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Concepts of finance_analysis

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HAMAYOON AKHTAR CHEEMA MBA 5th
overconfidencecan be summarized as unwarranted faith in one’s intuitive reasoning, judgments,and cognitive abilities.
The concept of overconfidence derives from a large body of cognitive psychological experiments and surveys in which
subjects overestimate both their own predictive abilities and the precision of the information they’ve been given.
Specifically, the confidence intervals that investors assign to their investment predictions are too narrow. This type of
overconfidence can be called prediction overconfidence. Investors are often also too certain of their judgments. We will
refer to this type of overconfidence as certainty overconfidence
Repreentative: In order to derive meaning from life experiences, people have developed an innate propensity for
classifying objects and thoughts. Similarly, people tend to perceive probabilities and odds that resonate with their own
preexisting ideaseven when the resulting conclusions drawn are statistically invalid. In base-rate neglect, investors
attempt to determine the potential success of, say, an investment in Company A by contextualizing the venture in a
familiar, easy-to-understand classification scheme. In sample-size neglect, investors, when judging the likelihood of a
particular investment outcome, often fail to accurately consider the sample size of the data on which they base their
judgments.
When required to estimate a value with unknown magnitude, people generally begin by envisioning some initial, default
number—an “anchor”—which they then adjust up or down to reflect subsequent information and analysis. Anchoring
and adjustmentis a psychological heuristic that influences the way people intuit probabilities. Rational investors treat
these new pieces of information objectively and do not reflect on purchase prices or target prices in deciding how to act.
When newly acquired information conflicts with preexisting understandings, people often experience mental discomfort
a psychological phenomenon known as cognitive dissonance. Cognitions, in psychology,represent attitudes, emotions,
beliefs, or values;and cognitive dissonanceis a state of imbalance that occurs when contradictory cognitions intersect.
Selective perception. Subjects suffering from selective perception only register information that appears to affirm a
chosen course, thus producing a view of reality that is incomplete and, hence, inaccurate. Selective decision making.
Selective decision making usually occurs when commitment to an original decision course is high. Selective decision
making rationalizes actions that enable a person to adhere to that course, even if at an exorbitant economic cost.
The availability bias is a rule of thumb, or mental shortcut, that allows people to estimate the probability of an outcome
based on how prevalent or familiar that outcome appears in their lives. People often inadvertently assume that readily
available thoughts, ideas, or images represent unbiased indicators of statistical probabilities. There are several categories
of availability bias, of which the four that apply most to investors are: (1)retrievability, Retrievability.Ideas that are
retrievedmost easily also seem to be the most credible, though this is not necessarily the case. (2) categorization, Here, we
will discuss how people attempt to categorize or summon information that matches a certain reference. (3) narrow range
of experience, and : Narrow range of experience.When a person possesses a toorestrictive frame of reference from which
to formulate an objective estimate, then narrow range of experience biasoften results. (4)resonance. Resonance. The extent
to which certain, given situations resonate vis-à-vis individuals’ own, personal situations can also influence judgment.
Self-attribution bias(or self-serving attributional bias) refers to the tendency of individuals to ascribe their successes to
innate aspects, such as talent or foresight, while more often blaming failures on outside influences, such as bad luck. Self-
attribution is a cognitive phenomenon by which people attribute failures to situational factors and successes to
dispositional factors. Self-serving bias can actually be broken down into twoconstituent tendencies or subsidiary biases.
1.Self-enhancing bias represents people’s propensity to claim an irrational degree of credit for their succession 2.Self-
protecting bias represents the corollary effectthe irrational denial of responsibility for failure.
The illusion of control bias describes the tendency of human beings to believe that they can control or at least influence
outcomes when, in fact, they cannot. This bias can be observed in Las Vegas…Ellen Langer, Ph.D., of Harvard

