Free Behavioral Biases Essay Sample
Behavioral biases in finance are psychological and cognitive decisions that are made by investors but do not reflect economic rationality at all (Baker et al, 2010). On the other hand behavioral finance is a discipline that they apply alternative approaches in refining classical finance for the purpose of economic rationality (Pompian, 2006). This paper will focus on the various types of biases that investors are prone to and the initiatives that can be taken by financial planners to address the problem. The paper will use that case of Helsinki Stock Exchange for the period between 1995 and 2004 as an example.
The financial markers have witnessed a number of anomalies that appear not to be in congruent with the rational decision-making process (Parikh, 2009). Investors fail to evaluate decisions logically in respect to the prevailing conditions of uncertainty (Ainslie, 2005). The characteristic of deviating from the concepts of normative finance by investors is referred to as bounded rationality. The realization of anomalies among investors has been used to provide alternative approaches to such scenarios. Studies conducted in the last few decades have found out that the economic decisions that are made depend on the rational behaviors made by financial planners. There are instances when traditional behavioral finance becomes unable to define the lack of rationality; in this case behavioral finance is applied as an alternative solution to economic decision-making.
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The general definition of behavioral finance is the predisposition towards error. It can also be defined as a prejudice in decision-making as a result of influence from underlying beliefs (Cavol, 2005). Financial planners can be able to address this problem by creating portfolios for investors and advice them on assets allocation. Financial planners are trained to advice investors on how they can get rid of behavioral biases. Such types of biases that are considered in this paper are: overconfidence, excessive optimism, familiarity heuristic and confirmation bias.
This is the scenario where investors estimate and predict high numbers of favorable outcomes over the unfavorable outcomes. This condition is very common in cases where new products are introduced into the market. The investors who are interested in such products at the early stages make forecast that are free of errors. Investors in this case rush into buying the new product and assume that the new product will have ready market. Companies are also affected by this excessive optimism especially when their operations are based on favorable forecasts.
This type of behavioral bias affects both individuals and corporation investments (Kahneman, 2001). The bias comes as a result of the way individuals base their abilities depending on their level of knowledge. In real life situation, people have the tendency of overrating their capabilities. When such a case occurs, impulsive decisions are made since managers or other decision makers tend to believe they can do more than what they are capable of doing. When an investor is overconfident, he or she believes that any action taken is under control and therefore there is no need to seek for help any directions regarding decision- making (Baron, 2000). Researches conducted indicate that ne w investors tend to know more information about a business idea before committing their resources into the idea than those who have been in the investing world for a longer time (Barberis & Thaler, 2003). The difference in reasoning result from the overconfidence characteristic that is common in many successful entrepreneurs. The investors in this case do not recognize their limitations and thus end up making biased decisions based on premises that are not error free (Seru, et al, 2010).
This behavioral bias results from cognitive reasoning. This is the case where information is interpreted based on preconceptions while at the same time a person avoids to contradict the beliefs he or she had earlier (Ning zhu, 2010). When an investor is interested in a certain business venture, he or she tend to base the information depending on the earlier information held about the idea. The same case happens to consumers of a specific product; in case when a new product is introduced into the market, they will tend to judge the product in conjunction with the older product. People therefore tend to believe in what they know while ignoring anything that comes from outside preconceived reasoning (Ferraro, 2010).
The type of behavioral bias arises when investors tend to link a new event depending on a past event that is related to a current one. The familiarity that with knowledge or information determines the action they would take. This form of bias is also linked with the ability of an investor to recall history (Kumar, 2009). Marketing is the most affected branch of business by this bias. This is because people's perception on a brand depends on the knowledge they have concerning a related product. The consumer decision to purchase a product tends to be higher when he or she is familiar with the product (Thakor, 2008).
This objective of the research was to determine whether excessive trading frequency would realize investor return. Behavioral and rational hypothesis are considered to play a critical role in determining the decisions of investors. The research proposed that investors are usually compensated when the acquire information thus higher returns are expected to uncover important information for security value. The research was premised on the fact that technological advancement has played a major role in stock markets where trade is done online at a low cost by traders who wish to make short term profits. Primary data from Nordic Central Security Depository is considered as useful in this research (Kumar, 2009).
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The research hypothesis suggests that investors in the stock market expect to make huge profits. Based on trade frequency, investors would only trade when the trade would lead to increased profits. When investors trade frequently, it is expected that they would at least make some profit. However, due to behavioral biases like overconfidence and optimism, there returns from the trade would not be high. When the shares of the investors are not calculated in a certain month, the return is calculated value of the share that changes over the months. The return on the shares that are held for the specific month will be calculated as:
CPV= Cost Price Value
OPV= Optimal Price Value
A second scenario would be when a purchased share has been held up to the end of the month. In this case, the investor's return is determined by deducting the cost of purchased share on that month form the value of the same share at the end of the month (Landier & Thesmar, 2008). This is illustrated by the formula:
CPV= Cost Price Value
TPV= Total Price Value
TPP= Total Purchase Price
The paper has determined the various types of biases that investors are likely to make. The case of return realized by investors make on the Helsinki Stock Exchange for the period between 1995 and 2004 has been considered. It has been found out that depending on trade frequency, investors are likely buy shares at an early stage in order to make short term profits. But behavioral biases like overconfidence and over optimism would lead to less returns form the trade.