Behavioural Finance:
How Investor Reacts in Decision Involving Risk?


By

Ms. Priyanka Verma
Faculty (Accounts and Finance)
Skyline Institute of Engineering and Technology
Greater Noida
 


ABSTRACT

Behavioral finance is a new field in economics that has recently become a subject of Significant interest to investors. This article provides a general discussion of behavioral Finance .In this article survey is made between two different groups of investors. This article shows how we behave or the psycology when we make decisions involving risk, or in the possibility of loss .This article also throw some light on economists who stress psychological and behavioral elements of stock-price determination challenge Efficient market theory. Investor behave irrationally during risk decisions such as:

Losing Money - Individuals typically measure risk by money that has been lost. These losses are measured against the original cost of the stock or bond. Individuals sometimes feel money has been lost only when the security is sold.

Unfamiliar Instruments - Unknown or complex securities may seem riskier Previous Losses in Familiar Instruments- a stock that has lost money for the individual in the past is considered unattractive.

Contrary Investing - Not "following the crowd" may appear risky to an individual Historical v Potential Levels of Risk - Many individuals regard past levels of volatility as more important than projected levels of risk.

Key words: Behavioral finance, psychology, Efficient Market Theory

INTRODUCTION

Behavioral finance is the integration of classical economics and finance with Psychology and the decision-making sciences. This study is related to the fact that how investors give different weigtage to investment under similar situation. Some people systematically make errors in judgment or mental mistakes. Much of the economic theory available today is based on the belief that individuals behave in a rational manner and that all existing information is embedded in the investment process or no attention being given to the influence of human behaviour on the investment process.

In fact, researchers have uncovered evidence that rational behavior is not often the case. Behavioral finance attempts to understand and explain how human emotions influence investors in their decision making process. These mental mistakes can cause investors to form biased expectations regarding the future that, in turn, can cause securities to be mispriced. Behavioral finance is based on the psychology of investors. Psychology primarily deals with human fallibility, systematic mistakes and biased judgment.

HOW INVESTOR BEHAVE WHILE INVESTING & WHY?

Behaviour Finance field is so new, most professionals responsible for large portfolios were not exposed to the principles of behavioral finance in their college curricula and these principles have significant practical implications for investment management.

Consequently, this article provides an overview of behavioral finance. No matter how much investor is well informed, have done research, studied deeply about the stock before investing then also he behave irrational with the fear of loss in the future. For instance the loss of $1 dollar twice as painful as the pleasure received from a $1 gain.

It consider the Idea that people are Irrational & make investment decision from many reasons for instance some while investing wants to behave like professional & are over confident, some follow the past trends followed by others.

Tversky and Kahneman originally described "Prospect Theory" in 1979. They found that contrary to expected utility theory, people placed different weights on gains and losses and on different ranges of probability. They found that individuals are much more distressed by prospective losses than they are happy by equivalent gains.

Following Question was asked to the two groups of investors 'A' & 'B' (Identification is not disclosed due to secrecy reason)

When you invest in a new stock issue, what effect do you expect?

INVESTOR'S GROUPS

(I)
Investment will give sure gain of 50% of your investment

(II)
Probability of .5 to gain 100% & probability of.5 to loose 100%

A

84%

16%

B

31%

69%


From the above table it is clear in the survey that in Group A 84% of the investors choosed (I) & in Group B 31% choosed (I) Thus it is found that individuals will respond differently to equivalent situations depending on whether it is presented in the context of losses or gains This research found that people are willing to take more risks to avoid losses than to realize gains. Faced with sure gain, most investors are risk-averse, but faced with sure loss, investors become risk-takers. Buying a stock with a bad image is harder to rationalize if it goes down. Investors typically give too much weight to recent experience and extrapolate recent trends that are at odds with long-run averages and statistical odds. In general individuals tend to feel sorrow and grief after having made an error in judgment.

