Behavioral Finance Assignment: 1028345

Overconfidence or excessive optimism refers to a state of mind in which a person is certain about the happening of a particular event and does not consider any other factors that may lead to the non-happening of the event. While optimism is considered one of the key factors that influences an investment, there should be a limit to it. It should not interfere with the rational and informed decisions that are taken by a person in his right state of mind. Due to this particular aspect, a person takes decisions, which cannot be explained in a logical manner. Some of the behavioral biases that occur due to over confidence are as follows:

1. Loss Aversion: The Prospect theory suggests that the perception of people towards profits and losses of the same quantity is not the same. It has been noted that the profit and loss of a same amount, say, a million dollars will not have the same impact on the thinking of the people. Many researches and scholarly papers suggest that while people are happy to make a profit of a million dollars on an investment, they are more worried about avoiding the losses that may occur due to taking up a particular investment. This is one of the primary reasons for people holding onto loss making stocks. They have a confidence that stocks that are falling at a given point of time will rise in the future and they would cover up the losses sustained by them. This may or may not happen in the real world. But the bias of people towards avoiding losses is so high that it makes them suffer losses in the present moment in the hope that they will recover all of it in the future, which does not happen every time. This excessive optimism of people towards the mechanism of the functioning of markets is responsible for making them incur losses that could have otherwise been avoided easily by selling off the stock at the right time.
2. Anchoring Behaviors: The most important aspect of succeeding in the stock markets is information. Availability of right information at the right time is essential to make a decision about holding or selling a particular stock. However, in situations where no new information is available, people give extreme importance to the discussions, trends and market opinions that circulate in the market. Even the prices determined by the analysts are closer to the ones, which have been occurring recently in the market. All the stakeholders tend to overlook the possibility of the prices of the stock rising or falling of a sudden. They tend to overlook the long-term performance of the stock that is also necessary to determine the performance of the stock in the future.
3. Over reacting and under reacting: One of the most popular forms of behavioral biases, this happens on an extremely regular basis in the stock market. Analysis of investor behavior in stock markets suggests that during an upturn in the markets, investors tend to become extremely positive and vice-versa. In general, people have a lot of confidence in their abilities and do not tend to accept anything that is not in agreement with their ideas. This is what happens during the boom in the stock market. People expect that if their portfolio is on the rise, it will continue to rise for an indefinite period. They even tend to value their shares above their intrinsic value. Anchoring behaviors, as discussed above, are a similar phenomenon where investors continue to undervalue their stocks without considering all the possible factors that may affect the value of the stock.

