Final Project

Previous studies have showed that investors should some understanding of behavioral finance or otherwise seek the services of professional investment advisors while making important investment decisions. Some investors whose investment decisions are based on emotions psychological issues make different decisions from what is expected of rational human. Rational decisions apply use of logical theories like the efficient market hypothesis (EMH) and capital asset pricing models (CAPM). With this rational approach, investors are predictable in their investment decisions and most of the outcomes can be explained. However in reality, some results deviate from the normal or from the expected leading to anomalies and unexplainable behavior.

Progress: Completed Tasks

As of now, I have completed the first two parts of the research. I have researched on prospect theory and biased identification as this report outlines.

According to conventional economics, investors will always try to maximize their wealth and emotions have no effect on people’s economic decisions. Background of behavioral finance states that anomalies were observed and the currently available theories at the time could not fully explain them. Some of the activities that highlight such irrational behavior is buying lottery tickets while the probability of winning the jackpot is so small, but still you will find people doing it.

One of the famous theories under this concept is the prospects theory and that’s where most of my research will be based. Prospects theory by Daniel Kahneman and Amos Tversky.

The theory focuses on cognitive biases as well as heuristics that cause people to participate in irrational unanticipated behavior. It shows that different people value losses and gains differently and therefore they will make decisions based on perceived returns rather than the perceived losses, expressing of the two choices possible gains and the second option in terms of possible losses. The first option will be an automatic choose.

Biases Identification

Scenario one: The key concept displayed is overconfidence. The investor is exaggerating his ability to trade and also his knowledge of the technology industry. This could affect his long run potential returns.

Scenario two: The investor displays a form of bias called investment anchoring. His investment decision is made majorly based on irrelevant statistics and figures. Since the sales growth of Omega Corporation has continued to decline, the investor acts irrationally by assuming that the drop in prices provides an opportunity to purchase the stock at a discount. In reality, the stock value might also decline due to changes in the underlying fundamentals.

Scenario three: The investor is making investment decisions based on the fact that the Commercial property has been increasing in value from 2000. The concept of prospects theory applies because the decision is based on possible gains.

Useful sources for completing my assignment:

I have selected several relevant sources that I will refer to throughout my assignment;

1. JD Coval, T Shumway- The Journal of Finance, 2005-Wiley Online Library.

2. A new paradigm for practical application of behavioral finance: MM Pompian, JM Longo-The Journal of Wealth Management, 2004-iijournals.com

3. Barberis, N., Thaler, R. (2003) A Survey of Behavioral Finance. Retrieved from https://d1wqtxts1xzle7.cloudfront.net.