Financial Decision-Making: Heuristics Chapter 8

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Questions and Answers

What was the average appraisal price for the first group of real estate agents?

$75,190

$71,500.50

$69,136.43

$67,811 (correct)

What does the variable 'a' represent in the appraisal estimate mechanism?

0.7

0.34 (correct)

0.59

What was the calculated appraisal price that equated 'a' for the two groups of agents?

$75,190

$69,136.43 (correct)

$67,811

$71,500.50

What was the influence of the list price factor for the first group of real estate agents as indicated by 'a'?

0.34 Signup and view all the answers

How much was the gap between the two appraisal averages?

10 Signup and view all the answers

In general terms, what can be inferred about the nature of anchors in economic and financial situations?

They tend to be common. Signup and view all the answers

Which of the following best describes the relationship between anchoring and herding?

They are closely related. Signup and view all the answers

What was the appraisal price of the second group of real estate agents?

$75,190 Signup and view all the answers

What is one reason investors might not favor countries with lower trading costs?

International tax burdens are similar for most investors. Signup and view all the answers

What does the term 'intra-national home bias' refer to?

A tendency to invest more in local companies than in diversified options. Signup and view all the answers

What is an implication of over-weighting local companies in a portfolio?

It creates a dependence on the local economy's performance. Signup and view all the answers

What behavior was observed after AT&T's divestiture into Baby Bells?

A disproportionate number of customers held shares in their local Baby Bell. Signup and view all the answers

From a diversification standpoint, owning local stocks can be considered detrimental because:

You have multiple income streams in the same sector. Signup and view all the answers

Why does diversification theory recommend seeking weakly correlated income streams?

To mitigate risk and enhance stability. Signup and view all the answers

What factor weakens the argument for avoiding foreign investments?

Investors' tendency to prefer local familiarity. Signup and view all the answers

The similarity of tax burdens for most investors primarily results from:

A complex international taxation system. Signup and view all the answers

What behavior was observed in Canadian workers regarding their retirement investments?

They were more likely to chase momentum. Signup and view all the answers

How did employees of top-performing companies differ in their investment in company stock compared to those in bottom-performing companies?

They invested 40% of their discretionary money into company stock. Signup and view all the answers

What does the evidence suggest about momentum-chasing in terms of its profitability?

Momentum-chasing yields positive returns in the short term but may lead to losses in the long term. Signup and view all the answers

According to the findings, what percentage of Canadian respondents were identified as momentum-chasers?

63.8% Signup and view all the answers

What was the performance comparison in the year after portfolio formation for those who allocated the most to company stock?

They earned 6.77% less than those who invested less. Signup and view all the answers

What type of correlation is found for risk-adjusted returns in the short term according to the evidence?

Positive serial correlation for 3- to 12-month intervals. Signup and view all the answers

What tendency do individuals show when information about events is readily available?

They perceive those events as more likely to occur. Signup and view all the answers

What strategy would contrarians typically follow when investing?

Allocate more funds to lower-performing stocks. Signup and view all the answers

How does overconfidence affect price volatility in the market?

It increases price volatility due to higher trading activity. Signup and view all the answers

What is one of the predictions derived from Terrance Odean’s model regarding overconfidence?

Expected trading volume increases as overconfidence increases. Signup and view all the answers

What happens when an investor with an extreme view becomes more overconfident?

They exert a greater influence on the price due to increased trading. Signup and view all the answers

According to the discussed model, how does overconfidence affect traders' expected utility?

Overconfident traders have lower expected utility. Signup and view all the answers

What general behavior is observed when an investor increases their holding shares due to optimism?

Others in the market may need to adjust their shares to accommodate this increase. Signup and view all the answers

Which of the following statements best describes the impact of overconfidence on the quality of market prices?

Market prices become less accurate estimates of value due to overconfidence. Signup and view all the answers

In scenarios involving overconfident investors, what is frequently the outcome regarding their trading activity?

There is an increase in overall market trading volume. Signup and view all the answers

How does an overconfident investor’s perception of their information accuracy typically differ from reality?

They consider their information precise when it is often miscalibrated. Signup and view all the answers

What reference point did Odean use to distinguish between winners and losers in individual investor transactions?

Purchase price of each security Signup and view all the answers

What is the term used for the ratio that compares the frequency of realized gains to the total opportunities for selling winning stocks?

Proportion of gains realized (PGR) Signup and view all the answers

What did Odean's findings indicate about individual investors' behavior regarding selling stocks?

They are more likely to sell winners than losers. Signup and view all the answers

During which month are investors notably more likely to sell losers rather than winners due to tax considerations?

December Signup and view all the answers

What is a reason mentioned for why investors tend to sell winners instead of losers?

To realize profits before they decrease Signup and view all the answers

What psychological factor is recognized in Odean’s study regarding investors’ tendencies?

Loss aversion Signup and view all the answers

How does the disposition effect affect portfolio rebalancing according to Odean?

Losers need increased positions to restore desired allocations. Signup and view all the answers

What problem does Odean address by examining the frequency of winner/loser sales?

