Lou Donaldson and his neighbor, both U.S. residents, are meeting at a local rest
ID: 2745543 • Letter: L
Question
Lou Donaldson and his neighbor, both U.S. residents, are meeting at a local restaurant. During lunch, they discuss investing and Donaldson, age 45, makes the following statements: “My father was a buy-and-hold investor but I am an active trader. To keep trading costs low, I use an online brokerage firm. I have done well investing in technology companies because I know the industry.” “I am holding a large position in Omega Corporation with a large unrealized loss. Omega’s stock price declined last year when reported sales and earnings failed to meet analyst expectations. I took advantage of the decline to increase my position. Omega sales growth has continued to slow over the last year, but I believe the stock is still a good investment.” “I read a newspaper article reporting that commercial property values in the city have increased 14 percent annually since 2000. According to the article, the average commercial property in the city sold for $1.5 million last year. This makes me very happy because I just purchased a piece of commercial property last month. There is no doubt that it will be a good investment.” Select the behavioral finance concept best exhibited in each of Donaldson’s three statements. Explain how the behavioral finance concept you selected affects Donaldson’s investment decision making.
Explanation / Answer
1. Illusion of control bias: Donaldson believes that he knows the technology industry well and he can control the outcome of technology stocks, which is a classic case of illusion of control bias.
2. Overconfidence Bias: Despite slowing growth in Omega, Donaldson is overconfident with his bet on Omega and has also increased his position despite the company's sales and earnings not meeting analyst's expectations.
3. Representative Bias: Because an average commercial property in the city has increased 14% annually since 2000, Donaldson has recently purchased a commercial property. He is expecting the trend to continue and is wrongly representating historical data to make new investment decision.
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