Irrationality/Overconfidence Flashcards
Outline the two main approaches by Baker and Wurgler (2013) of irrationality on financial markets
In their research, baker and wurgler (2013) investigate the potential impact of irrationality in financial markets on corporate decisions.
one approach of this research focuses on ow cognitive biases, such as overconfidence can affect the decision making of managers and executives. These biases can lead managers to make overly optimistic assumptions about the future prospects of their companies, which in turn can lead to over investment and excessive risk-taking.
the second approach of this research focuses on the effects of investor behaviour on corporate decision making. for example, research has shown that investors tend to overreact to new information, leading to exaggerated price movements in the stock market. This overreaction can affect the way companies make investment and financing decisions, as they base their decisions on the exaggerated price movements.
discuss how overconfident managers might affect companies and markets when making investment and financing decisions.
over confident managers can have a number of negative effects on companies and markets. for example, over confident managers may over estimate the potential return of a given investment and under estimate the risks, leading to suboptimal investment decisions. this can lead to a misallocation of resources and lower overall returns for the company. Additionally, over confident managers may be more likely to engage in excessive risk taking, such as trading on large amount of debt to finance risky investments. this can increase the financial venerability of the company and increase the likelihood of financial distress.
in the market as a whole, over confident managers can contribute to market volatility and instability. For example, if many managers are over confident and making suboptimal investment decisions, this can lead to mispricing of assets and a distortion of the market.
Overconfidence can have negative consequences for investors and the economy as a whole.
critically evaluate the evidence on over confidence and explain how this concept has facilitated a deeper understanding of financial decision making.
over confidence refers to the psychological phenomenon where individuals have an excessive belief in their own abilities, knowledge or information. in the context of behavioural finance, over confidence if often studied in relation to financial decision making and has been found to play a significant role in a number of financial behaviours.
studies of overconfidence in financial decision making have typically found that individuals who are overconfident tend to be more likely to take risks, trade more frequently and hold into their investments for longer periods of time. these behaviours can have negative consequences, such as under performance on investment portfolios, and have been linked to the well documented tendency for individual investors to underperform the market.
overconfidence can also affect market behaviour at the aggregate level. for example, over confident investors may be more likely to engage in speculative bubbles, where prices of assets become disconnected from their fundamental value which can lead to market instability and contribute to market crashes.
