Financial Markets and Human Overconfidence

QUESTION 1.

Overconfidence (excessive optimism) is very commonly observed in human beings. Overconfidence leads to which types of irrational behavior in financial markets? Please list 3 and explain in detail.

i. Over-precision

The third form of irrational behavior is over-precision, being too confident you know the verity and truths. For instance, Trump shows over-precision when he claims surety concerning opinions not in line with reality. He claimed that Arab Americans in their thousands in New Jersey openly were happy with the bombing of the W.T.C. building on September 11th, 2001, with no validation claiming the surety of his accusation (Fox News, 2015).

Over-precision is too much faith that you are knowledgeable with the truth. Most corporations suppose that they know all facts about the financial request situations. They would make an easy investment into the financial markets but only realize that they lack actual information if they succeed on the subject. Thus, it is not possible to tell how sure they were. In the business world, opinions portraying similar loss functions queries will force businesses to transfer their responses to one area or the other of their swish thoughts (Latif et al., 2011). So, for instance, if a company is not sure about the amount of money left in their account, but they want to make sure that they don’t bounce any check, they should put it into useless money. Many organizations worldwide lack facts about certain markets or investment information but would blindly invest as only guided by their faith that what they know is the truth.

ii. Over-placement

This type of irrational behavior, known as over-placement meaning; the exaggerated perception that you rank higher than others. The validation for “more-than-normal” beliefs is so substantial that it has led several people to conclude that over-placement is universal. Suppose business people make any mistakes figuring how well they have performed or will do. In that case, it remains that they are more likely to overestimate poor returns and more probable to underestimate returns (Latif et al., 2011). This is known as the hard-easy influence. Even if corporations table further query on others’ returns, they will make more cumulative figures than themselves. The result means that over-estimation and over-placement will be negatively linked across various activities that vary in such cases. Contrary to over-estimation, that’s a natural outcome of activity difficulty, not forgetting over-placement.

Still, it’s surprising since the correlation between over-estimation and over-placement is better within activities (Latif et al., 2011). It’s also at loggerheads with the clear understanding of being overconfident as one merged element; simple understanding doesn’t differentiate between its different results being unique. For instance, when Trump claimed that he attained the biggest electoral win after President Ronald Reagan, he over-placed himself above all leaders.

iii. Overestimation

It’s considerably seen that wishful thoughts push overestimating futuristic optimism (Sharot, 2011; Taylor, 1989). According to this sense, utmost businesses or directors’ personal- serving over-estimate the liability of desirable issues. This claim in financial market phenomena is a challenge for actual, abstract, and empirical reasons. With an actual position, it’s challenging concerning these multitudinous situations in which incorrect perceptions are demonstrably maladaptive. It’s reasonably challenging since the cerebral methods analogous to personal deception operate and become unproven. It’s unclear to note that personal deception is personal-serving, representing an actual challenge claiming that over-estimation is often driven by personal-serving provocation. For this sense to hold, also over-estimation must contain self-interests. Poisoned or false perceptions can lead to worse opinions that have been made over the times by financial executives and C.E.Os of corporations.

Overconfident business directors, financial directors, and investors may not prepare well for their next investments and perform badly then they would when not overconfident. Organizations believing that they are not vulnerable can shorten their business life spans. Large corporations blindly believing that they are household names and well-liked can make them insufferable failures. The theoretical challenge for the claim that wishful thought pushes over-estimation is that this wishful thought warrants personal deception. Futuristic bias states that utmost people misunderstand the data to give themselves room to hold prejudiced perceptions (Von Hippel & Trivers, 2011). Overestimation has enabled managers to think that their companies rank higher than they are. For instance, Trump’s claim that he is worth over ten billion then (White, 2016) displayed an overrate relative to a farther reasonable figure of over four point five billion than by Forbes (Peterson-Withorn, 2016).

Questions 2

1. What psychological phenomena may have influenced the analysts, both generally and in their reaction to Intel’s announcement in September 2000?

