Cognitive Bias and Illusions
Now that we’ve covered a number of different biases and illusions, think about the implications that each of these have for finance, both in terms of their effects people’s personal finance or wealth, as well as the impacts on markets more broadly. Which bias or illusion do you think has the greatest impact? Are all the potential impacts negative, or are there some that you feel could potentially be good? Feel free to reference biases from the previous class as well as this one. Or alternatively, if you have another favorite cognitive bias that you know from outside the class that you feel is more important to finance or economics, feel free to share it. Head over to the discussion board to share your thoughts.
Post your response to the guiding questions in a casual, informal post. Your response should show your understanding and ability to apply what you have read in your text and the resources to this scenario.
Behavioral Economics and Finance
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Behavioral Economics and Finance
Cognitive bias and illusions affect decisions on various aspects that may either benefit or harm the outcome. People need to make unbiased and rational decisions about crucial things in their life. One needs to think before deciding if it will have an objective outcome (Jones & Sharpe, 2017). When someone has bias or illusions in his reasoning, there is a misinterpretation of information from the surrounding world that leads to an inaccurate conclusion. In this instance, someone has a lot of information flocked in their mind, and they need to decide which information is important. Biases and illusions may have an impact on people’s finances and markets as a whole.
Impacts on Wealth and Finance
Representativeness bias makes one overspend on specific items. Representativeness bias occurs when there are two similar objects or events that lead to confusion regarding the probability of the outcome (Jones & Sharpe, 2017). For example, when one wants to spend on either lunch or supper, and they do not have enough cash, it brings confusion. Someone might be forced to spend on the two events, which leads to overspending. Also, this kind of bias can make investors go astray. Here, someone might be tempted to forecast future earnings by only analyzing the short success history. These estimates or predictions might be used in the pricing of the stock of the company, which leads to overpricing. In such a case, investors cannot think that the high earnings are seasonal and might drop after a given time.
Impacts on Markets
Conjunction fallacy makes a market to prefer only active funds. Conjunction Fallacy occurs when one assumes that the probability of specific events is higher than a single general one (Jones & Sharpe, 2017). This bias makes investors and financial advisors of a specific market favor the active management of funds despite knowing that passive funds have better outcomes. Also, this bias affects how marketers convince consumers about the benefits of a particular product. It reaches an instance when a customer has to weigh between his idea and that of the seller. Marketers activate two stereotypes that the product under sale is the solution to their multiple needs. It might harm the consumer because they might realize later that the product does not significantly impact their needs. It might be beneficial to the marketer because they have profited. If this case occurs, customers might lose faith or patience with the offers of specific marketers, which might lower rat...