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Chapter 6-8 - DS Fall 09 - Finance 360 Investments Chapter...

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Finance 360 Investments Chapter 6-8
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Over Confidence Causes people to overestimate their knowledge, under estimate their risk, and exaggerate their ability to control events. 82% of College Students rate themselves above average drivers. 2,994 new business owners survey thought they had a 70% chance to succeed, but only 39% thought another business like theirs would be likely to succeed. From the Psychology of Investing, Third Addition by John R. Nofsinger
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Over Confidence People are more confident when they feel like they have more control. If people are asked to bet whether a coin toss will be heads or tails, most bet larger amounts if the coin has not been tossed. From the Psychology of Investing, Third Addition by John R. Nofsinger
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Over Confidence Effects on investors People believe they know more about the stocks they invest in than they really do. Overconfidence leads to more trading which typically has a negative effect on returns. Tend to purchase higher risk stocks. Tend to under diversify. From the Psychology of Investing, Third Addition by John R. Nofsinger
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Illusion of Knowledge The tendency for people to believe that the accuracy of their forecasts increases with more information; that is, more information increases one’s knowledge about something and improves one’s decisions. Roll a fair dice, first three rolls come up “4”. Many people believe 4 has a greater chance of coming up on the next roll. From the Psychology of Investing, Third Addition by John R. Nofsinger
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Illusion of Control People often believe they have influence over the outcome of uncontrollable events. People who choose their own lottery numbers believe they have a better chance of winning than people who have the numbers given to them at random. My wife believes if she watches the Bengals, they will lose. From the Psychology of Investing, Third Addition by John R. Nofsinger
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Anchoring Basing decisions on a set number, or “anchor”. Dow Jones with dividends example in class. Investors tend to anchor based on their purchase price, a recent high or a recent low. From the Psychology of Investing, Third Addition by John R. Nofsinger
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House Money Effect People who have experienced a gain or a profit tend to take on more risk. From the Psychology of Investing, Third Addition by John R. Nofsinger
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Trying to Break Even People who have experienced a loss are willing to take greater risk in an effort to “break even”. From the Psychology of Investing, Third Addition by John R. Nofsinger
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The Historic Record Small Stocks Large Stocks Long Bonds T-Bills Inflation Geo. Mean 12.7% 10.4% 5.4% 3.7% 3.0% Arith. 17.5% 12.4% 5.8% 3.8% 3.1% SD 33.3% 20.4% 9.4% 3.1% 4.3% $1 10,953.94 2,284.79 60.56 17.66 10.28 Real $1 1,065.44 222.23 5.89 1.72 1 End of 1925 – End of 2003
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Scenario Analysis Assign weights to possible outcomes Estimate Holding Period Returns for possible outcomes Calculated the weighted return Also known as the Expected Return E ( r ) = p ( s ) r ( s ) Σ s
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Variance Variance = Σ s p ( s ) [ r s - E ( r )] 2
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Standard deviation = [variance] Standard deviation = [variance] 1/2 1/2 Standard Deviation Variance = Σ s p ( s ) [ r s - E ( r )] 2
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Standard Deviation Square root of the Variance
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Risk Free & Risky Portfolio Risk Free Risky r r f = 7% = 7% E(r E(r p ) = 15% ) = 15% 50/50 75/25 25/75
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