Behavioural Finance Flashcards
Why do people always overestimate how good they will feel about something good and underestimate how bad they will feel
about something bad.
Take diet for instance, people work hard to lose weight believing that they will feel better about themselves when they get to
their target weight… when it happens they aren’t as happy as they thought they would be.
On the other hand, when they decide to give up dieting because it didn’t make them happy and put on weight again, they often
feel a lot worse about it than they had expected! In the context of investments this means that a positive return doesn’t give
the investor the positive feelings they thought they would get (I could have made more!!) but a loss makes them feel much
worse than they expected (what am I going to do now? It’s all going wrong….).
How do people feel when they make the wrong investment decision? This can also be described as regret.
Some people feel bad that they got it wrong when investments fall in value and really don’t like to admit their mistakes.
The mind never wants to be wrong so they might hang on to an investment for longer than they should simply to avoid having
to admit they got it wrong (I can’t have got it wrong, if I hold on it will all come right).
Investors will be less willing to sell an investment that is currently showing a loss
This is to avoid the pain and regret of admitting they have made a poor investment.
Describe overconfidence/ over and under reaction?
Some people will overestimate their own ability and back themselves and their predications.
The tendency for investors to overestimate their skills and predictions whilst underestimating the likelihood of
poor out comes .
Investors tend to be more optimistic when the market is rising and more pessimistic when the market is falling
Too much weight placed on recent experience.
Describe Prospect Theory/Loss Aversion
People often panic and many will sell out at the wrong time – i.e. when the investment is down in value rather than waiting
for it to recover. What might be seen by some as a buying opportunity (an investment that you really believe in, currently trading at a low price) for these people this would be a cue to sell up and lock in a loss.
Investors do not behave rationally in relation to risk tolerance
Difference weightings placed on gains and losses
Investors typical place more concern on losing a small amount than gaining a large amount
