ch 10 Flashcards
What are the three conditions that led to market efficiency?
Investor rationality, independent deviations from rationality, and arbitrage
Behavioral Finance
attempts to understand and explain how reasoning errors influence investor decisions and market prices.
Proponents of behavioral finance believe that what by investors will cause market inefficiencies?
Cognitive errors
Bounded Rationality
idea that individuals make decisions with limited information, cognitive processing, and time.
Satisficing
– making a “satisfactory” decision rather than expending the energy and resources necessary for making an optimal decision.
Making a decision that is good enough
What do the two group of behavioral economist believe in?
The first group of behavioral economists do not believe that markets are efficient, but since investors are bounded by rationality – there is no opportunity to use the inefficiencies to consistently beat the market.
The second group also rejects that markets are efficient, and believes these inefficiencies are (at least partially) exploitable if markets can be labeled as either “expensive” or “cheap”.
What proves that in the short term there are significant deviations from the treu intrinsic value that takes places due to investor irrationality?
market bubbles and busts.
Tulip mania
The great depression
Dot.com bubble
The great recession
What are the primary human characteristics that lead to financial markets into bubbles?
Human beings desire to follow the herd.
Human beings are more concerned about their well-being as it compares to others (rather than just their own well-being). - - Equity theory.
Human beings are susceptible to being overconfident - - and just as likely to be overly under confident.
Prospect Theory
investors are much more distressed by prospective losses than they are happy about prospective gains.
Research shows that a typical investor considers the pain of $1 loss to be about twice as great as the pleasure of $1 gain.
Loss aversion
Many investors have a reluctance to sell investments after they have fallen in value.
An individual stock investor is 1.5 times more likely to sell a “winner” than a “loser”.
House Money
Gamblers are far more likely to take big risks with money that they have won from some windfall.
It is likely that investors feel the money they earned is more precious because of the hard work they put into it. Won money feels less precious.
Overconfidence
Many of us are overconfident in our abilities (not just in investing). However, concerning investment behavior, overconfidence appears in several ways.
-trading frequency
-being male
-diversification
Gambler’s fallacy
the feeling that because a number hasn’t come up in a while – it’s due
Self-Serving bias and attribution error
Investors tend to think their successful investment choices are due to their own knowledge and skill. Those investments that do poorly; however, are unsuccessful due to outside forces or bad luck.
Confirmation Bias
People have a tendency to seek out evidence that supports their views while underweighting evidence that is contrary to their views.
