Behavioral finance relates to investor’s emotions
Behavioral finance is quite a new subject in the management realm that seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations for why people make irrational financial decisions. Classical investment theories are based on the assumption that investors always act in a manner that maximizes their investments returns. Yet, a number of researches show that investors are not always so rational. The fundamental principle of the classical theory is that the economy is self‐regulating.
People get puzzled when the uncertainty regarding investment decision overwhelms them. People are not always rational and same is the case with markets. They are not always efficient. Behavioral finance explains why individual do not always make the decisions they are expected to make and why markets do not consistently behave as they are expected to behave. Many studies have shown that the average investors make decisions based on emotion, not logic; most investor’s buy high on speculations and sale low on panic mood. Most of us do that; do we? Psychological studies reveal that the pain of losing money from investment is almost three times greater than the joy of earning money. Emotions such as fear, impulse and greed often play a pivotal role in investor’s decision; there are also other causes of unreasonable behavior.
It is observed that stock prices moves up and down on a daily basis without any change in fundamental of economies. It is also observed that people in the stock market move in herds and this influence stock prices. Theoretically markets are efficient but in practice, they never move efficiently. For example, a reputed company announces a mega investment in an emerging area over next few years, the stock price of the company starts moving up immediately without looking into the prospects, return or the amount of investment to be made in this project. That is how the behavior of investor moves the stock price. Let me give hear a classical example: there is news since many years that Government o Maharashtra is planning to have another airport in Panvel, Mumbai. Immediately the property prices in Panvel shot up. Even if the Government is planning an airport in Panvel, the execution might take years, but the news itself has already augmented the property prices there.
Behavioral finance is a relatively new field that seeks to combine behavioral and cognitive psychological theory with conventional economic and finance to provide explanations for why people make irrational financial decisions. It is very popular in stock market across the world for decisions related to investments. Behavioral finance is the study of psychology, sociology and anthropology on the behavior of the financial practitioners and the subsequent effect on the security market. It helps to understand why people buy or sell stock without doing fundamental analysis and study. It helps to understand why investors behave irrationally in investment decisions. Some important definitions of behavioral finance are summarized hereby.
According to Olsen (1998) behavioral finance seeks to understand and predict systematic financial market implications of psychological decision process. Belsky and Gilowich (1999) have referred to behavioral finance as a behavioral economics and further defined as combining the twin discipline. Jay R Ritter (2003) has given a brief introduction of behavioral finance published in Pacific Basin Finance Journal. In his research article, he rejected the traditional assumption of expected utility maximization with rational investors in efficient market. The two building blocks of behavioral finance are cognitive psychology (How People Think) and the limit of arbitrage (when market will be inefficient).
Behavioral finance seeks to find how investor’s emotions and psychology affect investment decisions. It is the study of how people in general and investors in particular make common investors make errors in their financial decision due to their emotions. It is nothing but the study of why otherwise rational between cognition. Leon Festinger’s theory of cognitive dissonance states that individual attempts to reduce inner conflict in one of the two ways: (i) he changes his past values, feelings or options; and (ii) he attempts to justify or rationalize his choice. This theory may apply to investors and traders in the stock market who attempt to rationalize contradictory behaviors, so that they seem to follow naturally from personal values or view point. In “Financial Cognitive Dissonance”, we change our investment styles or beliefs to support our financial decisions. For instance, investors who followed a traditional investment style (fundamental analysis) by evaluating companies using financial criteria such as, profitability measures, especially, profit/earnings ratios, started to change their investment beliefs. Many individual investors purchased retail internet companies in which these financial measures could not be applied. Since these companies have no financial track record, very little revenues and no net losses. These traditional investors rationalized the change in their investment style as per past beliefs in two ways: the first argument by many investors is the belief that we are now in a “new economy” in which the traditional financial rules no longer apply. This is usually the point and the economic cycle in which the stock market reaches its peak. The second action that displays cognitive dissonance is ignoring traditional form of investing and buying these internet stock simply based on price momentum.
In behavioral finance, Regret theory states that an individual evaluates his or her expected reactions to a future event or situations. Psychologists have found that individuals who make decision that turn out badly have more regret when that decision was more unconventional. This theory can also be applied to the area of investor psychology within the stock market, whether an investor has contemplated purchasing a stock or mutual fund which has declined or not, actually purchasing the intended security will cause the investor to experience an emotional reaction. Investors may avoid selling stocks that have declined in value in order to avoid the regret of having made a bad investment choice and the discomfort of reporting the loss.
In addition, the investor sometimes finds it easier to purchase the “hot or popular stock of the week”. In essence, the investor is just following “the crowd”. Therefore, the investor can rationalize his or her investment choice more easily if the stock or mutual fund declines substantially in value. The investor can reduce emotional reactions or feelings since a group of individual investors also lost money on the same bad investment. In investing, the fear of regret can make investor either risk averse or motivate them to take greater risk.
In behavioral finance, Prospect theory deals with the idea that people do not always behave rationally. There are different psychological factors which motivate people in investment decision under uncertainty. It considers preference as a function of “decision weights” and it assumes that these weights do not always match with probabilities. It further suggests that decision weights tend to overweigh small probabilities and under-weigh moderate and high probabilities. Prospect theory demonstrates that if investors are faced with the possibility of losing money, they often take on riskier decision at loss aversions. They tend to reverse or substantially alter their revealed disposition towards risk. People consult astrologers, tarot card readers, numerologists to seek divine interventions in their investments. This just proves how irrational investors become while choosing their investment options.
The Anchoring theory is a phenomenon in which in the absence of better information, investors assume current prices are about right. People tend to give too much weight to recent experience, extrapolating recent trends that are often at odds with long run average and probabilities.
The theory of Over and under reactions relies on the fact that market does not reflect the available information. The feelings are euphoric at times and depressing some other times. The information is most of the illusionary in character. Usually they are too pessimistic when it’s bad and too optimistic when it is good says Bill Miller. The consequences of investors putting too much weight on recent news at the expense of other data are market over or under-reaction. People show overconfidence. They tend to become more optimistic when the market goes up and more pessimistic when the market goes down. Hence, prices fall too much on bad news and rise too much on good news. And in certain circumstances, this can lead to extreme events.
Behavioral Finance builds on existing knowledge and skills. The primary focus of this subject relies on how behavioral approaches change the decisions of investors in financial markets.
