7 & 8 - Investor Behavious & Market Outcomes

Question 1

Most individuals are averse to risk when…
Most individuals are risk-seeking when…

Answer 1

Most individuals are averse to risk when gains are involved.
Most individuals are risk-seeking when there is a chance to avoid loss.

Question 2

What is the endowment effect (Thaler, 1980)?

Answer 2

An application of loss aversion. It is the tendency to value a good more when owned. A person’s valuation of/preference for something increases when they own it.
People attach additional value to things they own, simply because the item belongs to them.
This goes against standard economic theory which states that preference and initial assignment/endowment are irrelevant in decision-making.
Losses (giving up the good) are felt much more strongly than gains (receiving the good).

Question 3

How can endowment effect be considered evidence for reference-dependent preferences and loss aversion?

Answer 3

• Seen as evidence for loss aversion around a reference point determined by current ownership
• Selling something regarded as a loss; the loss in utility associated with giving up a good is greater than the gain of getting that good
• May also be explained by status quo bias

Question 4

What is the anchoring effect?

Answer 4

A psychological phenomenon in which an individual’s judgements or decisions are influenced by a reference point or “anchor” which can be completely irrelevant.

Question 5

What is herding?

Answer 5

The process where market participants contemporaneously trade in the same direction and/or their behaviour converges to the consensus. Analysts may herd if influenced by other analysts. Retail investors may infer information from the actions of other investors.

Question 6

What is the framing effect?

Answer 6

A person’s decisions are influenced by the manner in which the setting for the decision is described. Different representations of the same problem yield different preferences. This goes against the principle of invariance which states that different representations of same problem should yield same preference.

Question 7

What is herding in financial markets?

Answer 7

The process where market participants contemporaneously trade in the same direction and/or their behaviour converges to the consensus.
Analysts may herd if influenced by other analysts.
Retail investors may infer information from the actions of other investors.
May be explained by anchoring and regret aversion. May be made worse by increased amount and frequency of information transfer/spread through social media.

Question 8

According to the behavioural approach, why can arbitrage be much weaker and more limited than assumed in the traditional approach to market efficiency?

Answer 8

The key forces by which markets are supposed to attain efficiency, such as arbitrage, are likely to be much weaker and more limited due to various risks:
- Noise trader risk:
* Mispricing can become even worse before it gets better. So only arbitrageurs with deep pockets can afford the long-term horizon.
* Irrational investors may push prices further away from fundamentals, even after arbitrageurs take their positions
* Smart investors might temper their trades, and as a result the inefficiencies might be neither small nor temporary.
- Fundamental risk:
* Some stocks are more difficult to value (and thus arbitrage) than others. E.g., young, small, currently unprofitable, experiencing extreme growth, do not pay dividends for many years, has no earnings history, etc.
* Problematic for professional money managers betting on them
* Short-sell over-valued stocks when un-anticipated new (good) information suddenly arrive – price will rise, and a loss will be incurred
- Restrictions and transaction cost:
* Restrictions on short selling can limit arbitrage (some countries have limits on arbitrage).
* Nonavailability of the stock to short – less-liquid stocks
* The higher transaction costs of taking short positions in stocks, relative to long positions, dampens arbitrage activity.