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MASTERPIECE2020

Behavioral finance sample paper

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Behavioral finance

Accounting and finance are the basis of prosperity in business enterprises. However, accounting was a fundamental principle, even before civilization. Accounting refers to the reporting of activities and finance use within a business (Sewell 12). Accounting, integrity, and transparency are correlated. An institution that fails to establish the recommended accounting procedures is most likely to lack both integrity and transparency. Evolution has led to the development of designs used in accounting and finance management. Despite, the existence of predetermined formats, investors and managers make the final decision. Therefore, the systems must have a human aspect. On the other hand, human intervention is associated with errors that infer losses to investment. Behavioral finance combines psychology and finance knowledge to explain investor behavior (Sewell 34).

Accounting and finance are the basis of prosperity in business enterprises. However, accounting was a fundamental principle, even before civilization. Accounting refers to the reporting of activities and finance use within a business (Sewell 12). Accounting, integrity, and transparency are correlated. An institution that fails to establish the recommended accounting procedures is most likely to lack both integrity and transparency. Evolution has led to the development of designs used in accounting and finance management. Despite, the existence of predetermined formats, investors and managers make the final decision. Therefore, the systems must have a human aspect. On the other hand, human intervention is associated with errors that infer losses to investment. Behavioral finance combines psychology and finance knowledge to explain investor behavior (Sewell 34).

 Human aspect in finance has both positive and negative outcomes. One of the positive impacts of human involvement is memory and recognition of a pattern. However, the negative impacts include personal bias and emotion-oriented decisions. Irrespective of the impact derived from human involvement, it is mandatory. Therefore, the discipline helps minimizing of the negative outcomes while enhancing the positive outcomes of human involvement (Sewell 20). Institution of balance between the negative and positive aspects of human involvement ensures growth in business enterprises. Consequently, the stability will generate a development effect on the society in general (Sewell 43).  The paper discusses the important aspects of behavioral finance. These aspects include; overconfidence, the illusion of knowledge, disposition effect, ostrich effect, house money effect, familiarity, mental budgeting, cognitive dissonance, herding, personal bias and adaptive market hypothesis. Also, the paper discusses the attributes of the aspect in terms of negative or positive influence on investments.

Overconfidence

Often when returns from an investment are high, the investor claims credit for their impressive market and financial analysis skills (Sewell 18). Seldom do investors acknowledge that their analytical skills were inappropriate when an investment experience loss. Overconfidence stems from successive impressive returns from an investment. The investor at this point will presume that their decisions were the basis for the success. The presumption empowers their ego, and they consider themselves as experts. However, there is a possibility that the impressive returns might be as a result of other issues apart from the investor decision. Some of these reasons include; economic growth, increased employment level, and increased demand.

Nevertheless, the investor’s decision might also be the reason for the positive response in returns. Overconfidence can only be beneficial if the status quo is maintained (Sewell 19). Unfortunately, when the status changes and the investors misguided by their ego, they might be misguided, and lead to poor returns. Confidence is appropriate for finance and accounting, but overconfidence is hazardous to the investment.

Familiarity

Psychological studies reveal that people respond more positively to familiar occurrence than to new events or developments. They will prefer the normal routine as opposed to an abrupt change in the order of operation. Similarly, an investor will respond to more positively to familiar options as opposed to new alternatives in a financial context. Most investors will only purchase shares from familiar companies (Sewell 22). As a result, in a set up where employees are allowed to purchase shares from the company, they might end up being the lead shareholder group. Familiarity response has both positive and negative impacts on investments. When investors cling to familiar companies, there is a high possibility that they will miss on new opportunities. Suppose the rapid technological advancement is to go by, investors will lose. In the modern world, new opportunities are the stock leaders in most developmental sectors. On the other hand, new opportunities are associated with a higher risk. Since a new company has not been in operation for long, most of its negative aspects might not have been discovered yet. As a result, investors will be exposed to unknown risks that have a probability of lowering profits and causing investment flops (Sewell 14).

Behavioral finance explores that an investor can make either of the decisions based on their experience or adventure spirit. Either of the decisions can lead to positive or negative effects on the resultant investment. Therefore, familiarity is a two-faced concept since it can yield both profits and losses to the investment.

House money effect

The concept of house money is derived from gambling or betting scenarios. When someone bets and wins the bet, a portion of the reward is the house money. House money is the result of the subtraction of the bet amount from the reward amount(Sewell 12). These are the amount received from the winning. The player or investor might withhold the initial amount, and only continues playing with the amount won. Therefore, house money effect is the tendency to amass more winnings from the house money effect. According to psychology, winning stirs up the courage that causes the player to continue (Sewell 26). In Investment perspective, if an investment reaps profit, the investor is more likely to invest the profit either in the same business or others to increase their profit margin.  House money effect develops higher risks. Unfortunately, if an investment return provides a loss, the investor would be influenced to increase their investment and risks with the hope of compensating for the initial loss. However, there is a possibility that the second investment can also fail leading to more losses. Suppose, the second investment becomes successful, the investor might invest the profits to other business to expand their returns, and the process might be continued until a loss in incurred.

