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Question 1

1.

How does behavioral finance differ from traditional finance in its view of investors?

Answer 1

Traditional finance assumes investors are rational, utility-maximizing, and fully informed. Behavioral finance examines actual investor behavior, recognizing that investors may be biased, influenced by others, and not always rational.

Question 2

Does market efficiency require all investors to be perfectly rational?

Answer 2

No. Semi-strong form efficiency only requires that investors cannot consistently earn abnormal returns using public information. Some investors may be irrational, but this doesn’t necessarily mean markets are inefficient.

Question 3

What is loss aversion?

Answer 3

Loss aversion is the tendency for investors to feel the pain of a loss more strongly than the pleasure of an equivalent gain. This can lead to irrational risk aversion in some situations.

Question 4

What is investor overconfidence?

Answer 4

Investor overconfidence is the tendency for investors to overestimate their ability to analyze information and pick winning investments.

Question 5

What is herding behavior in investing?

Answer 5

Herding is when investors mimic the actions of others, rather than making independent decisions based on their own analysis.

Question 6

What are information cascades and their potential impact on market efficiency?

Answer 6

Information cascades occur when less-informed investors follow the actions of those they perceive as more informed. This can contribute to market efficiency if the initial actors are truly informed, but it can also lead to bubbles or crashes if based on misinformation or herd behavior.

Question 7

How can behavioral finance explain deviations of market prices from intrinsic value?

Answer 7

Behavioral biases, like loss aversion, overconfidence, and herding, can lead to mispricing and market bubbles or crashes.