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 dont 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, thats a natural outcome of activity difficulty, not forgetting over-placement.
Still, its surprising since the correlation between over-estimation and over-placement is better within activities (Latif et al., 2011). Its also at loggerheads with the clear understanding of being overconfident as one merged element; simple understanding doesnt 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
Its 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, its challenging concerning these multitudinous situations in which incorrect perceptions are demonstrably maladaptive. Its reasonably challenging since the cerebral methods analogous to personal deception operate and become unproven. Its 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...
…price solely occurs due to the right information from the market reaction. Moreover, the momentum of existing stock prices happens as influenced by the trends on its performance on past consecutive months, days, or even weeks.Despite the existing information and data in the public domain, the mentioned different performance trends tend to occur still as opposed to the anticipated output from the rational and knowledgeable traders in the stock market. The finance discipline has majorly applied the behavioral theory model as a reference point for seeking direction (List, 2003). E.M.H. has not exhaustively described anomalies, and maybe some of these anomalies happen basically due to the incorrect pricing tools to estimate the normal output. Several researchers have discussed and portrayed how financial information analysts related to different media outlets worldwide lead to some anomalies due to distortion of their reports. Thus, based on the research by different scholars, the discussed anomalies can still occur with the perfection of markets and stock traders becoming quite rational. These traders would not benefit from the stock data as the stocks already have that needed information.
d) If the anomalies persist, what financial frictions might be responsible for the persistence (make sure and cite frictions that apply to the anomalies in part b)?
All decision-making process of stock market traders is often affected by what is known as Financial Frictions. With the availability of financial frictions, business investments form part of the deadweight costs, which render the business investment somewhat elastic to the difference in the discounted levels as opposed to when financial frictions do not exist (De Bondt et al., 2008). Market anomalies can persistsince there are hindrances to arbitrage, including short-selling and challenges. According to an online article by Swedroe, the financial frictions responsible for the persistence of market anomalies include; short-selling frictions that…
References
De Bondt, W. F., Muradoglu, Y. G., Shefrin, H., & Staikouras, S. K. (2008). Behavioral finance: Quo Vadis? Journal of Applied Finance (Formerly Financial Practice and Education), 18(2).
Gilchrist, S., Sim, J. W., & Zakrajšek, E. (2014). Uncertainty, financial frictions, and investment dynamics (No. w20038). National Bureau of Economic Research.
Glaser, M., & Weber, M. (2010). Overconfidence. Behavioral finance: Investors, corporations, and markets, 241-258.
Latif, M., Arshad, S., Fatima, M., & Farooq, S. (2011). Market efficiency, market anomalies, causes, evidences, and some behavioral aspects of market anomalies. Research journal of finance and accounting, 2(9), 1-13.
List, J. A. (2003). Does market experience eliminate market anomalies? The Quarterly Journal of Economics, 118(1), 41-71.
Ross, S. A., Westerfield, R. W., & Jaffe, J. F. (2010). The McGraw-Hill/lrwin Series in Finance, Insurance, and Real Estate. Corporate Finance 9th edition, capitolele, 4-6.
Tirole, J. (2010). The theory of corporate finance. Princeton university press.
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