7 - Investor Behavious Flashcards
(18 cards)
What is the disposition effect? Why is this counterintuitive in the US?
The tendency of investors to sell winners too early and hold losers too long. It is caused by loss aversion. This is counterintuitive in the US because short-term capital gains are taxed more highly than long-term gains. Optimal tax-loss selling for taxable investments would include postponing taxable gains and realising losses gradually, so you pay less taxes.
What are some possible rational reasons why investors may choose to hold their losers and sell their winners?
- Expect short term mean reversion (expect price to bounce back soon)
- Sell if price reflects new information; hold if new information is not yet incorporated into price
- Sell winners to restore diversification
What are behavioural explanations for disposition effect?
- Prospect theory: Selling a winning asset would mean a sure gain. Selling a losing asset would mean a sure loss.
- Mental accounting: decision makers encounter considerable difficulty in closing mental accounts at a loss.
- Regret aversion.
Most individuals are averse to risk when…
Most individuals are risk-seeking when…
Most individuals are averse to risk when gains are involved.
Most individuals are risk-seeking when there is a chance to avoid loss.
What is the endowment effect (Thaler, 1980)?
An application of loss aversion. What you currently have seems better than what you do not have. 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.
What is the status quo bias (Samuelson and Zeckhauser, 1988)?
A preference of ‘doing nothing or maintaining one’s current or previous decision’
How can endowment effect be considered evidence for reference-dependent preferences and loss aversion?
- 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
What is the anchoring effect?
A psychological phenomenon in which an individual’s judgements or decisions are influenced by a reference point or “anchor” which can be completely irrelevant.
What is herding?
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.
What is the framing effect?
A person’s decisions are influenced by the manner in which the setting for the decision is described. This goes against the principle of invariance which states that different representations of same problem should yield same preference.
What is availability heuristic?
We rely on information that is more easily available rather than relevant. Easiest to recall: own experience, memories, recent events, salience
What is the familiarity heuristic?
People tend to favour which is familiar (they are more comfortable with what they know). People are more likely to accept a gamble if they feel they have a better understanding of the relevant context (e.g. home bias, many people would rather invest mainly in domestic market even if it’s not actually the most beneficial choice).
What are possible explanations of home bias?
Rational explanations:
- Hedging demand (consume local goods and local prices, hedge by investing locally)
- Avoid foreign exchange risk (e.g., less home bias in Eurozone)
- Trading costs and capital movement restrictions
Behavioural explanations:
- Familiarity (what is familiar is good investment), ambiguity aversion, comfort-seeking,
- Perceived information advantage (overconfidence)
- Excessive optimism about prospects of domestic market
What is ambiguity aversion?
The preference for known (risk) over unknown (uncertainty/ambiguity).
What is representativeness?
People make judgements based on stereotypic thinking - judge the likelihood of an event by the extent to which it resembles our idea of what the typical case should look like.
How does representativeness affect stock selection?
Perception that Good company = Good investment
People act as if big high-growth firms are representative of good investments. “If a company has high-quality management, a strong image and has enjoyed consistent growth in earnings, it must be a good future investment…” However, positive qualities should have already been reflected in the stock price. No company attributes should be associated with investment value. May contribute to some market anomalies.
What is overconfidence?
Overconfidence is a bias that pertains to how well people understand the limits of their knowledge, their own abilities, or both.
- People think of themselves as more knowledgeable than others (miscalibration).
- People have an inflated sense of their own abilities (better-than-average effect).
How can overconfidence affect investment decisions?
Overconfidence can lead to excessive trading (excessive turnover (resulting in lower net profits)) and under-diversification (thinking they can outperform the market like Warren Buffett).