It is evidenced that markets worldwide can be irrational longer than humans. Over time this is the same script that has occurred. It’s always about the feelings, there foreseen feeling that Intel would grow between 8 % - 12% soon (Tirole, 2010). After clarification, the unexpected happened; the shares dropped drastically. This future expectation became very clear not to happen, and thus, the downward shift in shares was more disappointing.

The analysts do not recommend discounted cash-flow analysis but rather depend on representatives. This would make them ignore certain facts and information before coming up with their estimates (Tirole, 2010). They majorly rated credits as opposed to the company’s stocks which only reflect the quality of that particular company. This credit rating behavior recommendations by analysts only show its close relationship with Intel’s quality instead of how good its stock is.

Extrapolation bias, also known as the hot-hand fallacy, states that futuristic outcomes represent old events. This means that any future outcome relies solely on the previous accrued results. This would influence their decision-making process, including future expectations of business leaders or financial market analysts (Tirole, 2010). The people who follow this concept overweigh the recent acts while looking at the futuristic returns. It is also seen that financial executives became overconfident of their bet over the market; however, overconfidence often faces unanticipated surprises.

Intel organization in September 2000 released a press concerning their sales growth of between 3% - 5% comparatively to 8% - 12%. After this press release, in line with extrapolation bias, these analysts forecasted a similar fall in sales and profit in the years to come. Investors lost confidence in Intel shares due to the forecasted sales and fall in profit margins; thus, fall of share value by 30 percent (Tirole, 2010). Normally, no business investor or trader would want to put their investments where they feel their return on investment would fall, leading to losses. Therefore, the behavior relates to extrapolation bias.

2. Does James Stewart’s assessment of eBay reflect any psychological phenomena, discuss.

eBay’s situation was not much unique compared to Intel’s, even though the psychological influence also existed, showing that its earnings dropped to what they expected. In this aspect, and since there is a tremendous drop in the prices now, the analysts’ forecast growth at a steady rate, James Stewart considers purchasing the stock (Ross, Westerfield & Jaffe, 2010). James Stewart also believes that eBay is a top-notch company whose operations are changing. By notably describing eBay as a business leader whose operations were changing in the right direction thus, it would be a more profitable company shortly concerning its forecasted stock prices.

The assessment of eBay’s stock seems to rely on preference and representativeness. Moreover, there is no dispute over whether the recent sharp fall in the company’s stock price is truly reasonable. What influences an action to be good even without valuation analysis in place? Most people are normally easily influenced psychologically whenever they want to make a critical or convincing business decision (Ross, Westerfield & Jaffe, 2010). This psychological or rather mental influence has shortened the life spans of many multinational companies in most parts of the world. Therefore, James Stewart’s assessment of the e-Bay Company reflects a psychological phenomenon known as Heuristic.

Several scholars have since described how the three types of this phenomena relate to eBay’s situation. The representativeness comes clear when James Stewart preferred to use preferences and reps to judge the probability that the share prices or the forecasted share prices were eBay’s. Therefore, the degree to which the forecasted share prices resemble what eBay was (Ross, Westerfield & Jaffe, 2010). An availability heuristic is seen when the analysts assess the frequency of eBay’s share price or the probability of the share price growth; they do so by the ease with which this anticipated share price growth occurrences can be brought in the investors’ minds after James Stewart’s arithmetic analysis. The last heuristic bias is anchoring and adjustment in numerical prediction; when the values forecasted by James Stewart in his ‘Wall Street Journal Column,’ “Common Sense,” make available figures by starting from a previous value that is adjusted to bring out the final output. The figure forecasted may be made available by analysis of eBay’s natural monopoly, or it might be the result of little computation, which, either way, shows that adjustments are often not enough.

3. Discuss how the events described at Intel and eBay are similar and how they are different?

The year 2000, as analysts pointed out, was when Intel’s market capitalization was at its peak. The financial analyst predicted that it would continue to go up to a certain degree. When Intel communicated that their market capitalization would go up, contrary to what the financial analysts predicted, experts realized that Intel’s stock price had fallen (Ross, Westerfield & Jaffe, 2010). On the same page, eBay’s market capitalization was at its highest and communicated that their revenue would go up but contrary to what was forecasted. Thus, same as what happened to Intel Company, its stock price fell.

