Behavioral Finance: Heuristics And Biases Essay

850 words - 4 pages

People come in all different shapes, sizes, and colors. If that is the case why are we so similar? The goal of this paper is to discuss people and their behavior as applied to finance. I will attempt to deconstruct human psychology to evidence their patterns. I was twelve years old when I was introduced to the stock market. 1998 had seen significant growth underpinned by a stable political environment. My young mind recalls the irrational exuberance of the adults in my world. You put money in the stock market because it goes up they said. In my investments class in 7th grade a tech stock rose 2000% in one week investing through the Yahoo finance simulation. Likewise, the rest of my ...view middle of the document...

Kahneman and Tversky’s work as psychologists, not financial academics, has provided the fundamentals for behavioral finance. These two attempted to illustrate why the Efficient Market Hypothesis is an incomplete and potential defunct theory; it was lacking human sentiment. Human beings tend to hold either a gambler’s fallacy or a hot hand philosophy according to Barberis, Shleifer and Vishny (1998). Since information is public we must attend that those that hold possession of this information will hold to one of these two beliefs. These beliefs are determined by the volatility observed by the individual. This theory explains short-term price momentum and long-term price reversal. This is supported in this observation: “There is substantial evidence that indicates that stocks that perform the best (worst) over a three to 12 month period tend to continue to perform well (poorly) over the subsequent three to 12 months.” -Jegadeesh and Titman (2001) Another consideration that is essential to understanding of the human condition is our limited cognitive ability. The Efficient Market Hypothesis operates under the belief that information is the limitation, not the investor. “…The theory of efficient markets is concened with whether prices at any point in time “fully reflect” available information.”rm the best (worst) over a three to 12 month period tend to continue to perform well (poorly) over the subsequent three to 12 months.” -Fama (1970) I believe this is a critical flaw. As I illustrated in my example of algebra, human beings have cognitive limitations. This is augmented by the level of importance we place on the way...

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