Chapter 12, Problem 5CP

Summary Introduction

To determine:

Three concepts of behavioral finance which is demonstrated in the comments of Pierce and explain each concept. Discuss how these concepts will be challenged by the investor practicing traditional or standard finance.

Introduction:

Overconfidence refers to the behavioral bias which stand dangerous, especially in the financial markets. It was assumed that overconfidence does not impact the investor, however the more the investor is overconfidence the more it will impact. In other words, it depicts underestimation of risk, overestimation of knowledge and exaggerating the ability of controlling the events.

Loss aversion reflects the tendency of the people to avoid incurring losses for earning equivalent amount of gains. For instance the investors that possess behavioral characteristics of loss aversion find it optimum to find $5 but not to lose $5. This principle also stands important in economics domain.

Reference point stands to be one of the keys in the world of behavioral finance to understand that the outcomes are evaluated by the people in relation to a relative point and then the classification of loss and gain is done.