Question

1- Explain three types of biases people often exhibit in financial decision making and give an example of each.

Answer 1

1. Extrapolation error: Extrapolation error means we give too much weight to past trends particularly those are observed in the recent past and we poorly extend that observed information for future. In the long bull market period investor often committed this error and claims that since the price is growing over a long period of time so it is expected to continue to grow. Often heard that investment in the market simply cannot bring losses.
2. Herd behavior: This psychological behavior can be described as a tendency to mimic the crowd. The behavior of a single investor cannot affect the prices in the market. If investors in the market do not react collectively in the market and do no commit same physiological error their action to a large extent neutralize the market and there is no question of the bubble. The market will work efficiently.

In the bull, the market investor invests not on the basis of fundamental information available rather they invest by imitating the behavior of others in the observation of previously increasing prices in the market. They continue to invest in the market by not looking at the fact that it is already expensive. This might happened that they see others as investing more as demand rule they think the price will go more in future and will give more profit. Therefore it’s worth joining the party and contributes to bet on growth trends this is also called feedback mechanism.

3.Excessive Optimism: In the judgment of investment there is believe that the future will be more beautiful and positive than today is call excessive optimism. It basically stems from overconfidence. Overconfidence leads to unrealistic wishful thinking. Often in real life, we do the improper estimation of time required to complete a task such as completing assignments, going for shopping, writing another article. It actually shows that people do not learn from their mistakes though aware that previous forecasts were very too optimistic they still unrealistically believe that next time their prediction will be good.