Investors show many biases and few of these behavioral biases exist in solitude as different biases interact with each other and effects investor’s decision making process. Following list represents some common biases investors face.
Representativeness: Representativeness causes investors to label an investment as bad or good based on its latest performance. As a result, investors purchase stocks after prices have increased expecting the rise in price to continue and they ignore stocks when their prices are below their fundamental values. In actual practice, investors should have a clearly defined set of analytical procedure that they test and retest in order to clarify and upgrade the stocks over the long run.
Regret or loss aversion: Regret
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As disposition effect can inflate the taxes on capital gains payable by investors and can reduce returns before taxes, it is harmful to investors. The concept of cut losses and let profits increase, facilitates investors to employ investment management efficiently to achieve more returns.
Familiarity bias: Despite the gains from diversification, investors may have a preference for similar investments. Generally, investors prefer investment in familiar local assets and portfolios of domestic securities. Significance of this bias is that substandard portfolios are held by investors. This bias can be overcome if investors broaden their portfolio appropriation which results in risk reduction.
Anchoring: The propensity to hold on to a belief and exercise it as a instinctive reference point for making future judgments or decisions is termed as anchoring. It arises when an individual lets information oversight his rational decision-making process. Often people take decisions based on the initial source of information for example an initial purchase price of a share and they face difficulty in adjusting their view to new information. Anchoring can be avoided if investor chooses broad range of choices for investment and by considering different relevant
Before we invested, we decided to pick two types of companies to invest in. We would choose companies that had expensive stock but steady increasing prices and we would choose smaller companies that had cheaper stock but whom had a chance for potential huge price increases. If the smaller companies’ stock went down the bigger companies’ steadily increasing stock would even it out, but if the smaller companies’ stock price rose greatly, like we predict, we could sell and make a good profit. We found a big name company that had reliable stock prices pretty quick, but finding a small company whose stock price could rise was hard. We
The anchorage bias, or the relativity trap, is when people are over-reliant on the first piece of information they hear or receive. Using this bias as a tool of persuading someone, will expedite the decision making process between two people. One of the main problems with the anchorage bias is that just because the decision is made quickly, doesn’t mean the decision is right. Anchorage can also lead to tunnel vision, or only focusing on one thing and not paying attention to
Bias is a tendency, inclination, or outlook to present a partial perspective, often accompanied by a refusal to consider the
Investment theory is based upon some simple concepts. Investors should want to maximize their return while minimizing their risk at the same time. In order to accomplish this goal investors should diversify their portfolios based upon expected returns and standard deviations of individual securities. Investment theory assumes that investors are risk averse, which means that they will choose a portfolio with a smaller standard deviation. (Alexander, Sharpe, and Bailey, 1998). It is also assumed that wealth has marginal utility, which basically means that a dollar potentially lost has more perceived value than a dollar potentially gained. An indifference curve is a term that represents a combination of risk and expected return that has an equal amount of utility to an investor. A two dimensional figure that provides us with return measurements on the vertical axis and risk measurements (std. deviation) on the horizontal axis will show indifference curves starting at a point and moving higher up the vertical axis the further along the horizontal axis it moves. Therefore a risk averse investor will choose an indifference curve that lies the furthest to the northwest because this would r...
In turn everything in the present and the future is judged through the stocks as they hold a high importance in industrialized economies showing the healthiness of said countries economy. As investing discourages consumer spending over all decreases, it lead...
Hindsight bias explains the human inclination to perceive an event’s outcome as the one obvious and inevitable outcome. It starts with an original prediction or forecast of the future that helps us prepare, plan, and set goals for ourselves. These predictions influence our decision making, sending the reminder to our brain that one behavior sparks a desired outcome. So whether we are aware of it or not, every thought, decision, and act we make is based around our preconceived hypotheses on how the world operates. Foresight is a useful survival skill that allows us to use our current knowledge or beliefs to help guide us through the trials and tribulations of life.
We analyzed the market for two weeks to determine when the equity market would turn from a bearish to bullish market. Without a change in the market and a declining bond price, we decided to invest in equities according to our investment strategy, which brought us into the second phase of our portfolio. Therefore, at the beginning of February we bought shares in Sirius, Microsoft, Neon, Washington Mutual, and Nike. As assumed, the equity market continued to plummet decreasing the value of all our stocks except for our Gold Corporation stock.