Ostrich effect

Ostrich effect is a derivative of the literal ostrich behavior of burying its head in the sand. In literature, the statement symbolizes people who choose to ignore their problems as a tactic to evade pain. Problems and failures are synonymous with pain. They reveal aspects that lower morale and suppress people’s will and agility (Sewell 37). An investor might choose to neglect to monitor the trend of their investment so as to avoid the embarrassment that their investment will fail. Sometimes people are defined by their choices; therefore, failure in investment will be equated to failure in character. The ostrich effect is dangerous to an investor. When an investment begins to fail, stakeholders should deliberate on the next course of action that will reduce the rate of decline in terms of profits. The approach only consoles personal feelings, but fails to consider the real life situations.

 Failure to respond according to real life situations increases the risk exposure and chances of the risk evolving to become a hazard. Timely intervention can prevent an investment from completely failing. Therefore, behavioral finance helps to identify the greater risk associated with the ostrich effect (Sewell 45). As a result, it can be utilized in making timely decisions and interventions to save investment from losses.

Adaptive market hypothesis

Adaptive market hypothesis incorporate efficient market hypothesis to behavioral finance. Behavioral finance denotes the error making aspect from an investor’s point of view that will result in losses. It combines it with the efficient market theory that postulates that the investor makes a decision that will generate maximum benefits (Sewell 28). The incorporation of the two concepts leads to the establishment of a balance between the two extremes. The merging aids in the development of a holistic approach that is used to determine investment decisions. Without making errors, the most efficient tactic cannot be established. Therefore, through experiencing errors, the best alternative is generated through avoiding previous mistakes.

 Additionally, it also focuses on the positive aspects of a discovered technique. In the end, the investor shall have appropriate experience and skill required to operate on a scale of minimum errors. The collaboration of the two aspects also expands the human aspect in decision-making since it involves the selection and modification of techniques (Sewell 22). The existent techniques and trends are not the only tools that are required to make an ideal investment decision. There is a probability that the information provided by system analysts may be skewed to promote or fail a specific entity. The valuation of established systems (trends and financial analysis) and the actual situation is one of the vital capabilities that make human involvement irreplaceable (Sewell 30). 

In conclusion, the behavioral finance is an important tool for understanding investor behavior. Acknowledging the role of human involvement in financial systems helps in improving flaws associated with the existing system. Moreover, financial advice to an investor can only be adequate if the response pattern of the investor (behavior) is understood.

Ostrich effect

Ostrich effect is a derivative of the literal ostrich behavior of burying its head in the sand. In literature, the statement symbolizes people who choose to ignore their problems as a tactic to evade pain. Problems and failures are synonymous with pain. They reveal aspects that lower morale and suppress people’s will and agility (Sewell 37). An investor might choose to neglect to monitor the trend of their investment so as to avoid the embarrassment that their investment will fail. Sometimes people are defined by their choices; therefore, failure in investment will be equated to failure in character. The ostrich effect is dangerous to an investor. When an investment begins to fail, stakeholders should deliberate on the next course of action that will reduce the rate of decline in terms of profits. The approach only consoles personal feelings, but fails to consider the real life situations.

 Failure to respond according to real life situations increases the risk exposure and chances of the risk evolving to become a hazard. Timely intervention can prevent an investment from completely failing. Therefore, behavioral finance helps to identify the greater risk associated with the ostrich effect (Sewell 45). As a result, it can be utilized in making timely decisions and interventions to save investment from losses.

Adaptive market hypothesis

Adaptive market hypothesis incorporate efficient market hypothesis to behavioral finance. Behavioral finance denotes the error making aspect from an investor’s point of view that will result in losses. It combines it with the efficient market theory that postulates that the investor makes a decision that will generate maximum benefits (Sewell 28). The incorporation of the two concepts leads to the establishment of a balance between the two extremes. The merging aids in the development of a holistic approach that is used to determine investment decisions. Without making errors, the most efficient tactic cannot be established. Therefore, through experiencing errors, the best alternative is generated through avoiding previous mistakes.

 Additionally, it also focuses on the positive aspects of a discovered technique. In the end, the investor shall have appropriate experience and skill required to operate on a scale of minimum errors. The collaboration of the two aspects also expands the human aspect in decision-making since it involves the selection and modification of techniques (Sewell 22). The existent techniques and trends are not the only tools that are required to make an ideal investment decision. There is a probability that the information provided by system analysts may be skewed to promote or fail a specific entity. The valuation of established systems (trends and financial analysis) and the actual situation is one of the vital capabilities that make human involvement irreplaceable (Sewell 30). 

In conclusion, the behavioral finance is an important tool for understanding investor behavior. Acknowledging the role of human involvement in financial systems helps in improving flaws associated with the existing system. Moreover, financial advice to an investor can only be adequate if the response pattern of the investor (behavior) is understood.

Work cited

Sewell, Martin. Behavioral finance and technical analysis, University of Cambridge, 2007, print.