University of Essex Behavioral Finance Questions

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University of Essex


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QUESTION ONE a) How is overconfidence defined in the behavioural finance literature? Which cognitive biases encourage overconfidence? [25 marks] b) Critically discuss empirical findings on the impact of overconfidence. [25 marks] [TOTAL: 50 MARKS] QUESTION TWO a) Differentiate between value and growth stocks? Briefly summarise the evidence relating to the performance of value and growth stocks. [25 marks] b) Discuss competing explanations for the existence of the value premium. [25 marks] [TOTAL: 50 MARKS]
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Behavioral Finance

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1. Overconfidence
a. Which cognitive biases encourage overconfidence?
Overconfident individuals often show unwarranted faith and trust in their judgments, cognitive
abilities, and intuitive reasoning. In the behavioral finance literature, overconfidence is
characterized by overestimated access to information and knowledge levels. A significant number
of business people tend to overestimate their capabilities and skills about finance management.
Some cognitive biases significantly trigger confidence biasness. For example, Hindsight bias refers
to a situation where one believes that he/she can predict some event after experiencing the outcome
of a previous similar event. Since the Hindsight bias creates a situation in which we fool ourselves
that we already have information about an event even before it occurs, it makes us overconfident
and shuts up the desire to learn more from the past. Another cognitive bias that encourages
overconfidence is the Availability bias. This cognitive refers to a situation where decision-makers
utilize the most readily available information to make decisions. Availability bias discourages
individuals from learning facts from a new development because they presume that the available
information will adequately assist in the decision-making process. This barrier to further learning
encourages overconfidence.
Most importantly, Illusion control is another type of cognitive bias that encourages
overconfidence. For example, overconfidence convinces pe...

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