Saturday, February 28, 2009
<--- Before you start going further, image your brain as a box.Wednesday, February 25, 2009
What is Gambler's Fallacy?
Am i having a traits of a gambler in my investment decisions
Gambler's Fallacy, in Behavioral Finance, is the belief that if deviations from expected behavior are observed in repeated independent trials of some random process then these deviations are likely to be evened out by opposite deviations in the future.
This simply means this:
If a coin is tossed repeatedly and heads comes up more often than tails, a gambler may incorrectly believe that heads is more likely to appear in the future. But as a matter of fact, a coin has two sides and the chance of heads or tails is always 50-50.
An experiment carried out by Amos Tversky and Daniel Kahneman shows that people see (streaks of) random events as being non-random when they are actually much more likely to occur in small samples than expectations.
In relation to investing:
Do you gamble on the bottom more often at the start of a certain drop?
Have you considered the reasons of an entry/exit or are you just hopeful?
Do you see IPO as a sure-win opportunity?
Make sensible decisions based on analysis and not hear say or gut feeling as regret on a loss is always a worse feeling that the joy of a profit, Loss Aversion.
Saturday, February 21, 2009
What is Loss Aversion in Behavioral Finance?
How important is it to understand this aspect of yourself when it comes to your investing/ trading strategy.
"More money has probably been lost by investors holding a stock they really did not want until they could 'at least come out even' than from any other single reason." -- Philip Fisher
Loss aversion refers to the tendency for people to strongly prefer avoiding losses than acquiring gains. Some studies suggest that losses are twice as powerful, psychologically, as gains.
Investors have been shown to be more likely to sell winning stocks in an effort to "take some profits," while at the same time not wanting to accept defeat in the case of the losers.
It also doesn't help that we tend to feel the pain of a loss more strongly than we do the pleasure of a gain. It's this unwillingness to accept the pain early that might cause us to "ride losers too long" in the vain hope that they'll turn around and won't make us face the consequences of our decisions.
The mental framework of an individual is very important is this aspect.
Think of the following:
1. Would you rather get a $2 discount, or avoid a $2 ERP surcharge?
2. Will you lose more satisfaction if you made a loss of $1000 than gain satisfaction from a profit of $1000. In absolute terms, the figures are the same.
Sunday, February 15, 2009
First and foremost. I am not a guru in this area but I've been interested in this for some time and did some readup. My posts on this topic, for sharing, might be fairly shallow and critics would be apppreciated.
"Behavioral finance is a rapidly growing area that deals with the influence of psychology on the behavior of financial practitioners."
"Behavioral finance is the application of psychology to financial behavior—the behavior of practitioners."
"Behavioral finance is the study of how psychology affects financial decision making and financial markets."Shefrin (2001)
For a while, theoretical and empirical evidence suggested that CAPM, EMH and other rational financial theories did a respectable job of predicting and explaining certain events. However, as time went on, academics in both finance and economics started to find anomalies and behaviors that couldn't be explained by theories available at the time. While these theories could explain certain "idealized" events, the real world proved to be a very messy place in which market participants often behaved very unpredictably.
Important Characters to BF:
Daniel Kahneman and Amos Tversky
- Fathers of behavioral economics/finance in the late 1960
- Published about 200 works, relating to psychological concepts with implications for BF
- In 2002, Kahneman received the Nobel Memorial Prize in Economic Sciences for his contributions to the study of rationality in economics
- Focused much of their research on the cognitive biases and heuristics that cause people to engage in unanticipated irrational behavior.
- This field would not have evolved if it weren't for economist Richard Thaler.
- During his studies, Thaler became aware of the shortcomings in conventional economic theoryies as they relate to people's behaviors.
- After reading a draft version of Kahneman and Tversky's work on prospect theory, Thaler realized that, unlike conventional economic theory, psychological theory could account for the irrationality in behaviors.
- Thaler went on to collaborate with Kahneman and Tversky, blending economics and finance with psychology to present concepts, such as mental accounting, the endowment effect and other biases.
Examples of Anomalies: The Winner's Curse, January Effect, Equity Premium Puzzle and etc.
Conventional financial theory does not account for all situations that happen in the real world. This is not to say that conventional theory is not valuable, but rather that the addition of behavioral finance can further clarify how the financial markets work.
Saturday, February 14, 2009
It has been a long time since I last posted and I wonder if my site is still being visited.
But nevertheless, I will be posting on a series of posts about something in Behavioural Finance. Something which I think will help everyone understand a little bit more about themselves in their investing journey.
This series of posts will be done and completed by End Feb. I am expecting to post about 10 posts which will be completed by end Feb, early March.
So stay tuned!