Financial Behavioralism: A Behavioral Finance Approach to Minimize Losses and Maximize Profits from Heuristics and Biase
In an impressive line of experiments and field studies, the growing field of behavioral finance has offered behavioral insights on how markets deviate from rationality. Human actors are prone to base their investment choices on very many other factors tha
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Financial Behavioralism: A Behavioral Finance Approach to Minimize Losses and Maximize Profits from Heuristics and Biases
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Diversifying Nudges
When going on vacation and not knowing what the weather will be like, you better pack sunscreen and an umbrella. Diversification uses the same rational. When not knowing and unable to be influencing market decisions, one should be prepared for both—ups and downs. Diversification is a risk management technique to mix a variety of preferably contrary investments within a portfolio. A diversified portfolio featuring different kinds of investments will, on average, yield higher returns and pose lower risks than any narrow, single individual investment (Markowitz, 1959). Diversification thereby smooths out unsystematic risk. The different contrary options within a portfolio neutralize each other. Benefits of diversification hold if securities in one portfolio are not perfectly correlated, e.g., investing in domestic and foreign markets at the same time or betting on upswing and downswing options of markets concurrently. Mutual funds are an easy and inexpensive source of outsourced diversification that has gained popularity after the 2008/09 World Financial Crisis. While mutual funds provide diversification across various asset classes, exchange-traded funds (ETF) afford investor access to narrow markets such as commodities and international plays that would ordinarily be difficult to access. To ensure true diversification, divergent correlations among securities have to be achieved. What can we learn from diversification for nudging people into better choices? For one, intertemporal choice structures have shown that when individuals judge alternative choices, their decision-making is prone to be biased when evaluating alternatives one at a time. Contrary to standard utility theory would predict, presenting joint alternatives concurrently changes decision-making outcomes toward people becoming more likely to make more rational choices (Bazerman & Moore, 2009; Gourville & Soman, 2005; Tversky & Shafir, 1992). A natural tendency toward evaluating choices jointly rather than separately improves the quality of decisions as it alleviates complexity and allows to trade-off alternatives directly (Bazerman, Loewenstein, & White, 1992; Bazerman & Moore, 2009; Bazerman, © The Editor(s) (if applicable) and The Author(s), under exclusive license to Springer Nature Switzerland AG 2020 J. Puaschunder, Behavioral Economics and Finance Leadership, https://doi.org/10.1007/978-3-030-54330-3_4
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Financial behavioralism: A Behavioral Finance …
Moore, Tenbrunsel, Wade-Benzoni, & Blount, 1999; Bazerman, Schroth, Pradhan, Diekmann, & Tenbrunsel, 1994; Irwin, Slovic, Lichtenstein & McClelland, 1993; Kahneman & Ritov, 1994). Decision-making failures can thus be curbed when several choices are presented together (Milkman, Mazza, Shu, Tsay & Bazerman, 2012). Intertemporal discounting and intergenerational equity research find that human capacities to consider future outcomes in today’s decision-making
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