Question

Define and discuss three errors in information processing (forecasting errors, ovrconfidence,and conservatism) and three behavioral biases that occur within markets (framing, mental accounting, and regret avoidance).

Answer 1

Forecasting errors arise when people give too much weight to recent experience. This leads to forecasts that are too extreme. Overconfidence refers to traders believing that they are better than average. This belief that they are superior leads to frequent trading (and according to empirical evidence, lower returns). Conservatism refers investors being slow in responding to new information rather than acting immediately. Sample size neglect refers to investors ignoring the size of a sample and making inferences based on a small sample.

Behavioral biases are important because even if information processing was perfect, individuals may tend to make less-than-fully rational decisions using that information. The four behavioral biases are framing, mental accounting, regret avoidance, and prospect theory (or loss aversion). Framing refers to the tendency of investors to change preferences due to the way an investment is “framed” (i.e., in terms of risk or in terms of return). Mental accounting is a specific form of framing where an investor takes a lot of risk with one investment account but little risk with another account. Regret avoidance refers to the tendency of investors to blame themselves more for an unconventional investment that was unsuccessful than a conventional investment that was unsuccessful.