Behavioral Finance: Heuristics and Biases

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People come in all different shapes, sizes, and colors. If that is the case why are we so similar? The goal of this paper is to discuss people and their behavior as applied to finance. I will attempt to deconstruct human psychology to evidence their patterns. I was twelve years old when I was introduced to the stock market. 1998 had seen significant growth underpinned by a stable political environment. My young mind recalls the irrational exuberance of the adults in my world. You put money in the stock market because it goes up they said. In my investments class in 7th grade a tech stock rose 2000% in one week investing through the Yahoo finance simulation. Likewise, the rest of my classmates pursued other tech companies in an effort to be competitive with one another. I often reflected on the environmental causes of behavior. My fascination with numbers and finance stayed relatively stagnant up to college until corporate finance. It was then that I saw fellow student’s exhibit peculiar behavior again. This time, it was because they were asked to methodically apply algebra and numbers. It was odd to me that everyone used a calculator to solve the problems. They would say, “I put the right numbers in and this is what the calculator gave me.” As I have aged, that statement has become a red flag. Some classmates could solve algebraic problems. However, they did not understand them. I believe these traits are endemic of the overall human condition and run over into all aspects of finance. People are more upset by losses then they are by equal gains according to Kahneman and Tversky’s prospect theory (1979). Human beings are risk adverse creatures. We are willing to give up a large amount of upside to insulate from any downside. The No...

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...yet human, investor would be wise to consider the behavior of their fellow humans and themselves when making an investment decision.

Works Cited

1. Momentum: Narasimhan Jegadeesh and Sheridan Titman; October 23, 2001 2. From Efficient Market Theory to Behavioral Finance: Robert J. Shiller, Cowles Foundation Discussion Paper No. 1385; October, 2002 3. Behavioral Finance: Robert J. Bloomfield, Johnson School Research Paper Series #38-06; October, 2006 4. Efficient Capital Markets: A Review of Theory and Empirical Work: Eugene F. Fama, The Journal of Finance, Vol. 25, No. 2, May, 1970 5. Naive Diversification Strategies in Defined Contribution Saving Plans: Shlomo Benartzi and Richard H. Thaler, The American Economic Review; March, 2001 6. Prospect Theory: An Analysis of Decision under Risk: Daniel Kahneman and Amos Tversky, Econometrica, Vol. 47, No. 2. ; March 1979
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