IRRATIONAL EXUBERANCE, ROBERT J. SHILLER (BROADWAY BOOKS, 2000) D....

2. Irrational Exuberance, Robert J. Shiller (Broadway Books, 2000) D. “Psychological Anchors for the Market,” Ch. 7 Purpose: To test the candidate’s ability to identify and apply major tenets of behavioral finance in the context of observed investor behavior. LOS: The candidate should be able to “Overconfidence” (Study Session 9) a) discuss the effect of overconfidence on investors’ trading; b) describe how overconfidence may affect risk-taking behavior. “Fear of Regret and Seeking Pride” (Study Session 9) a) explain how the fear of regret and seeking of pride affects investors’ holding periods of winning and losing investments; b) describe how the concept of “reference point” may affect an investor’s trading behavior. “Considering the Past” (Study Session 9) a) compare and contrast the “house money,” “snake bite,” “trying to break even,” and “endowment” effects on investor decision-making behaviors; b) explain how various events in the past may affect an investor’s future risk taking. “Representativeness and Familiarity” (Study Session 9) b) infer the characteristics of a portfolio constructed by an investor affected by the concept of familiarity; c) discuss the investment decision problems of investors affected by the concept of familiarity. “Psychological Anchors for the Market” (Study Session 4) d) explain how overconfidence may influence investors’ judgment about future stock price movements. 2004 Level III Guideline Answers Morning Session - Page 1 Guideline Answer: Identify the behavioral finance concept most Explain how each behavioral finance Maclin’s three concept is affecting Maclin’s investment directly exhibited in statements decision-making each of Maclin’s three Maclin believes he is an expert on, and can make accurate forecasts about, the real estate market, solely because he has “I have used the Internet Illusion of knowledge extensively to research the studied housing market data on the outlook for the housing Internet. He may have access to a large market over the next five amount of real estate-related information, but he may not understand how to analyze years, and I believe now is the best time to buy a the information nor have the ability to house.” apply it to a proposed investment. Overconfidence causes us to misinterpret the accuracy of our information and our Overconfidence skill in analyzing it. Maclin has assumed that the information he collected on the internet is accurate without attempting to verify it or consult other sources. He also assumes he has skill in evaluating and analyzing the real estate-related information he has collected, although there is no information in the question that suggests he posses such an ability. Maclin’s reference point for his bond position is the purchase price, as evidenced “I do not want to sell any Reference point by the fact that he will not sell a position bond in my portfolio for a for less than he paid for it. This fixation on a reference point, and the subsequent lower price than I paid for the bond.” waiting for the price of the security to move above that reference point before selling the security, prevents Maclin from undertaking a risk/return-based analysis of his portfolio position. Morning Session - Page 2 Maclin is evaluating his holding of company stock based on his familiarity with the company rather than on sound “I will not sell any of my Familiarity company stock because I investment and portfolio principles. Company employees, because of this know my company and I believe it has excellent familiarity, may have a distorted perception of their own company, prospects for the future.” assuming a “good company” will also be a good investment. Irrational investors believe an investment in a company with which they are familiar will produce higher returns and have less risk than non-familiar investments. Maclin is confusing his company (which Representativeness may well be a good company) with the company’s stock (which may or may not be an appropriate holding for his portfolio and/or a good investment) and its future performance. This can result in employees overweighting their company stock resulting in an under-diversified portfolio. Morning Session - Page 3 LEVEL III, QUESTION 2 Topic: Portfolio Management − Individual Minutes: 20 Reading References: