Question

Chapter : BEHAVIORAL FINANCE: IMPLICATIONS FOR FINANCIAL MANAGEMENT

1. How can framing effects result i inconsistent and incorrect decisions?

2. What is confirmation bias?

3. What are effects of overoptimism?

4. What is loss aversions?

Answer 1

1. If the same question is framed in two different ways, we would get a different response in both cases. This is called framing bias. If an investment opportunity is defined by its return characteristics we would invest in this. But, if the investment opportunity is defined in terms of its risk characteristics we would not invest in it. With framing bias, we make the decisions inconsistently.

2. Confirmation bias is a cognitive bias, in which we will look for information which confirms our belief. We may overlook the information that is relevant to decision making but instead, we will consider only the information which confirms our belief, which may not be relevant.

3. Over-optimism leads to taking on risky investments and excessive trading. We may hold a significant portion of our portfolio in just one security leading to under-diversification.

4. Loss aversion is defined as the tendency of investors to avoid loss. For the same dollar amount of loss and gain, investors place a greater weight to the loss. They tend to hold on to the losses for a longer period but look profits sooner.

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