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Question: How does the representativeness bias influence individual and institutional financial decision-making? Determine if it is detrimental to an investor’s financial health

06 Nov 2023,2:08 PM

 

This assignment is to be completed individually and consists of an essay answering the following question:

 

How does the representativeness bias influence individual and institutional financial decision-making? Determine if it is detrimental to an investor’s financial health.

 

Clearly define what the representativeness bias is using academic sources. Critically review the existing academic literature (incl. empirical evidence) in your answer. You must consider both the impact on individual investors as well as that on institutional investors (literature permitting). You need to clearly judge whether the representativeness bias is detrimental to investors’ financial health.

 

You must clearly justify any selection you may make in your essay and support your arguments with academic literature. Non-academic sources are permitted but should only be used for brief illustrative purposes rather than as the sole source of an argument. You should also prioritise depth over breadth, so it is better to focus your analysis on a small selection of specific situations, rather than trying to cover every documented possibility in a superficial manner.

 

Your essay must be between 2,500 and 3,000 words long, excluding references. It must be typed, using an 11 point font and 1.5 line spacing. Essays which are not in the specified format may be penalised.

 

Include all references (this reference list does not count towards your word limit) and number all pages. Instead of a cover page, you may put your student number in the document header. Please save your document as a pdf file.

 

The use of generative AI (e.g. ChatGPT) to complete this assignment is not permitted. The assignment must contain the results of your own work and have been composed by yourself. Following normal academic conventions, you must make due acknowledgement of the work of others.

 

This assessment will account for 30% of your final mark for this class. The assignment should be submitted by uploading it on myplace. To ensure your submission displays correctly for marking on myplace, you must submit the assignment in pdf format.

 

There are two main purposes to the coursework assessment. The first is to develop skills in reading and critically reviewing research papers in the area of behavioural finance. The second is to develop skills in comprehensively addressing a specific argument in this area of finance

 

The essay must clearly state and justify the issues you choose to discuss. If possible, address both empirical findings in favour as well as against your chosen argumentation. You should clearly define all the terms you are using, and anchor your discussion in the academic literature. Newspaper articles and material published on web sites may only be used for very brief illustrative purposes.

The essay will be assessed on how well these criteria are met, as well as the level of understanding demonstrated in your writing. Feedback will be provided on the evaluation form on the essay within 3 weeks of the submission deadline.

 

Reading:

The following references are designed to allow you to start your research. You are encouraged to read widely and to research beyond these sources. You should also consider the material we have previously discussed in class.

 

Ayal, S., Bar-Haim, D., and M. Ofir (2018) ‘Behavioral Biases in Peer-to-Peer (P2P) Lending’, working paper Reichman University (IDC Herzliya). Available at: https://ssrn.com/abstract=3207163

 

Chen, G., Kim, K. A., Nofsinger, J. R., anf O.M Rui (2007) ‘Trading performance, disposition effect, overconfidence, representativeness bias, and experience of emerging market investors’, Journal of Behavioral Decision Making 20(4), pp.

425-451.

 

Du, Q., Shen, R., and K.-C.Wei (2022) ‘Expectations and Interpretations: Testing Confirmatory Bias Against the Representativeness Heuristic in Financial Market’, working paper Southwestern University of Finance and Economics (SWUFE).

Available at: https://ssrn.com/abstract=4126817

 

Kahneman, D., and A. Tversky (1972) ‘Subjective probability: A judgment of representativeness’, Cognitive Psychology 3(3), pp. 430–454.

 

Krawczyk, M. W., and J. Rachubik (2019) ‘The representativeness heuristic and the choice of lottery tickets: A field experiment’, Judgment and Decision Making 14(1), pp. 51-57.

 

Li, S., He, F., and F. Shi (2022) ‘Cognitive Biases, Downside Risk Shocks, and Stock Expected Returns’, working paper Southwestern University of Finance and Economics. Available at: https://ssrn.com/abstract=4230013

 

Tversky, A., and D. Kahneman (1982) ‘Evidential Impact of Base Rates’, in Kahneman, D., Slovic, P., and A. Tversky (Eds.), Judgment under Uncertainty: Heuristics and Biases. Cambridge: Cambridge University Press.

 

STUDY TIPS / DRAFT:

Representativeness bias is a cognitive bias that influences individual and institutional financial decision-making by causing people to make judgments or decisions based on past experiences, stereotypes, or generalizations rather than considering all relevant information. This bias can have both positive and negative effects, but in many cases, it can be detrimental to an investor's financial health.

Here's how representativeness bias can influence financial decision-making:

  1. Overreliance on Past Performance: Investors may be overly influenced by the past performance of an investment or asset, assuming that it will continue to perform in the same way. For example, if a stock has performed well in the past, an investor might assume it will continue to do so and invest without fully considering the current market conditions or the company's fundamentals.

  2. Stereotyping: Investors may stereotype certain assets or investments based on previous experiences or generalizations. For instance, assuming that all technology stocks are high-risk and speculative because of the dot-com bubble in the early 2000s, which might lead them to miss out on potentially profitable tech investments.

  3. Neglecting Diversification: Representativeness bias can lead investors to overweight their portfolios in familiar asset classes or sectors while neglecting diversification. This lack of diversification can increase risk and lead to substantial losses if a particular sector or asset class underperforms.

  4. Overestimating Rare Events: People often underestimate the probability of rare events and overestimate the likelihood of common events. This can lead to a failure to adequately prepare for black swan events or unexpected market disruptions.

  5. Chasing Trends: Investors may chase recent market trends or fads because they believe the current conditions are representative of future trends. This can result in buying at the peak of a bubble and suffering significant losses when the trend reverses.

  6. Confirmation Bias: Investors may selectively seek and interpret information that confirms their existing beliefs about an investment, ignoring information that contradicts their views. This can lead to poor decision-making and a lack of objectivity.

Overall, representativeness bias can be detrimental to an investor's financial health because it can lead to suboptimal investment decisions, increased risk, and potential losses. It's essential for investors to be aware of this bias and actively work to mitigate its effects. Conducting thorough research, diversifying portfolios, and seeking a variety of perspectives can help counteract the negative impact of representativeness bias on financial decision-making.

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