In the late 1990's into 2000 there was a rapid rise in US technology stock equity and

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Question:

In the late 1990's into 2000 there was a rapid rise in US technology stock equity and major investments in internet and dot com related companies. The NASDAQ index grew over this time from 1,000 to 5,000 points as investors speculated on these tech stocks; and the projected profits and company valuations grew.

Ben's brother lived in the US and kept telling Ben that these stocks were the next best thing and that everyone was investing. He repeatedly told Ben that if he left it too late, he would miss out. Ben was generally a conservative investor, however, he wanted to get in early and not miss the gains that were on offer. He quickly invested in three tech stocks, based on his brother's advice and what other investors were doing. In 2001, the bubble burst where a significant number of investors lost most of the value of these tech stocks with only a few major tech companies surviving the crash. Unfortunately, Ben's selected stocks did not survive the crash.

(a) Identify the key behavioural finance issue presented in this scenario. Include in your response a brief definition of the issue.

(b) Provide evidence from the scenario to support your assessment.

(c) Discuss the consequences of the impact of this issue in the context of the scenario provided if the issue is not identified and addressed appropriately.

(d) Based on the scenario, identify how the issue impacts either the giving or receipt of information. For example, what type of information is likely to be provided to investors in the scenario by the adviser, or what type of information would help the client in the scenario.

Scenario

(a)

The key behavioural issue in this scenario is the "Herding Effect" bias. Also known as the bandwagon effect individuals invest or make decisions not by conducting their own research or analysis but assuming other individuals have. Individuals displaying herd instincts will often follow the masses and invest in products identical or similar to what others are doing. This type of investor mentality often sees a large number of investors enter or leave the market at the same time thereby creating at times excessive volatility.

(b)

In the above scenario, Ben invests in three tech stocks based on his brothers advice and what other investors were also doing. Ben, eager to "get in early" invests irrationally in three tech companies so as "not miss the gains" and fails to conduct any research or seek professional financial advice. This "herding" tendency leads to assets bubbles and can falsely misrepresent the true value of the market. In this scenario Ben has not done his own due diligence and has invested assuming his brothers advice and the trading patterns of mass investors is a sign of a profitable investment.

Along with creating assets bubbles, a result of "herding" bias is the large market volatility created by investors irrational trading. As investors invest in shares due to rising prices brought on by mass trading and not true fundamentals , similarly when large amounts of investors sell down can see share prices plummet, markets crash as in the tech stock crash and ultimately lead to worthless shares as in Ben's case with his three tech companies.

( c )

If Ben or his adviser fails to identify his "herding" tendency it can have an adverse effect on his investment decisions. Ben, a conservative investor, invests irrationally in these speculative tech companies which does not match his risk profile. Ben and his adviser by not addressing or identifying this bias has failed to follow the correct financial planning process, invested based on research and informative information in line with risk tolerance. This type of irrational trading can lead to market bubbles and huge market volatility which can lead investors to lose large amounts of thie net wealth - as in this case Ben has lost all of his investment in these three tech companies.

In order to avoid "Herding" bias Ben could adopt a few strategies so as to avoid conforming with the crowd and making bad investment choices. Firstly, Ben could do his own research on companies he may wish to invest in or current market situation within that sector. By investing based on facts and information other than emotion or "fear of missing out" could help Ben make better investment decisions in the future. Ben could also complete a risk profile again to if investments match his risk tolerance. Already classified as a "Conservative" investor, completing a risk profile and engaging in the services of a financial adviser could improve future investment decisions.