Answer to Question 2

1. In the given case, Intel was an extremely successful company in the year 2000 and the level of its stock was running very high before the announcement made about decline in the growth of the revenue of the company. After the happening of the event, many analysts had realized that they never used the discounted cash flow analysis to value the stock of Intel. In this case, it can be suggested that two major psychological barriers called excessive optimism and anchoring bias were affecting the analysts’ judgment. Before the announcement made by Intel, analysts were highly confident about the performance of the stock and continued to value it on a very high scale. This happens because of the thinking of the analysts that the stock would continue to rise forever at a very high rate. However, this is not true even in the case of the most successful companies. After the announcement by Intel, it can be inferred that the analysts were suffering from anchoring bias. There are no valid reasons for the downgrading of the Intel stock on September 22. Except for the announcement made by the company, there was nothing to suggest any significant changes in the operations of the company. The press release by Intel contains only an estimate about the decrease in the growth of revenue over a quarter. There are no discussions about the long term prospects of the company or any other factors like new government regulations affecting the business, change in the quality of products manufactured by Intel or any other reasons which are likely to damage the business on a permanent basis. The main problem with regards to this situation is that most investors were rating the quality of the company and not the quality of the investment. This has not been an acceptable method of rating the equity aspect of any given investment. The final psychological barrier that the investors were suffering from was related to maintenance of self-esteem. Whenever a stock is on the rise and is hyped up by all sections of the media and investors as the next big thing, it becomes difficult for an analyst to state what they actually think about the prospects of the stock. This is due to the fact that investors may fear about their reputation being affected in the media and any occurrences which differ from their recommendations will be unfavorable to their reputation.
2. James Stewart suggests that the stock of eBay is the best internet related stock in the market and that purchasing eBay in the wake of the decline in its price is the most sensible thing to do. He suggests that the company is a major player in the e-commerce market and will continue to be one for a long time.  In this case, even though the prices of eBay have fallen to quite an extent, the confidence of James Stewart in the stocks is unwavering. It can be suggested that the analysis of James Stewart indicates a case of overconfidence. His comments indicate the problem of overconfidence in the performance of the stock of eBay and an extreme belief in the accuracy of his predictions. While he acknowledges the fact that the stock of eBay would not continue to grow forever at an extremely high rate, he cannot see any events in the near future that will affect the financial performance of the company. The problem with this particular analysis lies in the fact that Stewart has failed to consider the long run prospects of the company. He has also ignored the situation of the upcoming companies and the potential competition that eBay could face against them. If his suggestion about eBay monopolizing the market is true, then the company’s stock should not fall at such a drastic rate due to the absence of competition. It can also be suggested that the comments made by Stewart are a part of the loss aversion strategy followed by a majority of the investors. Most investors tend to believe that there will be a sudden change in the market conditions and hold on to their loss making stocks. They believe that holding on to a stock for enough time would decrease their losses. This may or may not necessarily happen. Hence, it can be suggested that the analysis and recommendations made by James Stewart are not completely bias free and a further analysis is required before confirming their validity.
3. The cases of Intel and eBay are similar in many manners. In both the cases, the stocks were performing on a very high level and the market capitalization of both the companies was very high. Analysts and investors continued to rate the stocks very highly due to their belief that the companies would continue to perform at a very high level for the near future. However, a press release in the case of Intel caused a lot of damage to the value of the stock of the company. In a similar manner, the performance of eBay fell below the expectations of the investors and analysts. This was followed by a public announcement by Meg Whitman, eBay’s CEO that the revenues of the company were expected to fall due to the increase in costs of advertising and reinvestment. In the case of both the companies, the prices fell more than 20 percent. In both the cases, long-term prospects of the companies like the possible market conditions, intervention of the government, strength of the operations of the company and various other factors were not considered in valuing the prospects of the stock in the future. Both the cases are good illustrations of stakeholders following the anchoring bias by using only a part of the information available. Although similar in nature, both the cases have their set of differences. In the case of Intel, apart from an estimation of the fall in the growth in the revenues of the company, there are no suggestions regarding the future of the business or any other factors that are likely to cause this slowdown. However, in eBay’s case, the CEO has mentioned that the increase in advertising costs and reinvestment would cause the revenues of the company to fall. The fall in the stock levels and market capitalization was relatively much higher than that of eBay. While there were no analysis of people suggesting that holding the stock of Intel was profitable, James Stewart has provided analysis about the profitability in holding the stock of eBay.

Answer to Question 3

1. Heuristics refer to the shortcuts that people consider to be true in almost any situation and use them in the process of decision making without completely analyzing the information available with them. In the given case, Professor French, according to the information available to him, suggests that the South African stock market is undervalued and that people should invest in it to obtain profitable returns. The type of bias that is being shown by Professor French in this case is the anchoring or confirmation bias where a person tends to place more emphasis on information that supports his opinion while ignoring other relevant information, which may adversely affect his decision. In the given case, Professor French has formed a certain opinion on the South African market. Although two students have provided him information about two different aspects of the market, he chose to congratulate the student who provided him with information that supports his decision. He chose to ignore the imposition of the corporate tax, thereby confirming the fact that he is showing confirmation bias in the following situation.
2. Trend-chasing bias refers to the bias that happens due to the belief of the investors that past events are an indicator of the events that are likely to happen in the future. Many investors believe it to be true despite the absence of any concrete evidence to prove the same. This may happen due to tools like aggressive marketing campaigns or advertising the past results of the company. These have been known to have an effect on the perception of the customers about a particular product. In the given situation, after analyzing the past four quarter results of the company MMM, Professor French has declared it as a growth company. He believes that the trend is likely to continue in the near future. However, there is no evidence to support the conclusion of the professor. While it can be suggested that the company was a highly profitable one in the last four quarters, there is no proper logic in labelling it as a growth company. Factors like operational stability, value of the investment, strength of the stock and other factors should be used in labelling the company as a growth one. Hence, Professor French is displaying trend-chasing bias in this situation.
3. Familiarity bias is a situation where a person chooses to invest in a particular investment because he feels that he knows it very well. He will not choose to diversify even if the benefits of taking such a step are evident. The investor suffers from an anxiety when faced with the option of diversifying his portfolio to lesser-known international investments with higher returns. In the given case, Professor French has decided to invest a significant amount in the stock of Boeing because he thinks that he is familiar with its functioning than some unknown international stock. He thinks that his investment is safe with Boeing and does not think of the fact that he could also lose all of his investment. Hence, he is suffering from familiarity bias in this case.

