G Contrast the behavioral finance view of investor behavior to that of traditional finance.

Question 1

Behavioral Finanace

Answer 1

• Study of how investor behavior may
affect pricing and trading decisions.
• Investors may not always be rational.
• Note that behavior issues may not
affect pricing if many rational investors
can trade to profit.

Behavioral finance examines whether investors behave rationally, how investor behavior affects financial markets, and how cognitive biases may result in anomalies. Behavioral finance describes investor irrationality but does not necessarily refute market efficiency as long as investors cannot consistently earn abnormal risk-adjusted returns.

Question 2

The Large Behavioral Issues

Answer 2

• Loss Aversion—Traders fear losses more
than they value gains. Loss aversion refers to the tendency for investors to dislike downside risks more than upside risks creating asymmetrical risk preferences. This dislike of losses may be a cause of investor overreaction. The standard economic notion of risk aversion assumes symmetric risk preferences. Conservatism is the behavioral bias whereby investors react slowly to new information and is unlikely to cause overreaction. Loss aversion is exhibited by an investor who dislikes a loss more than he likes an equal gain. That is, the investor’s risk preferences are asymmetric. Gambler’s fallacy is the belief that recent past outcomes affect the probability of future outcomes. Mental accounting refers to mentally classifying investments in separate accounts rather than considering them from a portfolio perspective. In behavioral finance theory, how is loss aversion most accurately defined? For gains and losses of equal amounts, investors: dislike losses more than they like gains. Behavioral finance proposes that investors are loss averse. Loss aversion means investors dislike losses more than they like gains of the same amount.

– May cause investors to overreact when prices
fall.
• Overconfidence—Traders place too much
emphasis on their information and
perspectives about values.
– May cause investors to trade too much.
– May cause investors to trade on stale prices.
– May cause investors to fail to recognize the
significant of bad news.

Question 3

Other Behavior Issues

Answer 3

• Representativeness
• Gambler’s fallacy
• Mental accounting
• Conservatism
• Disposition effect
• Narrow framing: Narrow framing refers to investors viewing events in isolation.

Question 4

Information Cascades

Answer 4

information cascades: The idea that uninformed traders, when faced with unclear information, observe the actions of informed traders to make decisions. refers to uninformed traders watching the actions of informed traders when making investment decisions. Herding behavior is when trading occurs in clusters, not necessarily driven by information
• People respond to what other people
are seeing and doing.
• Herd effects: Everyone does the same
thing.
– In the short run causes momentum and is
self-reinforcing.

Question 5

Behavior Finance and Market

Efficiency

Answer 5

• Behavior finance attempts to explain
various anomalies that are inconsistent
with market efficiency.