Irrational Behaviour of Investors:
Evidences from International Literature Review


Harsh Purohit
Associate Professor and Chair-ICICI Bank Chair for BFSI
Banasthali Vidyapith, Rajasthan

Sarika Srivastava
Assistant Professor
Global Institute of Management, Gandhinagar, Gujarat
Research Scholar
Banasthali Vidyapith

Behavioural finance uses cognitive and emotional factors to understand the investment decisions of investors. Investors commonly believe that a healthy growth of earnings in the past is the representative of high growth rate in future. They consider past data as a source to predict the future. Behavioral finance is important because it helps us in recognizing that the market is inefficient in the short run. The inefficient market is usually credited to behavioural biases of investors. As Benjamin Graham, the father of security analysis, said- "In the short run the market is a voting machine but in the long run it is a weighing machine." The latest World Wealth Report devotes a special ten-page section to behavioral finance, stemming from the conclusion that one of the most profound consequences of the financial crisis has been the increasing prominence of "emotional factors" in the decision-making process of investors with $1 million or more in investable assets.

Hirshleifer and Welch (2000) found that investors believe the positive company performances as representatives of a permanent growth prospective under the representativeness heuristic, and ignore the possibility that this performance is of a random nature. Humans also have a tendency of memory loss and they give more weight to the existing information than the earlier information. In one experiment, subjects were asked to estimate the percentage of United Nations countries that are African. More specifically, before giving a percentage, they were asked whether their guess was higher or lower than a randomly generated number between 0 and 100. Their subsequent estimates were significantly affected by the initial random number. Those who were asked to compare their estimate to 10, subsequently estimated 25 percent, while those who compared to 60, estimated 45 percent. Yates (1990) wrote that Anchoring is a phenomenon in which, in the absence of better information, investors assume current prices are about right. In a bull market, for example, each new high is 'anchored' by it closeness to the last record, and more distant history increasingly becomes an irrelevance. People tend to give too much weight to recent experience, extrapolating recent trends that are often at odds with long-run averages and probabilities. Mental accounting is the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities. Thaler (1985) developed a new model of consumer behaviour involving mental accounting.

Kahneman and Tversky (1979), psychologists, wrote the most cited paper ever to appear in Econometrica the prestigious academic journal of economics. They presented a critique of expected utility theory (Bernoulli 1738; von Neumann and Morgenstern 1944; Bernoulli 1954) as a descriptive model of decision making under risk and develop an alternative model, which they call prospect theory. Kahneman and Tversky found empirically that people underweight outcomes that are merely probable in comparison with outcomes that are obtained with certainty; also that people generally discard components that are shared by all prospects under consideration.

People seem to consider a past outcome as a factor in evaluating a current risky decision. In general, people are willing to take more risk after earning gains and less risk after incurring losses. After experiencing a gain, people are willing to take more risk. Gamblers refer to this as the house-money effect. After incurring a loss, people are less inclined to take risk. This is sometimes referred to as the snake-bite (or risk aversion effect).Losers, however, do not always shuns risk. People often jump at the chance to recover their losses. This is referred to as trying-to-break-even effect.

Odean (1999) demonstrated that overall trading volume in equity markets is excessive, and one possible explanation is overconfidence. He tested and found evidence of the disposition effect which leads to sell winning investments too soon and hold losing investments for too long. Overconfidence was found to be more acute in the analysts rather than in the small investors. Griffin (1992) found that experts tend to be more overconfident than inexperienced individuals. According to Wood (1996) if analysts believe with eighty percent confidence that a share is going to go up, they are right only for approximately forty percent of the time. De Bondt and Thaler (1985) suggested asset pricing model as a result of market Overconfidence.

Barberis, Shleifer and Vishny (1998) presented a model of investor sentiment that displays under-reaction of stock prices to news such as earnings announcements and overreaction of stock prices to a series of good or bad news. They claimed that people who observe a random walk are likely to fluctuate between beliefs in the gambler's fallacy (in which any trends are quickly reversed) and beliefs in the hot hand (in which trends continue); depending on how many reversals in price they have seen in recent periods. They then proved that such beliefs can account for both short-term price momentum and long-term price reversal.

