Excessive optimism or overconfidence is one of the most commonly observed characteristics in human beings. Excessive optimism (overconfidence) leads to which types (please list 3) or irrational of behavior in financial markets? Explain in detail.

Excessive optimization is explained as “the partiality of speculators to adjust an inside view in lieu of an outside view is frequently increasingly fitting when settling on venture choices”. An inside view centers around a present circumstance and reflects individual venture contribution of the speculator. Then again, outside views untie and impartially surveys the present market circumstance with regards to results acquired in past related money related market circumstances (Clark, Robert, & Hampton, 2016). Within versus the outside recognizes financial specialists showing good faith tendency from speculators displaying normal monetary choices making. Consequently, they will in general get from inclination emotions about market circumstances that are winning and by overlooking the results of recently related budgetary market circumstances.

Investors are realized as the prediction of the attainment of the taking better decisions as it is use in the better quality of the investment in an individual’s hand. With this perfect example, financial specialists are permitted to look at the experience of a class of comparative speculations and can get a harsh dispersion of results for a comparable venture class. Outside perspectives can create an increasingly exact gauge and are more averse to convey surprising results. The outside view permits financial specialists’ estimates to be increasingly objective and dependable. Essentially, inside perspectives, are similarly viewed as important on the grounds that they are progressively instilled and natural. Generally speaking, there should be a decent harmony among good faith and legitimacy. The outside view can produce possibly fruitful venture thoughts however outside center ought to eventually undermine whether one chooses to make those speculations or not.

Optimism permits individuals to begin their own organizations since they don’t accept they won’t be influenced by monetary variables. Awkward optimism predilection can associate with home inclination which the longing to contribute close to home since individuals might be impractical of possibilities inside their locale. Good faith inclination can similarly make speculators load up on organization stock keeping in mind the desire of finishing their long haul venture objectives.

Undue optimism can make financial specialists conceivably over-burden themselves with organization stocks since good faith inclination can make them feel that different organizations are bound to encounter downturns contrasted with their own firm. Workers feel a decent feeling of solace in optimism with the load of their boss since they feel it is less dangerous than a speculation somewhere else.

optimism inclination can similarly make financial specialists accept that they are getting market-like returns when in reality they should know about things like swelling, expenses, assesses that can lessen their profits which can wipe out the long pull benefits. Typically, speculators like to hear uplifting news about the market which can trigger their confidence. Unnecessary positive thinking inclination can make financial specialists think they are better than expected speculators just in light of the fact that they are hopeful people (Pastusiak & Keller, 2013).

Optimism inclination could be make financial specialists contribute close to their own geographic locales which is called home predilection since they are hopeful of the possibilities of their region. For instance, a rancher can be viewed as hopeful since they are dependent on their yields to endure. Right now, financial specialists see their zones substantially more hopefully than others would.

Hopeful financial specialists ought to in every case live beneath one’s methods and spare routinely in light of the fact that sparing and contributing is the key of long haul speculation objectives. Besides, hopefulness predisposition as a rule break down reserve funds so individuals attempt to contribute carefully. Resource distribution is basic to an effective portfolio since it makes financial specialists favor certain classes and overlook others that can conceivably be fruitful too.

Question 2

1.      Discuss whether the analysts following Intel appear to have been influenced by any psychological phenomena, both generally and in their reaction to Intel’s announcement in September 2000.

2.      Discuss whether James Stewart’s assessment of eBay reflects any psychological phenomena.

3.      In what ways are the events described at Intel and eBay similar and in what ways are they different?

In the March and July 2000, it was measure that Intel’s stock income will rise 8 to 12 percent in this way there are several financial experts who decided to put resources into this stock. After it was accounted for that Intel won’t develop true to form, however will just increment by 3 to 5 percent, several never again observed the value in putting into this stock. The stock cost quickly dropped by 30 percent. The director of Intel proposed that the market overcompensated. It was verified later on that the experts who anticipated this figure, didn’t utilize the limited income examination which is the reason the forecasts were wrong.

 Speculators in the market must be impacted by the estimated outcomes since they rushed to put resources into the stock without doing any further examinations, to guarantee that these anticipated results will unfurl. Apparently examiner didn’t follow the ideas on the limited income model, which converted several procedures to put into the Intel stock. The limited income is a “valuation strategy used to assess the allure of a venture opportunity”. With this idea, investigators will have the option to utilize future free income projections and limits them to decipher the current worth appraisals. When the current worth gauge is resolved, one ready to assess the potential development of the speculation there must be high chances of increasing income in the investment project. When estimations are perfect and the outcome reflects current expense of the speculation to be lower than the limited income, at that point the open door is one worth putting resources into (Costan & Devadas, 2016).

Since a great deal of financial specialists were worried to put resources into the Intel stock dependent on estimate development, it is sure to state that examiners were affected by mental wonders of the individuals who anticipated this potential extension. Everybody depended forcefully on the representativeness of the individuals who estimated the 8 to 12 percent development. Studies later presumed that the limited income strategy was not utilized during the time spent anticipating Intel’s development.