However, it’s easily noticeable that Intel and eBay may have similarities in how their decisions influenced their stock prices. Their contradictory statements concerning the forecasted by being lower than what was expected led to their stock prices falling (Ross, Westerfield & Jaffe, 2010). Both companies are also similar in that they have been in existence for several years with the challenges of inflation, recession, and carried out activities that have changed the world. Intel and eBay have had successes over several periods, and then decreases came about after incredible increases.

Finally, experts explained that the influence of the phenomena on Intel and eBay made their stock values fall after making a press release with figures lower than the predicted tend to be similar (Ross, Westerfield & Jaffe, 2010). On the other hand, experts also stated that the growth of the two company’s revenues tends to be different since their market values and capitalization are different in line with their target customers and specialization. Both companies have set out their missions, goals, targets markets, core values, areas of competencies, and varied products bringing out their differences.

QUESTION 3

• Bias Identification, please identify the biases and heuristics displayed by Professor French

1. Professor French tells you that South Africa’s stock market is undervalued and suggests a good investment. You discover that South Africa is about to impose a new tax on security transactions, which will results in lower liquidity. The next class, you bring this to Professor French’s attention. Simultaneously, another student mentions that South Africa’s stock market will rise sharply as commodity prices recover. Dr. French ignores the information you provide and congratulates the other student on excellent research. Which type of bias is Professor French displaying? Explain briefly.

Professor French displays the type of heuristic known as anchoring and adjustment. This type of heuristic is when the decision-makers link their perceptions to their common state of mind with which they are well conversant (Ross, Westerfield & Jaffe, 2010). Such people often have a certain kind of perception towards other people; thus, their decisions are hugely influenced mentally or psychologically. Professor French decided to accept another student’s research work; as product prices become stable, the South African stock market will go up steadily.

Thus, Professor French’s thinking and decision are based solely on the recovery of the South African product prices. In this scenario, Professor French shows confirmation bias resulting from his direct influence of belief and desire, thus being motivated by wishful thoughts (Ross, Westerfield & Jaffe, 2010). The professor became very biased towards the other student when the other student justified that the South African market would be stable in the long run. Thus, this, in turn, proved his earlier statement correct.

2. While reviewing the most recent four quarters of earnings estimates for MMM, Professor French notices that earnings growth rates were 15% per quarter. He announces to the class that MMM is a growth company. Which type of bias or heuristic is Professor French falling victim to? Explain briefly.

Professor French portrays the heuristic in this scenario as the representative heuristic. This type of heuristic, to be specific, people normally use a representative heuristic to find a solution of solving a problem using a shortcut by avoiding long routes in finding solutions to certain problems (Ross, Westerfield & Jaffe, 2010). It involves using mental or psychological shortcuts when deciding a particular solution. Representative heuristic certain psychological methods when making decisions using past or old traits or similar events or acting as an existing representative situation.

Therefore, in this regard, Professor French used the long gone or past earnings to approximate MMM’s growth desires (Ross, Westerfield & Jaffe, 2010). In this scenario, Professor French has displayed regency bias as described by certain scholars since he only took into account the most recent growth rate of MMM and hadn’t looked farther than the most recent figures to decide the growth of the stock. Professor French believes the stability of the market based his thinking on the 15 percent rise of MMM; there are several notable variables that he didn’t consider as possible causes of the stock market’s fall

3. Professor French’s father works for Boeing. Professor French holds 18% of his portfolio in Boeing. Which type of bias or heuristic is Professor French displaying? Explain briefly.

In this scenario, Professor French portrays what is known as the availability heuristic. This type of heuristic is when people decide to accept and agree with the easily and readily accessible information. Most investors or traders worldwide often prefer to invest majorly in their home countries and prefer not to cross borders due to uncertainties that would await them in the foreign lands. They mostly rely on the information about organizations or firms in their localities or firms that have employed their relatives or friends. This is seen as the only route to information accessibility (Tirole, 2010). Since French’s father works for Boeing Company, and French has a cordial relationship and understanding with Boeing, his shares then stand at 18 percent.

