Chapter 9 Flashcards
(10 cards)
Why might hiring a professional money manager not always result in better investment performance compared to a passive index fund?
Professional money managers are often highly skilled and well-compensated, which might lead investors to believe they will outperform the market. However, while a few actively managed funds do beat the market, most do not, and the high fees charged by active funds can erode returns. Passive index funds, which track a broad market index, often perform better due to their low costs and consistent exposure to market growth.
How does overconfidence impact individual investment decisions?
Overconfidence can lead investors to believe they can predict market movements or pick winning investments, often resulting in excessive trading. This frequent buying and selling generates high transaction costs, which can diminish returns over time.
Is overconfidence equally prevalent among men and women investors?
No, studies show that men are generally more overconfident than women when it comes to investing. This leads men to trade more frequently than women, who tend to be more patient. As a result, women often achieve better investment results because they avoid excessive trading fees associated with frequent transactions.
How does optimism affect investment behavior?
Optimism causes investors to maintain a positive outlook on their investments’ profitability, even if the performance is subpar. This optimism is often reinforced by overconfidence in their initial choices, leading investors to ignore evidence of poor performance and continue believing in their investment choices.
Why do people often mistake randomness for skill in investing?
Investors tend to see patterns in random events, attributing a fund’s success to the manager’s skill rather than luck. For instance, if a fund outperforms the market for a couple of years, investors may assume the manager has exceptional abilities, ignoring the fact that market performance often regresses to the mean over time.
What role do anchoring, status quo bias, and procrastination play in poor investment choices?
Many investors stick with certain asset allocations out of inertia, such as a 50% bond, 50% stock split, without adapting to long-term goals or market changes. Status quo bias makes them reluctant to make changes, while procrastination leads them to delay critical investment decisions. This can result in missed opportunities for higher returns.
How does prospect theory explain investors’ tendencies to hold on to losing stocks and sell winning stocks too early?
According to prospect theory, investors avoid selling stocks at a loss to avoid feeling like “losers,” and they are more likely to sell stocks that have appreciated to lock in gains. Investors are often risk-averse with gains, leading them to sell winners prematurely, while they become risk-seeking with losses, holding onto losing stocks in the hope of future recovery.
What led to the popularity of day trading in the 1990s, and why did many day traders ultimately fail?
Economic growth and the rise of the internet made technology stocks and online trading popular, lowering transaction costs and attracting day traders. However, many day traders failed as profits regressed to the mean, high trading costs ate into gains, and heavy taxes on short-term capital gains reduced profitability. Additionally, day traders were often at a disadvantage against institutional investors with more experience and information.
What is one of the biggest dangers of herd behavior in investing?
Herd behavior can lead individuals to follow investment trends without considering the underlying value, as seen when day traders bought stocks simply because others were doing the same in a booming market. This can lead to speculative bubbles and heavy losses when the trend reverses.
What are three tips for effective investment planning?
Choose your asset allocation carefully – Develop a plan that suits your financial goals, balancing stocks, bonds, and other assets as appropriate.
Opt for low-cost investing – High fees can erode returns, so consider low-fee funds or other cost-efficient investments.
Invest regularly – Consistent, regular contributions can help build wealth over time and reduce the impact of market volatility.
