1. You have been offered the following two choices–Choice A: Â£10,000 for certain; Choice B: Â£20,000 with a 50% chance of occurring, Â£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. 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, â€˜at the most general level, behavioural finance is the study of human fallibility in competitive markets.â€™ 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. Taking this choice will guarantee the investor a return of Â£10000. This is consistent with much of the traditional market theory. The assumption of investor rationality is essential to all the main market investment theories such as the Efficient Market Hypothesis (EMH) and the Arbitrage Pricing Theory (APT). Without this assumption the models would collapse. Another reason why most investors will take option A is the absence of risk. It is 100% certain that the investor will get a Â£10000 return. Again, this is consistent with traditional market theory that states that investors will favour projects with the least amount of risk if the projects being considered all return the same amount of money. Another reason why most investors will choose option A is that concerning ‘herd mentality’. Many authors have observed that some investors will simply invest in a project because that is what everyone else is doing. This leads to the assumption that these investors are not rational as none of the market data or theory is being considered in their investment decision. This leads into the area of behavioural finance to try to explain the actions of these investors.
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