They built a model of the behavior of a representative investor based on the concepts of representativeness and conservatism. In their terminology, "representativeness" means that investors ignore the laws of probability and behave as if the events they have recently observed are typical of the return (or earnings) generating process. "Conservatism" means that investors are slow to update their prior beliefs in response to new information. These two behavioral tendencies, and a particular model structure involving two states of nature, namely, mean reversion and trending regimes, combine to produce under-reaction in some circumstances and overreaction in others.

Barberis and Huang (2001) attempted to incorporate the phenomenon of loss aversion into utility functions. Loss aversion refers to the notion that investors suffer greater disutility from a wealth loss than the utility from an equivalent wealth gain in absolute terms. Barberis  and Huang (2001) showed that loss aversion in individual stocks leads to excess stock price fluctuations, i.e., more than that justified by fluctuations in dividends (viz. Shiller, 1981). This happens because, for example, agents' response to past stock gains is to increase their desire to hold the stock and thereby, in effect, lower the discount rate, raising the stock price still further. Further, a book/market effect also obtains because stocks with high market/book are ones that have done well and thus require lower returns in equilibrium.

Coval and Shumway (2005) provided some evidence on the affect of behavioural biases of agents on prices through trading activity by arguing that proprietary traders on the Chicago Board of Trade exchange (which mainly trades derivatives) take more risk late in the day (as measured by number of trades and trade sizes) to cover their losses in the beginning of the day. This implies loss-averse behaviour. Prices are affected by this behaviour in that they are willing to buy contracts at higher prices and vice versa than those that prevailed earlier.

Ashta et al. (2005) identified herd behaviour as a possible factor in corporate financing and report that the listing and delisting decisions of a firm were influenced largely because many other firms happened to be listing or delisting at that time. Similarly, the internet bubble points to herd behaviour in accepting expectations based on such measures as hit rate. The essential point is that expectations of people may not be grounded on the past but may be based on the expectations of others. They assumed that others have done their homework and looked at the past. Or, as in the case of internet, they hope that, even if there is no economic justification for the herd behaviour, they would be able to get out before the bubble bursts by selling off their investments.

Prechter (2001) studied human behaviour and concluded that it provides a psychological basis for financial market performance. He introduced a very basic human behaviour function: 'herding', based on 'impulsive mental activity' and in response to the actions of others. The human genetic makes us to act emotionally faster than rationally, due to the biological response time within our brains in challenging situations.  In support of this thesis, the concept of the Triune Brain is further explained. The human brain can be divided in three components (a) The brain stem, (b) The limbic system, and (c) The neocortex. The limbic system is the primitive brain responsible for emotional response while the neocortex is the generator of rational responses and reason.

Odean (1998) revealed clear evidence of the disposition effect among thousands of individual investors at a brokerage firm. Unfortunately for the investors, selling winners and holding on to losers is nearly the opposite of the profitable momentum strategy, which involves buying recent winners and selling recent losers. As a result, the stocks the investors held subsequently underperformed the stocks they sold.

Fama, Fisher, Jensen, and Roll (1969) examined the effect of stock splits on returns for 940 stock splits on the New York Stock Exchange for the period 1927-1959. They found that prior to the split, the stocks earned higher returns than predicted by the market model. After the split, however, stocks earned returns which were more or less in conformity with the market model.

Mishra (2005) studied the stock price reaction to bonus issues in India using the event study methodology. The samples of 46 bonus issues from June 1998 to August 2004 were used to study the announcement effect. The results indicated that there were significant positive abnormal returns for a five –day period prior to bonus announcement in line with evidence from the developed markets. The results provided stronger evidence of semi-strong market efficiency of the Indian stock market.

Koustubh Kanti Ray (2011) examined the announcement effects of bonus issues and stock splits on the Indian stock market during the period April 1996 to March 2008. An event study was conducted using a 61- day event window. It proved that in the Indian market the investors can make abnormal returns around the stock split announcements only. It was evident that the reaction of market players to stock split was more pronounced than that of bonus issues.


These help us to understand the irrational behaviour of investors and the potential to be a significant supplement to the traditional finance theories. The amount of research in the area of behaviour finance has grown over the recent years but need of the hour is to explore some new dimension in decision making that can comprehensively depict decision style of investors.


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Harsh Purohit
Associate Professor and Chair-ICICI Bank Chair for BFSI
Banasthali Vidyapith, Rajasthan

Sarika Srivastava
Assistant Professor
Global Institute of Management, Gandhinagar, Gujarat
Research Scholar
Banasthali Vidyapith

Source: E-mail August 2, 2011


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