Behavioral Finance
Jay R. Ritter
Cordell Professor of Finance
University of Florida
P.O. Box 117168
Gainesville FL 32611-7168 http://bear.cba.ufl.edu/ritter jay.ritter@cba.ufl.edu
(352) 846-2837
Published, with minor modifications, in the
Pacific-Basin Finance Journal Vol. 11, No. 4, (September 2003) pp. 429-437.
Abstract
This article provides a brief introduction to behavioral finance. Behavioral finance encompasses research that drops the traditional assumptions of expected utility maximization with rational investors in efficient markets. The two building blocks of behavioral finance are cognitive psychology (how people think) and the limits to arbitrage (when markets will be inefficient).
The growth of behavioral
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This is especially true when one is dealing with a large market, such as the Japanese stock market in the late 1980s or the U.S. market for technology stocks in the late 1990s. Arbitrageurs that attempted to short Japanese stocks in mid1987 and hedge by going long in U.S. stocks were right in the long run, but they lost huge amounts of money in October 1987 when the U.S. market crashed by more than the Japanese market (because of Japanese government intervention). If the arbitrageurs have limited funds, they would be forced to cover their positions just when the relative misvaluations were greatest, resulting in additional buying pressure for Japanese stocks just when they were most overvalued!
2. Cognitive Biases
Cognitive psychologists have documented many patterns regarding how people behave.
Some of these patterns are as follows:
Heuristics
Heuristics, or rules of thumb, make decision-making easier. But they can sometimes lead to biases, especially when things change. These can lead to suboptimal investment decisions.
When faced with N choices for how to invest retirement money, many people allocate using the
1/N rule. If there are three funds, one-third goes into each. If two are stock funds, two-thirds goes into equities. If one of the three
Understanding behavioral economics will also help in making critical decisions like how much a person need to be saving, how much effort we need to put in our works and where we will choose to live in future.
I strongly advocate tactical asset allocation process and diversification over several different income and growth strategies. I believe that risk management and protection of investor's endowment are major objectives. In my portfolio, stocks may occupy a large portion and the
In October 29, 1929, the fate of the United States and the rest of the world completely shifted as one of the biggest economic downfalls in American history. An unstable banking system led to many Americans attempting to retrieve their money from the Stock Market until the overload eventually crashed the economy Tuesday, October 24 1929. Due to the impact of World War I , the Stock Market’s Black Tuesday brought many Americans during the 1920’s, years of worldwide economic downfall, as well as strong backflash that eventually led to World War II.
When people are asked how people will plan or rethink for retirement, the first thing that people will think about, is saving. There are some positive ways to save money, the author suggests to the readers to sign up for 401(k) plan. It is a plan help employees save for retirement, 401(k) should allow anyone to build up a nice nest egg. For example, “In Dave Ramsey’s The Total Money Makeover, for instance, he gives us “Joe and Suzy Average” who invest $7,500 per year ($625 per month) using their tax-free retirement account. They do this from age 30 to 70, getting 12 percent interest per year. At the end, they have $7,588,545 to their names.” When people invest in 401(k) plan, it is safer and more money in retirement and it also has a benefit that you don’t need to pay for tax when you take the money out. Beside 401(k), people prefer to invest money in the stock market for retirement-plan. According to author “ During a recent 40- year period,
Over the holidays, I had occasion to socialize with a group of very bright, successful people who are saving for retirement. We talked of many things, including their investments. And, sad to say, not one of them could coherently explain what he or she was doing, and why.
3. Then, those funds often are invested in mutual funds available inside the retirement plan.
Decisions, decisions, decisions. Everything in life entails making decisions, whether it be the decision to go back to school to pursue a higher education, deciding to eat cereal in the morning, or even reading this paper. Everything we do is based on decisions. Now, if you’re a computer, making decisions may be an objective task solely based on logic, but since we are humans, there are many factors that affect our decisions. These factors may be external, like the weather, but many are internal and may make an even bigger impact on our decisions than the external factors. Biases and errors are prime examples of influential internal factors and beliefs that affect the decision making process. This week our group discussed such biases and errors in decision making. We delved into the biases that affect us personally, like Anchoring Bias, Hindsight Bias, and Overconfidence Bias, as well as a few other biases.
Behavioral economics is “a method of economic analysis that applies psychological insights into human behavior to explain economic decision-making” according to the Google dictionary. This type of economics concludes that people behave irrationally in certain ways. People are neither entirely rational nor entirely irrational, rather their behavior shows a combination of the two. Contrarily, traditional economics assumes that people will make entirely rational decisions, which allows economists to simplify behavior into a model. Juxtaposing the assumption, the coffee mug experiment showed that people behave irrationally in certain cases.
THE RELATIVE FRAMING AS SAVINGS A m a z o n ’s s t r a t e g y t o c r o s s - s e l l additional products to consumers by highlighting the remaining amount of a balance required for free shipping. The relative framing of additional purchases as savings in shipping costs helps consumers overcome the reality of a higher total price after additional items are added.
A good question was why were so many people in the United States invested in
Challenges are presented to people on the daily basis. What to eat, drink, where they have to go, who they need to see, and etc... These things all impact the decision making process and the decisions made. In financial decision making, highly successful people do not make investment decisions based on past sunk outcomes, rather by examining choices with no regard for past experiences; this approach conflicts with what one may expect. In addition to past experiences, there are several cognitive biases that influence decision making.
Some didn't learn from this stock market crash and let another crash occur October 19, 1987 in San Francisco though it didn’t have the same aftermath of the crash of 1929 it did begin a new era of volatility. The Americans that were affected by the crash of 1929 called
When Nick Leeson was being promoted on the Singapore branch of the Barings bank, the strategy of the bank was to reduce the risk exposure by using a combination of one short straddle (combination of put / call) and for one long future. Since Nick Leeson used to be a specialist on Future contracts on Nikkei 225 and Japanese 10 years bond and was sure this market would arise.
Some clothing, shoes, and handbags made in Mexico cost less to make than those in the United States.
Behavioural economics is the study of the effects that psychology has on the decision making of the economy. This tends to be the way that people think and feel when they are spending money on a certain good or service. The great economist Adam Smith was the first follower of this idea through his book “The theory of moral sentiments” which dates back to 1759. However, it took over 100 years to get a more clarified meaning of how big of a role the psychology of a buyer plays in economics. In behavioural economics there are seven basic principles which all contribute to the decision making process. Behavioural economics can explain how people will react to different situations such as times when there are no economic problems and times when