Behavioural Finance: The rationale behind stock market irrationality

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Behavioural Finance: The rationale behind stock market irrationality

By

Prof. Priya Angle
CFA, PGDBA
Faculty
ICFAI Business School
Pune

A new area of financial research, Behavioural Finance is receiving a lot of attention from individual and institutional investors. Behavioural finance draws inputs from the field of psychology and finance in an attempt to understand and explain irrational stock market and investor behaviour.

Since the 1950s, theories of finance have assumed investors to be rational and objective decision makers. Focus of all finance theories has been on market efficiencies with little or no attention being given to the influence of human behaviour on the investment process.

The Efficient Market Hypothesis (EMH) assumes that stock prices move in a random fashion. It asserts that share prices reflect all relevant information and it is not possible to predict future stock price movements. The three forms of efficiency that the EMH talks about are:

1. Weak Form of efficiency – states that historical price movements cannot be used to predict future price movements. Hence abnormal returns cannot be earned by studying past price patterns

2. Semi Strong Form of efficiency – states that share prices reflect all publicly available information and thus excess returns cannot be earned from trading rules based on publicly available information.

3. Strong Form of efficiency – states that share prices reflect all information pertaining to a particular company, be it publicly available or privately available (insider information). Therefore no information can be used to earn superior returns.

In reality though, markets are not truly efficient. Market segmentation does lead to information asymmetry, resulting in above normal return. Also, investor behaviour is also not perfectly rational and unbiased at all times.

Behavioural Finance attributes such stock market irrationality to six traits that lead to errors of perception and judgment, each of which is discussed in brief:

1. Overconfidence: Investors are often overconfident about their own abilities in relation to others' abilities. As a result they tend to overestimate the accuracy of information. Investors believe that they have superior forecasting abilities and control over the occurrence of future events. This results in an investor trading excessively. Excessive trading in turn does not imply higher returns. In fact, too much of trading would yield returns lower than the market, over a period of time.

2. Pain of Regret: Very often, investors are unwilling to admit to their mistakes. This leads to investors avoiding harsh decisions or delaying them. The result is that investors hold on to loosing stocks and selling of potentially good stocks too soon.

3. Cognitive Dissonance: This refers to investors' tendency to deny or avoid conflicting information. Investors' try and seek a source of information that is in line with their own thinking and that will support their view. Any source providing conflicting information is immediately discredited and ignored. Objective decision making process must necessarily incorporate a step of re- evaluating the validity of a decision taken over time, to avoid errors of judgment.

4. Anchoring: refers to choosing the wrong point of reference. It is important that investors take decisions based on a detailed analysis rather than focusing only on a few specific attributes of a stock. For example, recent prices and earning of a company may not necessarily guarantee similar returns at a future point in time.

5. Representativeness: Classifying stocks as "good" stocks or "bad" stocks on the basis of a few characteristics can lead to errors of judgment. It is important to acknowledge that reclassification of stocks over a period of time is necessary. "Bad "stocks may move to the " good buys" category and "good" stock may slip to " not good buys" category over a period of time.

6. Myopic Risk Aversion: Investors have a tendency to take decisions based on short term gains rather than having a long term perspective. Such shortsightedness can lead to losses at a future point in time.

Behavoiural Finance does give insights relating to the investor decision making process. However, its utility as a proactive investment tool is yet to be ascertained. Gains from stock market investment can be reaped if investors' keep in mind the following trade rules drawn from this field of finance, namely:

Avoid self – fulfilling prophecies

Look at conflicting views

Remember that you may not have all information

Carefully analyse how information is presented.

Don't lose sight of long term goals for short term gains

References:

The psychology behind common investor mistakes; R. Douglas Van Eaton