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University’s psychology department, defines the illusion of control bias as the “expectancy of a personal success
probability inappropriately higher than the objective probability would warrant.
Conservatism biasis a mental process in which people cling to their prior views or forecasts at the expense of
acknowledging new information. Conservatism bias may cause the investor to underreactto the new information,
maintaining impressions derived from the previous estimate rather than acting on the updated information. Conservatism
causes individuals to overweight base rates and to underreact to sample evidence.
People do not like to gamble when probability distributions seem uncertain. In general, people hesitate in situations of
ambiguity, a tendency referred to as ambiguity aversion. people dislike uncertainty (ambiguity) more than they dislike
risk. Frank H. Knight,of the University of Chicag o, was one of the twentieth century’s most eclectic, thoughtful
economists and one of the first to write on ambiguity aversion. Knight’s 1921 dissertation, entitled “Risk, Uncertainty,
and Profit,” Leonard J. Savage, author of the classic 1954 book The Foundations of Statistics, developed “Subjective
Expected Utility Theory” (SEUT) as a counterpart to the expected utility concept in economics. This theory states that,
under certain conditions, an individual’s expectation of utility is weighted by that individual’s subjective probability
assessment. The experiment suggests that people do not like situations where they are uncertain about the probability
distribution of a gamble.
People who exhibit endowment bias value an asset more when they hold property rights to it than when they
don’t.Endowment bias can affect attitudes tEndowment biasis described as a mental process in which a differential weight
is placed on the value of an object. That value depends on whether one possesses the object and is faced with its loss or
whether one does not possess the object and has the potential to gain it.oward items owned over long periods of time or
can crop up immediately as the item is acquired.
Simply put, self-control biasis a human behavioral tendency that causes people to consume today at the expense of saving
for tomorrow. Money is an area in which people are notorious for displaying a lack of self-control. The technical
description of self-control bias is best understood in the context of the life-cycle hypothesis, which describes a well-
defined link between the savings and consumption tendencies
Most people have heard of “rose-colored glasses”and know that those who wear them tend to view the world with undue
optimism. Empirical studies referred to in previous chapters demonstrate that, with respect to almost any personal trait
perceived as positivedriving ability, good looks, sense of humor, physique, expected longevity,and so onmost people
tend to rate themselves as surpassing the population mean. Many overly optimistic investors believe that bad investments
will not happen to them—they will only afflict “others.Nobel Prize winner Daniel Kahneman, of Princeton University,
and Daniel Lovallo, of the University of New South Wales, Australia, describe optimism biasin more technical terms.
They note a tendency of investors to adopt an inside view, in lieu of the outside view that is often more appropriate when
making financial decisions.1 An inside view is one that focuses on a current situation and reflects personal involvement.
An outside view, however, dispassionately assesses a current situation in the context of results obtained in past, related
situations.
First coined by University of Chicago professorRichard Thaler, mental accounting describes people’s tendency to code
categorize, and evaluate economic outcomes by grouping their assets into any number of nonfungible
(noninterchangeable) mental accounts. A completely rational person would never succumb to this sort of psychological
process because mental accounting causes subjects to take the irrational step of treating various sums of money differently
based on where these sums are mentally categorized, In framing, people alter their perspectives on money and investments
according to the surrounding circumstances that they face. Mental accounting refers to the coding, categorization, and
evaluation of financial decisions.
Confirmation biasrefers to a type of selective perception that emphasizes ideas that confirm our beliefs, while devaluing
whatever contradicts our beliefs. To describe this phenomenon another way, we might say that confirmation bias refers to
our all-too-natural ability to convince ourselves of whatever it is that we want to believe. Confirmation bias can be

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HAMAYOON AKHTAR CHEEMA MBA 5th overconfidencecan be summarized as unwarranted faith in one’s intuitive reasoning, judgments,and cognitive abilities. The concept of overconfidence derives from a large body of cognitive psychological experiments and surveys in which subjects overestimate both their own predictive abilities and the precision of the information they’ve been given. Specifically, the confidence intervals that investors assign to their investment predictions are too narrow. This type of overconfidence can be called prediction overconfidence. Investors are often also too certain of their judgments. We will refer to this type of overconfidence as certainty overconfidence Repreentative: In order to derive meaning from life experiences, people have developed an innate propensity for classifying objects and thoughts. Similarly, people tend to perceive probabilities and odds ...
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