Answer to Question 4

1. Anomaly refers to a condition in which under a given set of assumptions, the actual result differs from the expected result. It serves as an example to the fact that an assumption or proof that is the basis for forming a theory does not hold good in practice. In stock markets, anomaly is an occurrence that contradicts the efficient market hypothesis that suggests that all investors are rational and their decisions are based on the information available to them.
2. There have been various anomalies that have been discovered over the years in the financial markets. One of them is the growth effect anomaly. This suggests that smaller firms tend to outperform larger firms in the end. Concerning large firms, growth becomes extremely complicated after a certain point of time. In case of smaller firms, it is much easier as they do not need to generate large figures like larger firms to be able to achieve an acceptable growth rate in the end. Another anomaly that has been found out to be true is that profitability from price momentum, asset growth, idiosyncratic volatility and other factors is concentrated around stocks which are rated very low (Avramov et al., 2013). After the rating of a stock goes above BB+, all of the above-mentioned factors become irrelevant in determining the profitability of a firm and profits through short trading is the only option to make profit from such stocks.  Another anomaly that is highly popular in the financial markets is the reversal anomaly. This suggests that the performance of stocks completely reverse to what it was during the course of a financial year. This means that a stock that is over performing at the beginning of the year tends to underperform by the end of the year and vice-versa. There are some statistical evidences to back this anomaly (Fischer & Krauss, 2018). It has been widely accepted that trading in anomalies is a risk and there is a very minor advantage provided by trading them in comparison to the vast amount of analysis that is required to be performed to successfully identify an anomaly.
3. In an efficient market system, information is freely available to all the investors and it is assumed that they make rational decisions with the information provided to them. If the markets were efficient, the above mentioned anomalies would not remain anomalies for long. People would always try and invest in stocks which are either low in cost or which have a lot of scope for making huge amounts of profits. They would also look at obtaining underperforming stocks and invest in them to be able to gain profits from them. The major flaw in the efficient market hypothesis is that markets are never efficient and it is the irrationality of people which is responsible for creating anomalies in the market. If people were to invest in the anomalies mentioned above, they would in turn effect the value of other stocks and there is a scope for the formation of new anomalies. This remains a never ending process and is not concerned with the efficiency of the markets.
4. Financial frictions refer to the indirect costs which are incurred for the completion of a financial transaction. Transaction costs are very high in case of highly valued stocks and hence the value produced by such stocks becomes less. This makes people search for value in the lower levels of the market and would ultimately lead to a decrease in the value of a highly rated stock. Excessive information sharing costs lead people to lose interest in investing in a stock with higher credit ratings. Hence they look to cash in on the volatility of a lower rated stock and hence prefer to invest in stocks which are deemed to be neglected in the market. An over performing stock becomes saturated at certain point and there is no scope for further growth from it. This makes people shift their investments to under performing stocks and make them grow. This ultimately leads to changes in the performances of the stocks in the market.  

References

Avramov, D., Chordia, T., Jostova, G., & Philipov, A. (2013). Anomalies and financial distress. Journal of Financial Economics, 108(1), 139-159.

Fischer, T., & Krauss, C. (2018). Deep learning with long short-term memory networks for financial market predictions. European Journal of Operational Research, 270(2), 654-669.