Lecture 9 Flashcards
Premise of behavioural finance
Conventional financial theory ignores how real people make decisons
Investors are irrational (2)
- Don’t always process information correctly therefore make incorrect decisions
- Make inconsistent/ systematically sub-optimal deicisions
Errors in information processing
Can lead investors to mis-estimate the true probabilities of events/ returns
Information processing > Forecasting errors
People place too much reliance on recent experiences when making forecasts (memory bias) therefore make extreme decisions
Information processing > Overconfidence
Individuals over-estimate their abilities
Self-attribution bias
Positive outcome > due to skill
Negative outcome > misfortune
Information processing > Conservatism
Investors are too slow to update their beliefs in response to new evidence therefore under-react therefore prices fully reflect new information only gradually
Information processing > Sample size neglect and representativeness
Don’t take sample size into account therefore take small sample as representation of the whole population and infer patterns too quickly
Behavioural biases
Even if information processing is perfect individuals make less than rational decisions using the information
Behavioural biases > framing
How opportunity is posed > framed as involving gains/ losses
Behavioural biases > mental accounting
People segregate certain decisions eg one risky account and one safe, both park of the same portfolio
Behavioural biases > regret avoidance
Individuals that make decisions that turn out badly have more regret when the decision was unconventional eg investing in new start up
Behavioural biases > prospect theory
higher wealth provides a higher utility at a diminishing rate (graph)
