Question

With the aid of examples, critically evaluate the following psychological biases and
their impact on investors and financial markets.
i) Herding

ii) Mental accounting

iii) Herding

iv) Illusion of Control

v) Representativeness

Answer 1

Impact of following psychological bias on investors and financial markets-

I) Herding- hardinge in finance is a psychological bias that reflects investors follow what other investors are doing rather than their own analysis.it is a mentality that is distinguished by lack of individual decision making which makes people to think and behave in similar fashion to those who are around him.

the fear of missing out is a common investment phenomena which happens due to herding, and it causes financial market to move into a state of bubble.

II) mental accounting-this is a concept of behavioural economics which had been associated with the work of Richard Thaler ,according to which people think of value in relative rather than absolute terms. people derive pleasure not just from the object value but also the quality of the deal.

mental accounting often leads people to make irrational investment decisions and behaviour which are financially counterproductive.

money should be treated perfectly fungible when investors allocate among different accounts in order to avoid mental accounting bias.

C) Herding- Herding in finance is a psychological bias that often reflects the lack of decision making of an individual and doing and following what other individuals are doing.

Hardinge creates fear of missing out in stock market and it can lead to massive rallies to trap people.

D) Illusion of control-illusion of control is a behavioural bias in stock investing when investor who pick up stock based upon their hard work, believes that their hard analysis and knowledge will provide them with control over the asset they own.

It is a control bias that reflects that people start to believe that they have more control than apparent, over events.

this behavioral bias leads people to hold onto their stocks even if they are losing on to the investments for long period and it can easily lead to wiping their capital off.

E) Representativeness-it is a behavioural bias which occurs when similarity of objects or event confuses people thinking regarding the probability of an outcome.

this can have impact on investing when investor start to assume that good companies will always make good investment. But that is not the case a company may be excellent at their own business but they may not be good at others business.