As with the concern of eBay, it is experienced as a comparable situation, similarly as Intel. After eBay reported their profit will be lower than determined, the stock declined definitely. eBay then declared that they are not keen on “dealing with eBay’s possibilities and not its stock value.” James Stewart referenced that he would in any case put resources into eBay in light of the fact that he trusts it can possibly develop. In spite of the fact that, this development may not occur quickly, he believes it is creating and will in the long run emerge to the top indeed. His musings of eBay’s latent capacity, closes he accepts the stock merits clutching. Once more, his assessments depend on representativeness. He is predisposition in his choices since he didn’t make reference to how or why this stock merits putting resources into however basically put together it with respect to his conviction that eBay is in the “procedure of changing world trade and has normal syndication (Cabral & Hortacsu, 2010).

The occasions depicted at Intel and eBay are comparable and diverse from various perspectives. The two organizations were fruitful at one point in time and arrived at their pinnacle. Soon after, the precise conjectures were discharged; the two organizations additionally encountered a tremendous decrease in speculations. The main contrast inside these two cases is the means by which the organizations reacted to the value drop. While Intel recommended that the market had gone overboard, eBay agreed they were increasingly keen on dealing with the firm for the since quite a while ago run execution and not the association’s stock cost.

 Question 3: Bias Identification

Professor French is an entirely biased person. Most of his decisions entail biases and heuristics. The following are examples of his biases and heuristic display.

1)      South Africa Stock Market and Bias of Professor French

During the class, Professor French told to his students that South Africa’s stock market is undervalued therefore it is an attractive investment opportunity for students. However, when a student conducted research on the stock market of South Africa and discussed lower liquidity of stock then he just ignored his research. Instead of accepting his research, Professor French appreciated the research of another student regarding commodity prices rising sharply in stock markets. In this example, Professor French is representing confirmation biases. A fair ehavior requires research and confirmation of information regarding a topic when information collected from two or more sources contradicts. In this case, both students had a different perspective on the stock market of South Africa. Here Professor French had the responsibility to ensure cross check and confirmation of information. However, regardless of confirming he just ignored the information of one student (KATZEFF, 2019; Pompian, 2012).

            Decision making with searching for the reality or confirmation of information represent confirmation bias. It shows his tendency to search for the favour, interpret and recall information in the way that reduced the chances of getting actual information or reaching at reality for preexisting beliefs and hypotheses ( Michael M. Pompian, 2012). 

2)      MMM Company Growth and Bias of Professor French

Regarding this situation, Professor French presented recency biases. He announced in the class that MMM Company is a growth company as it was displaying a 15% growth rate in the earnings of each quarter. Professor French only paid attention to this growth rate and declared that the company is a growing company. In fact, we cannot declare a company a growth company just based on its earnings growth rate in the quarters. Some other factors are also required to be taken into consideration in this decision. For instance, recent sales and other expense figures are also required to be considered in such decisions. Somehow, Professor French’s decision only accounted for the recent growth rate and ignore the other important information about recent figures and stock growth rate. Therefore, it is clear that Professor French’s decision was based on recency bias. According to findings, recency bias is a situation in which a decision maker easily remember something happened recently in comparison to the something that happened in past ( Michael M. Pompian, 2012; KATZEFF, 2019).

3)      Boeing Portfolio and Investment Bias of Professor French

Professor French has 18% of investment in his father’s company Boeing (following case information his father works for Boeing). Such a situation indicates the home bias. Professor French is intended to have a home bias which is about investment in the home companies. According to literature, home business is a behavior in which a person tries to investment majority of his/her money or investment in the equity of the home company (or investment products of his/her home country) (Pompian, 2012). Opposite to this, the fair behavior of a person supports him to invest in different companies to diversify risk factor. Moreover, fair behavior encourages an investor to invest in the products and equity after conducting research on the risk and return of that particular investment product. Investment products should be selected based on higher return and minimum risk factor instead of selecting a home company without research on risk and return. Therefore, it can be said that Professor French’ decision to invest in the home company is containing home bias. 

Question 4.
a. What is an anomaly in finance?
b. Give three examples of anomalies that academic research has uncovered in the past two decades (make sure and explain these anomalies in detail including references).
c. If markets are efficient what would you expect to happen to these anomalies after they were discovered?
d. What financial frictions might enable these anomalies to persist (make sure and cite frictions that apply to the anomalies in part ‘b’)?

Anomaly in finance: 

In finance, When the actual results calculated under given assumptions are different from the one that predicted in expected result of the model is known as financial anomaly. The market anomalies contradict with the efficient market hypothesis (EMH).