The access to information he has obtained about the company through his cordial relationship enabled him to invest in Boeing with much ease. Others may view Professor French as having portrayed what is known as Home bias. In this case, French’s father is employed by Boeing, and he sees this as an appropriate investment because he agrees with the fact his father works with Boeing, which must prove that it must be a good company (Tirole, 2010). The vital thing in overcoming the home bias is changing how we view investing outside our home nations or even in this scenario outside the comfort zones we are used to. Remember, all investing is subject to several risks, not forgetting the possibility of losing your investment money. Even if you diversify, this is not guarantee profit-making or protection against losses. Poorly diversified global investors might be opportunities to invest in fast-paced markets.

Question 4

a. Explain what is meant by an anomaly in finance?

The meaning of market anomaly in behavioral finance is that the outputs or returns under a set of hypotheses are different from the anticipated outputs or returns forecasted by the model. It refers to a lack of efficiency in the market. Often, anomalies show proof that a certain model doesn’t hold when put into action. The concept can be relatively new or older, as discussed by several researchers who have majored in behavioral financial markets. Certain anomalies appear only once and disappear, whereas others can repeatedly happen (Ross, Westerfield & Jaffe, 2010). These stock market anomalies are phenomena that sometimes contradict the existing market model. They might seem to show the likelihood of continuously attaining abnormal outputs by using an investment plan that takes advantage of such anomalies. In the underlying asset-price model, these anomalies result into market inadequacies.

The role of anomalies in financial economics differs from their behavioral finance roles, which seems to be a new area in financial markets studies. Market anomalies should not command an investment decision or opinion made by a trader but should only influence since most are psychologically or mentally driven (Ross, Westerfield & Jaffe, 2010). It is often said that market anomalies are a great opportunity for people who want to invest in financial markets the world over. Since there is no way to justify these anomalies, the effect will only be seen in their creation. There are several market anomalies currently as presented by different scholars.

b) Give 3 examples of anomalies uncovered by academic research in the past two decades (make sure and explain these anomalies in detail, including references).

i. The Dogs of Dow

One of the dangers of trading anomalies; is the Dogs of Dow as it is commonly referred to. The Dow Jones Industrial Average would allow investors to beat the market by picking stocks with specific value traits. Even though investors practiced several versions of this technique, there are two well-known techniques. Investors would select Dow stocks with the ten highest outputs in the first technique. The second technique is to move ahead and pick five stocks from the previous list with the lowest stock price holding them for a year (Latif et al., 2011). To an extent, this technique is seen as a modified version of reversal anomaly; the Dow stocks having the highest returns became relative underperformers and would be anticipated to outperform.

ii. January Effect

This is a very prominent anomaly. In this case, the model is that stocks that did not perform well during the 4th quarter of the year will try to beat the markets in January. This effect is also seen as logical, and thus, it’s near impossible to describe it as a market anomaly. Most traders will often turn to jettison for stocks that are not performing well later in the year to use their losses to offset the capital returns. This is known as tax-loss harvesting by many people in the stock market (Glaser & Weber, 2010). The push-in selling is normally separate from the firm’s valuation; tax selling can catapult stocks to the highest points, attracting several buyers when January comes. With the same breath, investors normally d not purchase stocks that are not performing well in the 4th quarter; therefore, they decide to wait till January to escape being boxed up in tax-loss selling.

The traders in the stock markets business are always not in a hurry to invest their money but rather take their time to study and consult about the right time to place their investment bet. Therefore, this effect is brought about by excessive selling pressure just before January comes and the excessive buying pressure immediately when January 1st comes (Glaser & Weber, 2010). This happens in countries that do not set December 31st as the end of their fiscal year, including the United Kingdom, Belgium, Italy, Spain, France, Greece, Denmark, and Australia.