Question

The textbook describes the field of Behavioral Finance as the study of “how reasoning errors influence financial decisions.” The textbook also contains a good discussion of how cognitive errors, biases and heuristics lead to irrational decisions by investors. What implications does all this have for stock market efficiency? Discuss. (150 words)

Answer 1

Reasoning errors impact market efficiency when investors conclude a stock is performing well by taking into account the information which he feels is important and ignoring what he feels is insignificant when in fact it might have consequences. This reduces efficiency in the stock market as there is a bias generated and seeking of information which validates it rather than contradictory evidence. Investors move towards growth stocks rather then value stocks which creates discrepancy in the stock market.

Cognitive errors arise when investors jump to conclusions and overgeneralize, this impacts efficiency as companies are preferred because they are of a particular sector, but individual companies have different business plans.Biases about a particular stock without a firm base increases the risk and valuation thereby making the stock expensive. Heuristics use short cuts to jump to conclusions which might prove inefficient and risky as market performance requires long term study and good research without which markets turn volatile as investors buy stocks based on asymmetric information.