Question

1. Describe three of the biases or types of framing and make up an example of how each might impact an investment decision.

2. If markets are efficient, how is it possible that market bubbles and crashes occur?

Answer 1

Answer 1 :

Biases :-

Familiarity Bias: This occurs when investors have a preference for familiar or well-known investments despite the seemingly obvious gains from diversification. The investor may feel anxiety when diversifying investments between well known domestic securities and lesser known international securities, as well as between both familiar and unfamiliar stocks and bonds that are outside of his or her comfort zone. This can lead to suboptimal portfolios with a greater a risk of losses.

Regret Aversion Bias: Also known as loss aversion, regret aversion describes wanting to avoid the feeling of regret experienced after making a choice with a negative outcome. Investors who are influenced by anticipated regret take less risk because it lessens the potential for poor outcomes. Regret aversion can explain an investor's reluctance to sell losing investments to avoid confronting the fact that they have made poor decisions.

Anchoring or Confirmation Bias: First impressions can be hard to shake because we tend to selectively filter, paying more attention to information that supports our opinions while ignoring the rest. Likewise, we often resort to preconceived opinions when encountering something — or someone — new. An investor whose thinking is subject to confirmation bias would be more likely to look for information that supports his or her original idea about an investment rather than seek out information that contradicts it.

Answer 2 :

Market Crashes and Bubbles - The logic behind Efficient Market Hypothesis

The efficient market hypothesis (EMH) is an investment theory that states it is impossible to "beat the market" because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and the only way an investor can possibly obtain higher returns is by purchasing riskier investments.
While academics point to a large body of evidence in support of EMH, an equal amount of dissension also exists. Detractors of the EMH also point to events such as the 1987 stock market crash, when the Dow Jones Industrial Average (DJIA) fell by over 20% in a single day, as evidence that stock prices can seriously deviate from their fair values.

The logic behind this deviation from fair values is that markets are weak form efficient. Investors react in a different way to different pieces of news. Insider trading is another concern behind the eccentricities of the market. Biases creep in the way f functioning of the investors and they do not behave rationally - The biggest assumption flaw of the Efficient Market hypothesis.