Behavioral finance proposes that psychology affects investment decisions. The field began in 1979 with prospect theory, which found that people value gains and losses differently and losses have a greater emotional impact. Endowment bias describes valuing something you own more than something you don't. Studies show people value owned items more than similar unowned items. This bias causes investors to hold onto inherited or purchased securities due to fears of loss, decision paralysis, wanting to avoid transaction costs, and preference for familiar investments, even if they are performing poorly.
4. Behavioral Finance
Behavior Finance is a field of Finance that proposes psychology-based
theories to explain stock market anomalies such as rises or fall in stock
prices.
Most people know that emotions affect investment decision.
5. History of Behavioral Finance
The official start of behavioral finance is 1979. the release of Daniel Kahneman and Amos
Tversky’s prospect Theory.
PROSPECT THEORY holds that people tend to value gains and losses differently from one
another, and, as a result, will base decisions on perceived gains rather than on perceived losses.
prospect theory suggests that losses hit us harder. there is a greater emotional impact associated
with a loss than with an equivalent gain.
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6. Example
(i) you find $50 lying on the ground
(ii) you lose $50 and then subsequently find $100 lying on the ground. if your reaction to the
former scenario is more positive than to the latter, you are experiencing the bias associated
with prospect theory.
7. Endowment Bias
the endowment bias , in behavioral finance, describes a circumstance in which an individual
values something that they already own more than something that they do not yet own.
Once you own something you consider it’s value more than the things which you don not
possess.
studies have shown repeatedly that people will value something that they already own more
than a similar item they do not own. according to the old adage, "a bird in the hand is worth
two in the bush." it does not matter if the object in question was purchased or received as a
gift, the effect still holds.
8. Practical Application
Investors prove resistant to change once they become endowed with (take ownership of) securities. We will
examine endowment bias as it re- lates both to inherited securities and purchased securities. Then, we’ll
look at two common causes of endowment bias.
Inherited Securities
1. A moderately risky stock.
2. A riskier stock.
3. A Treasury security. 4. A municipal security
Purchased Securities
Endowment bias also often influences the value that an investor assigns to a recently purchased security
9. Implication For Investor
There are some practical explanations as to why investors are susceptible to endowment bias.
1. Endowment bias influences investors to hold onto securities that they have inherited, regardless of
whether retaining those securities is financially wise. This behavior is often the result of the heirs’ fear
that selling will demonstrate disloyalty to prior generations or will trigger tax consequences.
2. Endowment bias causes investors to hold securities they have purchased (already own). This behavior
is often the result of de- cision paralysis, which places an irrational premium on the compensation price
demanded in exchange for the disposal of an endowed asset.
10. Implication For Investor
1. Endowment bias causes investors to hold securities that they have either inherited or purchased
because they do not want to incur the transaction costs associated with selling the securities. These
costs, however, can be a very small price to pay when evacuating an unwise investment.
2. Endowment bias causes investors to hold securities that they have either inherited or purchased
because they are familiar with the behavioral characteristics of these endowed invest- ments.
Familiarity, though, does not rationally justify retaining a poorly performing stock or bond