Finance and the Psychology of Financial Decisions

ntroduction:

You
were recently hired as an associate consultant by a major consulting firm (Shefrain Consulting). This learning
demonstration will guide you through several challenges allowing you to
demonstrate competencies in understanding the importance of psychology on
financial decisions and how to avoid common psychological mistakes in financial
decision making.Behavioral Finance
covers “individual and group emotion, and behavior in markets. The field brings
together specialists in personality, social, cognitive and clinical psychology;
psychiatry; organizational behavior; accounting; marketing; sociology;
anthropology; behavioral economics; finance andthe multidisciplinary study of judgment
and decision making”. (Source: Journal of Behavioral Finance).Developed in the
1970s and 1980s by academics including Amos Tversky, Daniel Kahneman, Richard
Thayer and Meir Statman, behavioral finance stresses that psychology and
emotion prompt investors to behave in ways that are inconsistent with what is
considered rational in traditional finance. The 2010World Wealth Reportdevoted a special ten-page section to
behavioral finance, stemming from the conclusion that one of the most profound
consequences of the financial crisis has been the increasing prominence of
“emotional factors” in the financial decision-making process of large investors.

II. Steps to Completion:

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Over
the course of this learning demonstration you will be required to complete a six
part deliverable for your new employer, Shefrain Consulting to demonstrate your
competence in the important field of Behavioral Finance. In particular, you will be required to
demonstrate a high level understanding of Prospect
Theory
 and the implications of this theory on traditional financial
decision making, understand major biases common in financial decision making
and the process of debiasing, demonstrate your knowledge of behavioral finance
in the context of a client’s investment decisions and portfolio allocation,
understand that behavioral factors impact many important corporate financial
decisions, and clearly articulate the important aspects of behavioral finance
on your career and the prospects for Shefrain Consulting. Since you are a recent hire of Shefrain
Consulting, it is important to make a good impression. Throughout this learning demonstration be
sure to always support your arguments with reputable sources, sound logic, and
your own unique insights.
Professionalism throughout this learning demonstration is expected and
required as Shefrain has a large pool of potential junior consultants if your
report is deficient. At the conclusion
of this learning demonstration, you will be required to submit a final report
with sixparts addressing each of the hypothetical issues raised throughout this
learning demonstration.

1.
Prospect
Theory

“We really want to help
clients make better decisions,” said Stephanie Jones, senior consultant at
Shefrain Consulting, LLC, “and if we understand their biases and tendencies in
making choices, it helps us be better consultants.”

Stephanie continues, “I
noticed you graduatedfrom UMUC and took a
class in behavioral finance.”

You
respond in the affirmative. “We have a
lot of new consultants that are unfamiliar with the core foundations of
behavioral economics…” Stephanie’s Samsung Galaxy S6 Edge interrupts her as
she ducks around the corner to take a client’s call. When Miss Jones returns, she seems on edge
as it’s been a volatile day on Wall Street.
She asks you to prepare a ‘white paper’ on Prospect Theory and its
behavioral foundations. You agree and head
to your corner office to get to work on the ‘white paper’. After a frustrating morning of writing you
come across a Dropbox folder with some of your old UMUC notes and
resources.

Biases and Debiasing

Relieved
to have completed your first assignment, you head out to JoJo’s Tavern for a
couple pints with some fellow associate consultants. Your colleagues brief you on some basic
office politics and you share some details of your conversation with Miss
Jones. The conversation turns to
investing as the past several years have been very good financially for your
new colleagues. During your conversation, several of your colleagues’ comments
seemed to demonstrate commonly known biases in behavioral finance. The most interesting of these are listed
below.

I. “My
father was a buy-and-hold investor but I am an active trader. To keep trading
costs low, I use an online brokerage firm. I have done well investing in
technology companies because I know the industry.”

II. “I am
holding a large position in Omega Corporation with a large unrealized loss.
Omega’s stock price declined last year when reported sales and earnings failed
to meet analyst expectations. I took advantage of the decline to increase my
position.” Omega sales growth has continued to slow over the last year, but I
believe the stock is still a good investment.”

III.“I
read a newspaper article reporting that commercial property values in the city
have increased 14 percent annually since 2000. According to the article, the
average commercial property in the city sold for $1.5 million last year. This
makes me very happy because I just purchased a piece of commercial property
last month. There is no doubt that it will be a good investment.”

 
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