Assessing investor behavior in decision making Signup and view all the answers

What effect does receiving a windfall of income have on traders' bidding behavior?

Traders bid higher for the asset. Signup and view all the answers

What is the primary influence on traders' subsequent behavior after a wealth increase?

The absolute level of wealth. Signup and view all the answers

How is affect defined in the context of decision-making?

The sentiment derived from a stimulus. Signup and view all the answers

Which psychological theory suggests people are influenced by emotional responses in financial decisions?

Prospect theory. Signup and view all the answers

What effect does the house money phenomenon have on traders?

They treat their gains as a cushion for losses. Signup and view all the answers

How do professional traders typically approach decision-making compared to casual traders?

They act in a more normative manner. Signup and view all the answers

What is the primary reason traders do not necessarily exhibit increased risk-taking with additional profits?

Increased wealth does not affect their behavior. Signup and view all the answers

In financial decision-making, what role do somatic states play in a person's assessment?

They shape cognitive perceptions and judgments. Signup and view all the answers

Study Notes

Chapter 8: Implications of Heuristics and Biases for Financial Decision-Making

Investors often use heuristics for efficient decision-making, but these can lead to poor choices.
This chapter focuses on how heuristics influence investor decisions, including those of future retirees.

Section 8.2: Financial Behaviors Stemming from Familiarity

Home Bias: Investors tend to overinvest in their domestic market. This is seen in American investors favoring US stocks, Japanese investors favoring Japanese stocks, etc.
Company Familiarity: Investors may be more inclined to invest in companies they work for or brands they know.
Recency Bias: Recent stock market performers are often seen as good buys.
Availability Bias: Investors concentrate on assets for which information is easily accessible.

Section 8.3: Financial Behaviors Stemming from Representativeness

Overestimating Predictability: The tendency to believe good companies are good investments
Past Success Leads to Future Success: Past success is often overestimated as a predictor of future success.

Section 8.4: Anchoring to Available Economic Cues

Anchoring: Using suggested or available cues instead of their own judgment or expertise.
Real Estate Appraisals: Example where list prices influence appraisals. Average appraisal values are affected based on presented list prices.

Section 9.1: Introduction

Overconfidence: Overconfidence is common in society and impacts financial decisions greatly.
Investor Behavior: This chapter analyzes how the tendency to overestimate one's abilities can affect investment choices.
Relationship between Overconfidence and Trading Activity: A simple model outlining the connection to trade activity, illustrating how overconfidence can lead to excessive trading.

Section 9.2: Overconfidence and Excessive Trading

Overconfidence and Trading Activity: Overconfident investors are likely to trade more frequently and excessively.
Illustrative Model to Connect Overconfidence to Trading Activity: A model outlining how estimations of intrinsic value and market prices interact to influence trading decisions.

Section 9.3: Demographics and Dynamics

Gender and Overconfidence: A noticeable difference between men and women's trading activity suggesting men trade more and negatively impacting their returns.
Overconfidence and Experienced Traders: Experience may increase overconfidence leading to more risk-taking.

Section 9.4: Underdiversification and Excessive Risk-Taking

Underdiversification: Investors often under-diversify their investments. This is linked to the tendency to favor familiar or recently successful stocks.
Excessive Risk-Taking: This can result from underdiversification or other emotional factors.

Section 10.1: Introduction

Emotions in Market Movements: Market movements can be linked to investor emotions like mood, regret and pride.
Affect: Emotions are influenced by cognitive, physiological and evolutionary factors.

Section 10.2: Is Mood of the Investor the Mood of the Market?

Mood and Market Movements: Emotional states, like mood, are factors influencing investor decisions on investments.

Section 10.3: Pride and Regret

Emotional Impacts on Decisions: The effect of pride and regret on investment decisions is examined; focusing on the importance of negative emotion like regret in decision making.
Regret: Investors tend to avoid experiences of regret which leads to some investment behaviors.
Pride: Pride in a successful investment can lead to further risks being taken.

Section 10.4: The Disposition Effect

Disposition Effect: The tendency for investors to sell winning stocks too soon and keep losing ones too long.
Realized Gains vs. Paper Gains: Calculations highlighting how gains and losses play a factor in decision making as investors tend to hold onto losing assets, and sell winning ones immediately.

Section 10.5: House Money

House Money Effect: The tendency to increase risk-taking after a prior gain
Break-Even Effect: Desire to avoid further losses by taking risk.
Snake-Bite Effect: Taking less risks after prior losses.

Section 10.6: Affect

Impact of Affect: Emotions (like pride, regret and fear) impact market decisions in an irrational way.
Prospect Theory and Affect: Prospect theory and emotional responses (affect) in financial decisions.

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Description

Explore Chapter 8, which delves into the implications of heuristics and biases on financial decision-making. This chapter highlights how biases like home bias, company familiarity, and recency bias can adversely affect investors' choices, particularly those of future retirees. Understand the intricacies behind investors' behavior in the financial landscape.