Behavioral Finance Flashcards
What is the main focus of behavioral finance?
Behavioral finance aims to understand and explain investor behaviors, particularly how biases and heuristics can lead to irrational decision-making and impact financial outcomes.
What is Prospect Theory, and who developed it?
Developed by Kahneman and Tversky, Prospect Theory explains how people make decisions based on perceived gains and losses, often exhibiting loss aversion—feeling losses more intensely than gains.
Describe loss aversion in behavioral finance.
Loss aversion is a tendency where investors feel the pain of losses more than the pleasure of gains, leading to risk-averse behavior and reluctance to sell losing investments.
Explain the Adaptive Markets Hypothesis.
Proposed by Andrew Lo, it suggests that markets evolve over time, incorporating both rational and irrational behavior as individuals adapt, using heuristics and biases to survive in changing markets.
What is the Paradox of Choice, and how does it impact investor behavior?
The Paradox of Choice, by Barry Schwartz, suggests that too many choices can overwhelm people, often leading to indecision, mistakes, or dissatisfaction with decisions.
Define Recency Bias and its effect on investing.
Recency Bias is the tendency to overemphasize recent events or market trends, leading investors to make decisions based on short-term performance rather than long-term analysis.
Describe mental accounting and its impact on investing.
Mental accounting occurs when investors treat various sums of money differently based on where they are mentally categorized, which can lead to inefficient asset allocation.
What is the Illusion of Control Bias?
This bias leads investors to believe they can influence or control outcomes, often resulting in overconfidence and excessive trading behavior.
Explain cognitive dissonance in behavioral finance.
Cognitive dissonance is the discomfort caused by new information that conflicts with existing beliefs, leading investors to rationalize decisions and potentially hold onto poor investments.
Define Confirmation Bias and its effect on investing.
Confirmation Bias is the tendency to seek out information that supports existing beliefs while ignoring contradictory evidence, leading to overconcentrated and possibly underperforming portfolios.
What is Conservatism Bias, and how does it impact financial decisions?
Conservatism Bias occurs when investors cling to prior beliefs despite new information, leading to underreaction and slow adaptation to market changes.
Describe Representativeness Bias in behavioral finance.
Representativeness Bias is when investors process new information using pre-existing beliefs, such as assuming a stock will succeed because it resembles past successes, which may be inaccurate.
What is Hindsight Bias, and how does it affect investors?
Hindsight Bias is when investors perceive past events as predictable, which can lead to overconfidence and excessive risk-taking in future investment decisions.
Explain Framing Bias and its potential impact on risk tolerance.
Framing Bias influences decision-making based on how information is presented, often leading investors to choose less risky options when framed negatively and more risk when framed positively.
What is Endowment Bias, and how does it impact investment decisions?
Endowment Bias is the tendency to overvalue assets one owns, making investors reluctant to sell underperforming assets due to an irrational attachment to their investments.
Describe how loss aversion can impact portfolio decisions.
Loss aversion can lead investors to avoid selling assets at a loss, often resulting in the retention of poor investments for longer than financially advisable.
