COMMERCE 3FA3 Study Guide - Final Guide: Efficient-Market Hypothesis, Vertical Draft, Investment Banking
5 Jun 2018
School
Department
Course
Professor
Introduction to Behavioural Finance
Behavioural finance deals with the implications of reasoning errors on financial decisions. This stems from cofnitive
psychology and cognitive errors.
Biases
Studies of stock investors indicate that investors overestimate their abilities leading to excessive trading -
accounts with the most trading underperform those with the least
•
Men tend to underperform compared to women suggesting they have greater degrees of overconfidence
•
Higher education contributes to greater overconfidence
•
of people believe they are above-average drivers
•
Overconfidence is the belief that ones abilities are better than others.
Leads to overestimated cash flows and underestimated probabilities of failure leading to an upward-biased
estimate of NPV
•
Stock traders become more risk adverse in darker months - optimism is linked with hours of daylight
•
Overoptimism occurs with overly optimistic views of potential outcomes.
Confirmation bias occurs when one searches for (and gives greater weight to) information and opinions that confirm
their beliefs, rather than the contrary.
Framing Effects
"Do you want to participate in the stock market" versus "do you want the risk of the stock market?"
•
Framing dependency is the tendency of individuals to make different and inconsistent decisions depending on how a
problem is framed.
Managers may bypass positive NPV projects if they have a low possibility of large loss
•
Debt avoidance from avoiding debt financing removes valuable tax shields due to fears of potential bankruptcy
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Individuals dislike losing more than they enjoy gaining
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Myopic loss aversion describes the unwillingness to suffer ST losses to obtain a LT gain
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Regret aversion is the tendency to avoid making decisions that might be less than optimal
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Loss aversion/get-evenitis/breakeven effect describes the willingness to hang on to bad investments and projects in the
hopes of breaking even
Endowment effect is the tendency to consider something you own to be worth more than if you did not own it
•
Money illusion describes the confusion between real buying power and nominal buying power (not accounting for
inflation)
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House money describes an individuals willingness to gamble with money gained in a windfall compared to money they're
earned personally.
Heuristics
Relates to reliance on intuition and experience, but overreliance on emotion ins decision making can affect
logical reasoning
○
Affect heuristics is the reliance on instinct instead of analysis to make decisions.
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Perceived patterns or causes of success are seen where they do not exist
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Clustering illusion is a human belief that random events occuring in clusters are not actually random - coin
flipping remains the same no matter the streak
○
Representative heuristic is the reliance on stereotypes, analogies, and limited samples to form opinions about an
entire class
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Law of small numbers places a small sample of outcomes as a LT distribution of outcomes
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Recency bias describes a tendency to give recent events more importance
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Anchoring and adjustment describes the inability to account for new information and the tendency to be
overly conservative
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Aversion to ambiguity results when people shy from the unknown
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False consensus is the tendency to think others think the same thing as yourself with no real evidence
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Availability bias occur when too much weight is put on readily available information, and too little on
Gamblers fallacy assumes that a departure from the average will be corrected in the ST
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Heuristics are rules of thumb or shortcuts used to make decisions.
Behavioural Finance: Implications for Financial
Management
March 30, 2018
3:30 PM
Managerial Finance Page 1
Document Summary
Behavioural finance deals with the implications of reasoning errors on financial decisions. This stems from cofnitive psychology and cognitive errors. Overconfidence is the belief that ones abilities are better than others. Studies of stock investors indicate that investors overestimate their abilities leading to excessive trading - accounts with the most trading underperform those with the least. Men tend to underperform compared to women suggesting they have greater degrees of overconfidence. Higher education contributes to greater overconfidence: of people believe they are above-average drivers. Overoptimism occurs with overly optimistic views of potential outcomes. Leads to overestimated cash flows and underestimated probabilities of failure leading to an upward-biased estimate of npv. Stock traders become more risk adverse in darker months - optimism is linked with hours of daylight. Confirmation bias occurs when one searches for (and gives greater weight to) information and opinions that confirm their beliefs, rather than the contrary.
