Impact Of Prior Outcomes On DM

Question 1

What does the behavioural decision research show?

Answer 1

• People often violate the sunk cost principle of economics

- Economic decisions are influenced by past investment (sunk costs) of time, money and effort

Question 2

What is escalation of commitment?

Answer 2

Tendency to commit additional funds to a failing project in an attempt to recoup prior sunk costs

Question 3

What are the explanations of sunk costs? 5

Answer 3

• try to avoid waste
• personal responsibility and the need for self justification
• reputation and information asymmetries
• mental accounting effects
• prospect theory

Question 4

How do prior outcomes affect decisions? 3

Answer 4

Disposition effect:tendency for investors to ‘sell winners too early and ride losers too long’

• mental accounting(narrow framing):investors focus on individual stocks rather than on the portfolio
• prospect theory:risk averse in gain domain and risk seeking in loss domain

Question 5

What are the criticisms of the prospect theory?

Answer 5

• Barberis and Xiong:based on theoretical discussion suggests that prospect theory can’t explain disposition effect alone (investors with prospect theory value function wouldn’t have bought stocks in the first place)
• kaustia:prospect theory predicts the propensity to sell declines as prices move away from purchase price. But trading data shows that propensity to sell jumps at zero return and is constant over losses, and constant/increasing over gains
• summers and Duxbury:merely experiencing prior gains or losses is not sufficient to produce disposition effect (specific emotions drive behaviour)

Question 6

What is the house money effect? 3

Answer 6

• evidence of increased risk taking following prior gains (contrary behaviour to prospect theory)
• subsequent loss is painful following prior gains (prior gains cushion the subsequent loss and make it bearable)
• broad implication for financial markets? Investors care less for a market dip that follows a substantial prior gain because they ‘are still up, relative to a year ago’

Question 7

What are the views of Dixbury et Al? 4

Answer 7

• disposition and house money effects contemporaneously coexist in a single stock market
• a lot of investors succumb to both types of behaviour
• the house money effect moderates the disposition effect
• important to distinguish prior outcomes along realised and unrealised, and assessing at the stock and portfolio levels…dimensions

Question 8

What is the economic finance theory on the sunk cost principle?

Answer 8

Individuals should evaluate decisions based solely on incremental analysis (only future costs and benefits are relevant)