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Behavioural Finance

  • Date Submitted: 05/27/2010 01:57 PM
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Marin Luisa
Gr.917

Behavioural Finance Essay
1. You have been offered the following two choices–
Choice A: $10,000 for certain;
Choice B: $20,000 with a 50% chance of occurring, $0 with a 50% chance of occurring.
Using behavioural finance, discuss and justify the choice that the majority of people would choose (i.e. choice A)
2. Outline the literature on Behavioural Finance to CRITICALLY EVALUATE whether such an assumption of rationality can be made.
3.Various theories exist to explain why long periods of growth in the price of shares are followed by sudden falls or market crashes. Evaluate the relevance of behavioural finance theory to the build up to the Dot.com bubble in 2000 and the subsequent market crash.
Introduction
In this essay I will be talking about behavioural finance and its increased popularity in recent academic literature. First I will give a brief description of what behavioural finance is. Basically behavioural finance is the study and theory that looks into why investors sometimes choose to ignore more traditional investment theory, such as the Efficient Market Hypothesis (EMH), and invest into projects that do not look economically sound or do not offer the most attractive returns. Behavioural finance attempts to incorporate elements of psychology into finance to better understand investor behaviour. Essentially, behavioural finance operates under the assumption that all investors are not rational. A good quote to sum up behavioural finance is provided by Shleifer (2000) who observes that, ‘at the most general level, behavioural finance is the study of human fallibility in competitive markets.’
Part 1
In this section I will attempt to explain why most investors would choose option A, as set out in the above question. I will also attempt to explain why some investors would not follow others and opt for option B.
The main reason why many people will undertake option A is simply because it is the most rational choice to make....

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