Biases/Mental Accounting Flashcards
what is meant by psychological barrier in financial markets?
Psychological barriers in financial markets refer to the psychological biases and heuristics that can effect the decision making process of investors. These biases and heuristics can lead investors to make suboptimal decisions and prevent them from making their investment goals. some examples of psychological barriers in financial markets include, over confidence, loss aversion and the anchoring bias, and confirmation bias.
Anchoring bias: This is the tendency to rely too heavily on a single piece of information when making a decision, and to give that information too much weight in comparison to other relevant factors. For example, if you are trying to determine the value of a stock, you might anchor on its current price and forget to consider other important factors such as its earnings potential or the state of the overall market.
Confirmation bias: This is the tendency to seek out information that confirms our existing beliefs and to ignore or discount information that contradicts those beliefs. For example, if you are a believer in a particular investment strategy, you might seek out information that supports that strategy and ignore evidence that suggests it may not be the best approach.
Loss aversion: This is the tendency to strongly prefer avoiding losses to acquiring gains. For example, if you are deciding whether to sell a stock that has lost value, you might hold onto it in the hopes that it will recover rather than selling it and taking the loss.
Overconfidence bias: This is the tendency to be overly confident in our own abilities and judgments. For example, if you are a novice investor, you might be overconfident in your ability to pick winning stocks and make successful trades.
Hindsight bias: This is the tendency to believe, after the fact, that events were predictable when in reality they were not. For example, if a stock you own goes up in value, you might believe that you knew it was going to happen and that you made a smart decision by buying it. But if the stock goes down in value, you might forget that you had any doubts about its potential and blame external factors for the loss.
and evaluate existing evidence of psychological barriers in financial markets
Donaldson and Kim (1993) provides evidence of the role of psychological barriers in financial markets. in the study, it is found that individuals who are more emotional and less rational are more likely to engage in overtrading, which can lead to lower returns on their investments. the findings are significant because they provide evidence of the role that psychological barriers can play a role in financial decision making.
Koedijk and Stork (1994) also provides evidence of psychological barriers in financial markets. the athors examine the study of the performance of mutual funds and find that funds that are managed by over confident managers tend to have lower returns than those managed by less over confident managers . this evidence suggests that overconfidence can lead managers to make sub optimal decisions, which can have negative consequences for their investors.
Behavioural finance recognises that investors are subject to biases and heuristics when making investment decisions. Define and discuss the concepts used in the models proposed by Daniel, Hirshleifer & Subrahmanyam (DHS, 1998) and Barberis, Shleifer & Vishny (BSV, 1998). What potential issues arise from the particular modelling approaches?
the models proposed by Daniel, Hirshlefief and Subrahmanyam (1998) and Barbieris, Shleifer and Vinshy (1998) are two influential frameworks in behavioural finance that aim to explain how psychological factors can influence investment decisions.
both of these models recognise that investors are subject to biases and heuristics and they seek to incorporate these psychological factors into economic models of decision making.
The model by Daniel, Hirshlefief and Subrahmanyam (1998) proposes that investors have bounded rationality, which means that their decision making is limited by their cognitive abilities and the information available to them. this can lead to suboptimal decision making as investors may not always be able to fully process all of the available information and make the best possible decision.
the model by Daniel Hirshlefief and Subrahmanyam (1998) also recognises the influence of psychological factors, such as emotions and social preferences on investment decisions. it suggests that these factors can lead investors to make decisions that deviate from what would be considered rational behavioural in traditional economic models.
The model by Barbieris, Shleifer and Vinshy (1998) on the other hand, focuses on the role of mental accounting in investment decision making. mental accounting refers to the way people categorise and evaluate different types of finanical information and decisions. the model proposes that investors use mental accounting to make judgements about the value of different investments, and that these judgements are influenced by psychological factors such as framing and loss aversion.
one potential issue with these modelling approaches is that they may not always accurently reflect the complex psychological processes involved in decision making. both of these models are based on certain assumptions about how epeople make decisions and those assumptions may not always hold true in practice. the models also may not be able to capture the full range of psychological factors that influence investment decisions
