Behavioural Finance

Question 1

What is behavioural finance?

Answer 1

New area of research which explores how emotional and psychological factors affect investment decisions

• it attempts to explain market anomalies that are not explained by traditional finance models such as MPT and EMH
• tries to explain why prices deviate from their fundamental values
• much of traditional financial theory is based on the assumption that individuals act rationally and consider all available information when making investment decisions
• key argument of BF is that investors are affected by psychological or behavioural biases
• These limit and distort their information and may cause them to reach incorrect conclusions

Question 2

Biases of Behavioural Finance

Answer 2

1) Overconfidence:
- investors overestimate their ability to identify winning investments
- traditional financial theory suggests holding a diversified portfolio will deliver the greatest return
- overconfidence can weigh against this advice with investors / advisors ‘sure of’ a good return from a given investment so believe diversification is unnecessary

2) too much trading
- investors with too much confidence often trade too much
- often the traders that trade the most earn the lowest returns

3) skill and luck
- over confidence may be fuelled by ‘self attribution bias’.
- view a positive out come as down to their own skill but negative outcome as just bad luck
- this process blocks negative feedback

4) fear of loss
- people more sensitive to loss than gain
- some estimates suggest that people weigh loses more than twice as heavily as gains
- people happy to see an investment to lock in a gain but not to lock in a loss
- sell winners and hold on to losers

5) regret avoidance
- not making decisions which later they may regret
- could switch funds or sell a stock now but that may turn out to be a bad decision so instead we’ll ‘wait and see’

Question 3

Other biases

Answer 3

1) Anchoring - calculating returns and rounding to a higher number to make it looks better e.g. 12% becoming 15%
2) cognitive bias - sheep like mentality- buying when prices are high
3) confirmation bias - find some confirmation that supports the decision for doing something, no matter how bizarre

Question 4

Why may an investor not sell a poor investment (6)

Answer 4

• loss aversion
• selling at current share price would realise a loss
• anchoring
• paid round figures for the shares
• emotional attachment
• sense of attachment / loyalty
• overconfidence
• still believes stock is a good investment / investors own analysis is best

Question 5

Five non behavioural reasons to keep a poor share (5)

Answer 5

• new sector/ scope for growth
• better ROCE than sector
• may be a recovery stock
• see through the effects of a rights issue
• possible takeover target