The role of anomalies in finance is quite different. The world was not showing much attention towards EMH efficient market hypothesis which was also known as Capital asset pricing model (CAPM) paradigm. But now this hypothesis is added in new literature and are applied in different techniques. This is more accurately called now Behavioral Finance (BF). The misapplication of the word anomaly is not accidental or coincidence. This paradigm is irreplaceable and it does not need any proof to show its validity

Towards the claim of mispricing, the common idea was anomaly has a dimension of risk that is not present in benchmark theory. For example, the anomaly can produce expected results measurable using CAPM regression because labor income is correlated with time series in it. The example of unmeasurable risk is present in Fama and French seminar papers; “if assets are priced rationally, variables that are related to average returns … …, must proxy for sensitivity to common (shared and thus undiversifiable) risk factors in returns. The [3-factor model] time-series regressions give direct evidence on this issue.”  Shortcoming of CAPM as a theory of risks is related to unmeasurable risk explanation

Examples:

There are 3 typically accepted anomalies in EMH;

1.      Size effect: companies that have market capitalization smaller have outperformed those companies that have market capitalization larger then others, even if they control risks to large extend. Eugene Fama and Kenneth French have performed research in this regard that the companies having smaller market capitalization than 30% have average of 4.5% stock in year 1926 which means they outperformed those with market capitalization larger than 30%. After recent researches it comes to know that the annualization return is 15.4% for small stocks. On other hand it is 10.8% for large stocks. But this outperformance is volatile as the below figure is elaborating this that there are many years when the large stock tends to outperform the smaller one.

2.      Valuation effect: many researches on this gave us the fact that low P/B multiples tend to outperform the one with higher P/B multiples. P/B is ratio of price and book. But this outperformance does not persist for longer time period

3.      Momentum effect: it simply says that the organization or companies who had gave their best performance in past six months to a year are very much destined to perform good than other companies who had not given their best in similar period of time.

Market efficiency:

Anomalies are basically inconsistent empirical results with balanced theories of asset pricing behavior. Under the highlighted asset pricing model, anomalies show their efficiency or in adequacies in a given market. Anomalies are often seen as disappearing, getting reversed or attenuated. So, if the market is efficient the anomalies are likely get reversed or disappeared according to the situation. If the market is efficient, all knowledge is indulging in prices and eventually there is no way possible to beat the market. Because there is no overvalued or undervalued security available in the market. The EMH state that the market anomalies can not exist as they will disappear or reversed and investors cannot outperform the market. EHM says that when anomaly become popular it will be possible that it will not exist. As the stock always go up on Friday and down on Monday. If this anomaly is known to everyone around the world, people start to buy shares on Thursday afternoon right before it close and sell them next day of Friday afternoon to get that bounce of Friday. But then if everyone will buy on Thursday afternoon then prices will go up on Thursday and down on Friday afternoon. And then Friday boom will turn into Friday bust.

Some typical examples of the anomalies

a)      Value effect

b)      Cross industry momentum

c)      Long run reversal

d)      Short run reversal

e)      Post earning drift 

Why do some anomalies persist or other fade away?

Some anomalies that that do have unexplained risk which differ them from arbitrage opportunity ten to persist. Fleeting instances of mispricing in many trading centers or venues may persist due to latency risk in it. Some anomalies can persist due to the limits in arbitrage. There are borrowing constraints, attentional and computational constraint, informational constraints that are faced by arbitrageurs. Cost is better word to use instead of constraint in this regard. If the anomalies are the result of date crunching or snooping, they can might get disappear. The EMH state that the market anomalies cannot exist as they will disappear or reversed and investors cannot outperform the market. EHM says that when anomaly become popular it will be possible that it will not exist. As the stock always go up on Friday and down on Monday. If this anomaly is known to everyone around the world, people start to buy shares on Thursday afternoon right before it close and sell them next day of Friday afternoon to get that bounce of Friday. But then if everyone will buy on Thursday afternoon then prices will go up on Thursday and down on Friday afternoon. And then Friday boom will turn into Friday bust.

References of Excessive optimism (overconfidence) leads to which types (please list 3) or irrational of behavior in financial markets

Michael M. Pompian. (2012). Behavioral Finance and Investor Types: Managing Behavior to Make Better Investment Decisions. John Wiley & Sons.

Cabral, L., & Hortacsu, A. (2010). The dynamics of seller reputation: Evidence from eBay. The Journal of Industrial Economics, 58(1), 54-78.

Clark, B. B., Robert, C., & Hampton, S. A. (2016). Christopher Robert, and Stephen A. Hampton. "The technology effect: how perceptions of technology drive excessive optimism. Journal of Business and Psychology, 31(1), 87-102.

Costan, V., & Devadas, S. (2016). Intel SGX Explained. IACR Cryptology ePrint Archive, 1-118.

KATZEFF, P. (2019). Don't Lose Money Playing Mind Games. Retrieved from www.investors.com: https://www.investors.com/etfs-and-funds/personal-finance/behavioral-finance-avoid-losing-money-playing-mind-games/

Pastusiak, R., & Keller, J. (2013). The structure of stock exchange recommendations in Poland in the context of anchoring effect and excessive optimism. Journal of economics, business and management, 1(3), 304-309.

Pompian, M. M. (2012). Behavioral Finance and Wealth Management: How to Build Investment Strategies That Account for Investor Biases. John Wiley & Sons.