Investors often use the book-to-market or price-to-book ratios to determine the value of a company when investing. However, it is critical to first assess whether they themselves are value stock investors or growth stock investors or a combination which will often guide their investment decisions. Mostly, this will be based on their goals as short-term or long-term investors. Value stocks are those stock shares that are sold for less than a buyer thinks they are really worth (Cambridge, 2011).
Hensel, C. R., Ezra, D., & Ilkiw, J. H. (1991). The Importance of the Asset Allocation Decision.
The concept of anchoring draws upon the tendency for us to attach or "anchor" our thoughts around a reference point despite the fact that it may not have any logical relevance to the decision at hand.
"Oh, I shouldn't have missed that question, I knew the answer." No I didn't, I just thought I did. I just further proved the concept of the Hindsight Bias, or the "I knew it all along phenomenon." This concept came about in the late seventies when psychologists Paul Slovic and Baruch Fischoff began studying how scientific results and historical happenings always seem like common sense to people when in fact , they had no idea. Once people find out something has happened, it seems inevitable that the event happened. Studies have proved this fact by taking a group of people and giving them two concepts exactly opposite of each other. For example, one group may receive "scientific findings" that opposites in people attract them to one another. The other could receive opposite "findings" that people tend to stay with others who have similar qualities to their own. After the "results" are read by the two groups, they both "knew that people behaved in that manner", when in fact, they only thought they knew.
There is a sense of complexity today that has led many to believe the individual investor has little chance of competing with professional brokers and investment firms. However, Malkiel states this is a major misconception as he explains in his book “A Random Walk Down Wall Street”. What does a random walk mean? The random walk means in terms of the stock market that, “short term changes in stock prices cannot be predicted”. So how does a rational investor determine which stocks to purchase to maximize returns? Chapter 1 begins by defining and determining the difference in investing and speculating. Investing defined by Malkiel is the method of “purchasing assets to gain profit in the form of reasonably predictable income or appreciation over the long term”. Speculating in a sense is predicting, but without sufficient data to support any kind of conclusion. What is investing? Investing in its simplest form is the expectation to receive greater value in the future than you have today by saving income rather than spending. For example a savings account will earn a particular interest rate as will a corporate bond. Investment returns therefore depend on the allocation of funds and future events. Traditionally there have been two approaches used by the investment community to determine asset valuation: “the firm-foundation theory” and the “castle in the air theory”. The firm foundation theory argues that each investment instrument has something called intrinsic value, which can be determined analyzing securities present conditions and future growth. The basis of this theory is to buy securities when they are temporarily undervalued and sell them when they are temporarily overvalued in comparison to there intrinsic value One of the main variables used in this theory is dividend income. A stocks intrinsic value is said to be “equal to the present value of all its future dividends”. This is done using a method called discounting. Another variable to consider is the growth rate of the dividends. The greater the growth rate the more valuable the stock. However it is difficult to determine how long growth rates will last. Other factors are risk and interest rates, which will be discussed later. Warren Buffet, the great investor of our time, used this technique in making his fortune.
What is the role of investor’s confidence in the financial markets? Why a downgrade of the US treasury sends ripples in the stock markets all over the world .How do investors react to such kind of information? Do we take all the information into account before...
Our understanding and the concept of investment in behavioural finance combines economics and psychology to analyse how and why investors make final decision. As an investor one’s decision to invest is fully influence by different type of attitudes of behavioural and psychological ( Ricciardi & Simon, 2000). Yet, in order to maximize their financial goal, investors must have a good investment planning. Furthermore , to gain a good investment planning , there must be a good decision making among investors. They have to choose the right investment plan I order to manage the resources for different type of investments not only to gain profit wise but also to avoid the risk that occur from investment.
This paper will define and discuss five financial theories and how they impact business decisions made by financial managers. The theories will be the Modern Portfolio Theory, Tobin Separation Theorem, Equilibrium Theory, Arbitrage Pricing Theory (APT), and the Efficient Markets Hypothesis.