Semi Strong From of Eff. Market
- Abnormally large profits cannot be consistently earned using public information - neither techinical or fundamental analysis will help - any price anomalies are quickly found out and the stock market adjusts
Strong Form Eff. Market
- there is no information, public or private that will allow you to earn abnormally high profits - insiders can beat the market - following the insiders can help and following buyers is more helpful than following sellers
Market Anomalies
- things that might work even if the market is random
Calender Effects
- stock returns may be closely tied to the time of year or time of week - January Effect, If January is up, then the year will be up
Small Firm Effect
- size of the firm tends to have an impact, small firms do seem to outperform large firms, even when you adjust for risk - small firms are riskier, return can be larger
Earnings Announcments
- stock price adjustments may continue afte3r earnings adjustments have been announced - usually or unexpectedly good earnings may signal buying oppurtunity
P/E Effect
Low P/E stocks may outperform high P/E stocks, even after adjusting risk
Psychology and Investing
- stupid things people do in the market, and how we can benefit
Financial Decision Making Assumptions
- People make rational decisions 2. People are unbiased in predicting the future
Percention of Risk
- in a state of constant flux - willingness to accept a risk depends on our mood - some people are willing to accept risk more than others (risk averse)
Risk Framing
- how we frame risk affects our attitude - Example. - 75% lean meat, 25% fat, both burgers are the same but wont be percieved the same - wording is important (people see word fat and are alarmed) - 75% fat free is perceived better than 25% fat
Overconfidence in Investing
- we tend to be overconfident, example. - most new businesses fail, but new business owners said that they had a 70% of succeeding - Overconfident investors tend to trade too much,take more risks - overconfidence increases as our knowledge increases
Fear
- we are most often afraid of the least likely dangers - a market crash makes stocks cheaper but less likely to buy
Pride and Regret
- avoiding regret and seeking pride affects our behavior - regret stronger emotion than pride - when you sell a loser there are two losses: financial and pyschological - anticipation of a loss has just as much on the brain as the actual loss - anticipation of a loss may drive us from making riskier investments (investing too safely)
Pride and Regret Implications
- we sell winners too early - ride losers too long “Im just going to wait till it goes back up”
Considering the Past
-When you win you are more likely to keep playing -Winning makes you more willing to accept risk - Be careful about thinking about past victories - Memory of the past tends to be skewed toward the positive (Overestimating
Represntatives and Familiarity
- Company X is a good company- therefore company X is a good investment? not the case sometimes because it might be too expensive to get a good return - People prefer the familiar: - we are drawn to companies that we know and avoid stocks in another region or ones that are not recognizable names (should avoid this behavior)
Social Interacting and Investing
- You’re success depends on the friends you keep - what do they discuss and in what do they invest? - Our tendency to herd magnifies psychological biases
Conclusions and Recommendations
- success in the market involves a certain amount of self control - develop strategies to beat biases: - understand the biases - know why you are investing- have specific goals - diversify - check your stocks once a month - trade on the same day of each month or develop a plan to restrain your emotions - review your portfolio annually
Emotions in Investing
- our feelings can be dangerous - good or bad moods will increase or decrease our willingness to take risks - optimistic people are greater risk takers