Lecture 7

Question 1

Non-event

Answer 1

Something which didn’t happen, not “new-news”
Example: EntreMed
- Supposedly found cancer cure, reported in small journal, share prices increase by 28% but not maintained
- Republished 6 months later in NYT, share price rises 330%

Question 2

Behavioural finance

Answer 2

Application of psychology to the behaviour of financial managers, corporate financiers and the capital market
- Recognises judgemental biases and decision errors which we’re all prone to and their financial/investment consequences

Question 3

Traditional Finance characteristics

Answer 3

Derived from neo-classical economics and assumes a world dominated by homo economicus
- Financial decision makers assumed to be rational
- They make unbiased forecasts about the future
- They are virtually omniscient, perfect information processors and statisticians
Markets assumed to be efficient
It is highly analytical, deductive and normative

Question 4

Behavioural Finance Characteristics

Answer 4

Recognises investors and financial executives are:
- Very imperfect decision makers
- Prone to cognitive errors, are loss-averse, subject to regret and exhibit imperfect control
- Poor intuitive statisticians
- Concerned with psychological factors and feelings not just expected return and risk
- “good enough” in their decisions rather than seek to “optimise”
- Are normal (irrational) human beings

Question 5

Behavioural Finance and Market Anomalies

Answer 5

• Market anomalies violate the EMH
• Anomalies don’t create large enough profit opportunities to allow active fund managers to earn abnormal profit
• BF proponents argue market prices deviate from fundamentals due to investor cognitive “limitations”
• BF provides plausible explanations (stories)

Question 6

Neural processing cognitive systems

Answer 6

System 1: Intuitive/reflexive
- Automatic, Effortless, Associative, Affective
System 2: Reflective
- Controlled, Effortful, Deductive and statistical, Conscious thought

Question 7

Bounded Reality

Answer 7

• Our cognitive limitations force us to construct simplified models of the real world to deal with it
• We act rationally with respect to these models but such behaviour isn’t optimal with respect to the real world

Question 8

Cognitive Style

Answer 8

• Our ability to different information stimuli and integrate and combine in complex ways

Question 9

Tendency to information overload

Answer 9

• Beyond the optimal point, additional information leads to poorer decisions
• Decision maker becomes swamped, ignores further information and makes random decisions

Question 10

Heuristics and biases

Answer 10

Help simplify complex judgements and decisions we have to make
- Their operation leads to cognitive errors

Question 11

Prospect Theory

Answer 11

How we deal with “loss” in making choices in the face of risk and uncertainty