Question

Discuss and illustrate with the examples some of the important findings of behavioral finance studies.

Answer 1

Important findings of behavioral finance studies are:

• Investors are not always rational.
• Investors have limits to their self-control.
• Investors are influences by their own biases. The important biases that investors get influences by are hindsight bias, conformation bias, representative bias, framing bias, and anchoring bias.
• Investors often make cognitive errors and these errors lead to wrong decisions.

For example many first time investors make investments on the basis of anchoring bias. This bias occurs when people tend to over rely on pre-existing information about a stock or the first information about a stock that they find. Many first time investors buy stocks of blue chip companies like GE, Apple, etc. on the basis of their prevailing prices. They tend to overlook the intrinsic value of these stocks and decide to buy or sell the stocks on the basis of current prices. Another example will be when a lawsuit is brought against a company. The news of the lawsuit will make the share prices of the company to fall and investors will start selling their shares. This will cause a significant fall in the asset value of the company. The investors in other companies in the same industry will now start fearing lawsuits and will start selling their stocks as well. This will cause prices of shares of other companies to fall as well even though no legal action has been taken against these companies. This happened due to investors not acting rationally.