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Flashcards in Behavioural Finance Deck (5)
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What is behavioural finance?


New area of research which explores how emotional and psychological factors affect investment decisions

  • it attempts to explain market anomalies that are not explained by traditional finance models such as MPT and EMH
  • tries to explain why prices deviate from their fundamental values
  • much of traditional financial theory is based on the assumption that individuals act rationally and consider all available information when making investment decisions
  • key argument of BF is that investors are affected by psychological or behavioural biases
  • These limit and distort their information and may cause them to reach incorrect conclusions

Biases of Behavioural Finance


1) Overconfidence:
- investors overestimate their ability to identify winning investments
- traditional financial theory suggests holding a diversified portfolio will deliver the greatest return
- overconfidence can weigh against this advice with investors / advisors ‘sure of’ a good return from a given investment so believe diversification is unnecessary

2) too much trading
- investors with too much confidence often trade too much
- often the traders that trade the most earn the lowest returns

3) skill and luck
- over confidence may be fuelled by ‘self attribution bias’.
- view a positive out come as down to their own skill but negative outcome as just bad luck
- this process blocks negative feedback

4) fear of loss
- people more sensitive to loss than gain
- some estimates suggest that people weigh loses more than twice as heavily as gains
- people happy to see an investment to lock in a gain but not to lock in a loss
- sell winners and hold on to losers

5) regret avoidance
- not making decisions which later they may regret
- could switch funds or sell a stock now but that may turn out to be a bad decision so instead we’ll ‘wait and see’


Other biases


1) Anchoring - calculating returns and rounding to a higher number to make it looks better e.g. 12% becoming 15%
2) cognitive bias - sheep like mentality- buying when prices are high
3) confirmation bias - find some confirmation that supports the decision for doing something, no matter how bizarre


Why may an investor not sell a poor investment (6)

  • loss aversion
  • selling at current share price would realise a loss
  • anchoring
  • paid round figures for the shares
  • emotional attachment
  • sense of attachment / loyalty
  • overconfidence
  • still believes stock is a good investment / investors own analysis is best

Five non behavioural reasons to keep a poor share (5)

  • new sector/ scope for growth
  • better ROCE than sector
  • may be a recovery stock
  • see through the effects of a rights issue
  • possible takeover target