Typically, investors deciding whether to sell a security are emotionally affected by whether the security was bought for more or less than the current price Investors sell winners more frequently than losers. Odean (2000) studies 163,000 individual accounts at a brokerage firm. For each trading day during a period of one year, Odean counts the fraction of winning stocks that were sold, and compares it to the fraction of losing stocks that were sold. He finds that from January through November, investors sold their winning stock 1.7 times more frequently than their losing loosing stocks. In other words, winners had a 70 percent higher chance of being sold. This is an anomaly, especially as for tax reasons it is for most investors more attractive to sell losers.

PSHYCOLOGY OF INVESTOR & EFFICIENT MARKET THEORY

Intellectual dominance of the efficient-market revolution has more been challenged by economists who stress psychological and behavioral elements of stock-price determination.

Efficient market theory makes two sharp predictions. First, market prices

Equal to intrinsic value. In other words, financial assets have an objective value based on economic fundamentals, expected cash flows and their level of risk (measured in various units). The second prediction is informational efficiency-- that prices adjust rapidly to the arrival of new information and therefore, because news arrives randomly, past price changes do not predict future price changes. There are very few people, if any, for whom the prediction is entirely correct that investors are rationale & reflection of new information is immediate & accurate on stock prices as per EMH Theory.

Another aspect of behavioral finance concerns how investors form expectations regarding the future and how these expectations are transformed into security prices. Researchers in cognitive psychology and the decision sciences have documented that, under certain conditions, people systematically make errors in judgment or mental mistakes. These mental mistakes can cause investors to form biased expectations regarding the future that, in turn, can cause securities to be mispriced.

By considering that investors may not always act in a wealth maximizing manner and that investors may have biased expectations, behavioral finance may be able to explain some of the anomalies to the EMH that have been reported in the finance literature. Anomalous returns such as those associated with "value" stocks, earnings surprises, short-term momentum and long-term price reversals are fertile ground for researchers in.

There is a growing consensus that security markets are not as efficient as we thought before. The inefficiency is generally attributed to behavioral biases of investors. Since many behavioral biases have been documented in the cognitive psychology literature, almost any patterns in the financial markets can be linked to one or several of these biases. However, "the potentially boundless set of psychological biases that theorists can use to build behavioral models and explain observed phenomena creates the potential for 'theory dredging.'" (Chan, Frankel and Kothari, 2002) Furthermore, many theories, while consistent with empirical patterns that they are set out to explain, are not consistent with other empirical results. For example, while Bloomfield and Hales (2002) find evidence supportive of behavioral model of Barberis, Shleifer, and Vishny (1998) in a laboratory setting, Durham, Hertzel and Martin (2005) find scant evidence that investors behave in accordance with the model using market data. The link between behavioral theory and investment behavior are often vague. For example, empirical works reveal that small investors' trading activities often hurt their investment return (Hvidkjaer, 2001). This is usually thought that small investors are more prone to behavioral biases than professionals, who are better trained (Shanthikumar, 2004). Yet some empirical work suggests that professionals exhibit some behavioral biases to a greater extent than non professionals (Haigh and List, 2005).

CONCLUSION

This study has empirically examines how investor behave while taking investment decisions which involve risk, it shows that market participants evaluate financial outcomes in accordance with prospect theory .It shows that psychology of investor effect the share movement. Moreover, a greater sensitivity to losses than to gains implies that decisions differ according to how a choice problem is framed.

One particularly important question to be answered within this context is, of course, whether irrational behaviour of individual market participants may also lead to inefficiency of the market as a whole. Indeed, it is conceivable that even if the average investor behaves according to the psychological mechanisms mentioned, the market as a whole will generate efficient outcomes anyway. However, this is not the case, behavioural finance argues, for example because the arbitrage required to compensate for price inefficiencies is costly and risky. We often hear the great news on television, the radio or read it in newspapers. "The market hits new highs!" With all this wonderful news and quotes from industry experts, it is easy to extrapolate that the upward trend will continue. Millions of people come to the conclusion that "It is safe to invest again!" Orders flood in and volume soars as prices rise. This, in itself, is irrational behavior. You would think that the rational man or woman would want to buy equities when they are on sale. Yet it is often when prices hit their peak that many people decide it is time to buy.

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Ms. Priyanka Verma
Faculty (Accounts and Finance)
Skyline Institute of Engineering and Technology
Greater Noida
 

Source: E-mail December 5, 2006

     

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