It is the irrational reaction to loss that causes

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Unformatted text preview: does not!). What is loss aversion? It is the irrational reaction What loss to loss that causes people to value losses twice as much as gains! Professor Schulze AEM 414 AEM Lecture 10 Avoiding Loss Aversion Lesson, if the market tanks, sell everything now! People do not sell because as the price goes down they will by selling have less than they did at the peak of the bubble. They avoid a small loss by riding it to the bottom and get a large loss!!! DO NOT SUFFER FROM LOSS AVERSION --SELL, SELL, SELL (AND GIVE SOME TO CORNELL). Professor Schulze AEM 414 AEM Lecture 10 More Psychological Explanation Do psychologists have an overall explanation for why the market behaves the way it does? The answer is they have many of the pieces, but not the whole story, figured out. Much of what follows is drawn from Shiller’s book Much Shiller book on behavioral finance. The first point that Shiller makes is that the Clinton The makes Clinton boom was far and away the biggest bubble in world history, dwarfing 1929. AEM 414 AEM Professor Schulze Lecture 10 Shiller Book Data: Prices and Shiller Book Earnings Compare the 1929 the crash to the 2000 bubble! Stock prices should follow earnings! If we look at the ratio of prices to earnings (the P-E ratio) it logically should stay constant--next slide. AEM 414 AEM Professor Schulze Lecture 10 Shiller Book Data: PriceShiller Book Earnings Ratio Oops! A P-E ratio of 14 is a 1/14=7% 1/14=7% rate of return. The P-E ratio is insane! Stock prices do not follow earnings! AEM 414 AEM Professor Schulze Lecture 10 P/E Ratio We measure the true value of stocks (fundamental value) by examining the price earnings (P/E) ratio. Note that the price earnings ratio which should absolutely never get above 20 (comparable to a 5% pretax rate of return) and should really not get above 15, if stockholders are getting a reasonable...
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This note was uploaded on 04/04/2009 for the course ECON 1120 taught by Professor Wissink during the Spring '05 term at Cornell.

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