Cognitive Psychology

Question 0

Portrait of investor (Werner De Bondt)

Answer 0

4 major points for individual investor behavior

1. Investors perception about price evolution - they think there is some trend, actually none exists. Often investors underestimate risk
2. Investor perception of value - they think good reputation is a good investment, but reputation is inversely correlated with return. They also overreact and under react
3. Managing risk and return - they think investing into well known company makes them control risk, no international diversification within investors
4. Trading practice - they like realizing gain ie selling but don’t like realizing loss

De Bondt shows evidence that investor perceptions are different much different than what is expected in finance

Question 1

Investor psychology (Werner and Du Bondt)

Answer 1

People come up with this idea of simplification called rules of thumb ie heuristics to deal with large information when they make investment decision. Of course they make a mistake due to over simplification. People get overconfident as they get more information while they don’t improve accuracy.
Sources of bias for individual’s decision
1. heuristic simplification
2. over-confidence
3. attribute good result to themselves but bad results to bad luck 4. most investor believe they are better than average
5. emotions- people are more optimistic when they are in good mood.
Prospect theory – magnitude of good news is different than magnitude of a bad news ie people react differently.