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Risk in Modern Finance

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  1. Introduction
  2. The field of behavioral finance
  3. The finding of Kahneman and Tversky
  4. The role played by overconfidence people's behavior
  5. Conclusion

Modern finance and much of economic theory is based on the assumption that individuals that make up the marketplace in which transactions occur, act rationally and know every piece of information associated with their decision-making process in purchasing or selling a product (whether it is a stock or a banana). These assumptions are shaky and dangerous, and researchers, especially academics in the fields of finance and economics, have concluded that this is not the case. Hundreds of examples have been documented on events where irrational behavior and errors repeatedly in judgment occurred. In Against The Gods, Peter L. Bernstein states that there is proof of evidence that ?reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty? (304). Are markets governed by psychology of the investors or is the market an entity of itself and makes its own decisions?

[...] Statman is a professor who is well-versed in the area of behavioral finance that deals with fear of regret. He states that investors are likely to feel anger and regret after making a poor judgement. Those people who are deciding whether to sell a stock are usually emotionally affected by whether that stuck was purchased for a greater or lesser value than its current price. One of Statman's theories is that most people will not sell the stock if it is currently at a lower price than what the investor paid for it because they do not want to deal with the regret of their poor judgement. [...]

[...] There are some economists that have stated that people get twice as much pain out of a one-dollar loss than pleasure out of a one-dollar gain. This research has also concluded that people are much more willing to take greater risks to avoid losses than to make profits. During a period when an investor is faced with a situation in which they are likely to gain, they become risk-averse, but when the tables are turned and they are faced with a sure loss, they become risk takers. [...]

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