Behavioral Finance - A Study of Investor's Emotion


By

Ms. Shradhanjali Panda
Lecturer (Finance)
Global Institute of Management
Hanspala, Bhubaneswar-752101
 


Abstract

Though Investment is a science deals with the study of capital market and then plan accordingly yet the study of investor's emotion has a major role to play with. It is not sufficient to analyze Efficient Market Hypothesis and its drawbacks rather one has to go for a behavioral explanation of investor's irrationality in a consistent and correlated manner. Thus comes Behavioral Finance, the study of the influence of psychology on the behavior of financial practitioners and the subsequent effect on market, into existence. In this study I have tried to analyze the concept of behavioral finance along with its four theories to explain the behavioral aspect of investors. This paper   also focuses on its limitations.

INTRODUCTION:

If we always assume that financial markets are efficient and investors are rational then why there are so many studies about investor's psychology? Investment managers always want to make money for themselves and for their clients. That is the reason they care about the "psychology" factor of financial market as well as investors.

The behavior of investors is not always rational, so investment managers do not forget how the psychology factor of a person plays a substantial role in behavior of financial market.

But, modern finance theories have almost completely ignored the role of the complex motivational and cognitive factors that influence investor's (the best asset of a company) decision making.

In today's buyer-market, we should face the truth that psychology systematically explores human judgment behavior and well being. It can teach us important facts about how humans differ from traditional economic assumption.

LITERATURE SURVEY

Earlier economics was closely attached to psychology, which was amply displayed in the book "The Crowd: A study of the popular Mind" published in 1896

by Gustave le Ban. The book was one of the greatest and most influential books of social psychology ever written.

But with the development of Neo-classical economics, it has been taught to us that –

1) People have rational preferences among outcomes that can be identified and associated with a value
2) Individuals maximize utility and times maximize profits and
3) People act independently on the basis of full and relevant information.

At that time, expected-utility and discounted-utility models began to gain wide acceptance generating testable hypotheses about decision making under uncertainty and intertemporal consumption respectively. By this time psychology had largely disappeared from economic and finance discussions.

A revolutionary paper in the development of the behavioral finance and economics was published in 1979. Two famous psychologists Kahneman and Iversky published their paper "Prospect theory - An Analysis of Decision under Risk" and where cognitive psychological techniques were used to explain a number of documented divergences of economic decision making from neo- classical theory.

In 1985, Wenner F.M. De Bondt and Richard Thaler published, "Does the Stock Market Over-react?" This is another milestone in linking psychology with Financial-Market and form the start of Behavioral Finance. They discovered that people systematically over-react to unexpected and dramatic news events, results in substantial weak form inefficiencies in the stock market, which was both surprising and profound.

In 1981, Iversky and Kahneman introduced "framing". They showed that psychological principles that govern the perception of decision problems and the evaluation of probabilities and outcomes produce predictable shifts of preference when the same problem is framed in different ways.

Gradually a number of psychological effects and factors have been incorporated into behavioral finance only to strengthen the subject.

DEFINITION:

This realization gave birth to Behavioral Finance, a study of the influence of Psychology on the behavior of practitioner and the subsequent effect on markets. Behavioral Finance explains why and how markets might be inefficient.

Thus, behavioral finance is a field of study that has evolved which attempts to better understand and explain (through the use of psychology and other social sciences) how emotions and cognitive errors influence investors and the decision-making process..

A STUDY / SCIENCE:

The key observations from the study of Behavioral Finance is that –

1) People often make decision based on approximate rule of thumb, not strictly rational analysis.

2) People do not appear to be consistent in how they treat economically equivalent choices if the choices are presented in significantly different contents, which referred to framing- effect.

3) There are explanations for observed market outcomes that are contrary to national expectations and market efficiency, which include mispricing, non-rational decision-making and return anomalies.

From the above observations it is clear that judgments can be systematically wrong in various ways. Systematic errors of judgment are called biases. Financial decisions are made in situations of high complexity and high uncertainty that preclude reliance on fixed rules and compel the decision-maker to rely on intuition.

Following situations will clear the theme more clearly.

SITUATION-1:

Let us take two identical examples. In first example you are walking to a play carrying a ticket that cost Rs.100/-. On reaching the theatre you discover that you have lost the ticket.

Would you pay another Rs.100 for a new ticket? Now suppose you are planning to buy the ticket at the door. On arriving you find that you have lost Rs.100 on the way.

Would you still buy the ticket?

Though both the examples appear identical from economic point of view yet people appear to "frame" the choice differently.

Interestingly most people would buy a ticket in the second case but not in the first, which shows that they treat the loss of cash differently from the loss of a ticket.

SITUATION-2 (i):

Choose between

a) A sure gain of Rs.2000
b) 25% chance to gain Rs.10, 00 and 75% chance to gain nothing

Now choose between

SITUATION-2 (ii):

a) A sure loss of Rs.7, 500
b) 75% chance to loss Rs.10, 000 and 25% chance to lose nothing

A large majority of people (even when they have been warned to avoid narrow framing) Choose A in situation 2(i) and b in situation 2(ii).

In first situation the sure thing seems most attractive whereas in second situation the sure loss is repellent and the chance to lose nothing induces a preference for taking risk.

It appears that people react differently to situations involving the prospects for large gains as opposed to large losses. That is investors are assumed to choose a riskier investment even a less risky one, exists only if the expected returns of the riskier investment is greater than that of the less risky investment.

Thus in a situation involving large expected losses, people do not seem to exhibit risk-averse behavior, which is a framing effect.

People also seem to overestimate the probability of unlikely events occurring and to under- estimate the probability of moderately likely events occurring. Popularity of lotteries best explains the statement.

So, all the above observations show the importance of cognitive psychology to study financial market. Investment decisions have both emotional and financial consequences over time. There is potential for worry and for pride, for elation and for regret and sometimes for guilt as no one likes to lose, but regret makes losing hurt more.

A financially optimal decision (the one that a fully rational investor would make) is of little use to an investor who cannot live comfortably with uncertainty.

THEORIES OF BEHAVIORAL FINANCE

There are four theories of behavioral finance. They are as follows

1- Prospect Theory
2- Regret Theory
3- Anchoring
4- Over-and-under reaction

PROSPECT THEORY

This theory says people respond differently to equivalent situations depending on
Whether it is presented in the context of a loss or a gain. Most investors are risk averse
when chasing gains but become risk lovers when trying to avoid a loss.

EXAMPLE

Mr. Gupta had started at 12.00 pm from his hotel room and on his way to airport gets blocked in a huge traffic jam. The plane was scheduled to take off at 3.00 pm. When he had been delayed for two hours, he decided to cancel his ticket, knowing that he cannot make it to the airport in time. The traffic finally got moving around 5.00pm, so he decided to collect his refund from the airport. While he was proceeding to the airport, he was feeling happy that he has saved money by canceling his ticket at the last moment and was feeling proud of his decision. However, when he reached the airport at 5.45pm,the ground staff told him that the plane has been delayed by three hours and will take off at 6.00pm.But, it is impossible for him to board it as he cannot get a ticket anymore… 

Mr. Gupta is now cursing himself for the decision he made, for which he was proud, an hour earlier.

REGRET THEORY

Regret theory is about people's emotional reaction to having made an error of judgment.

Investors may avoid selling stocks that have gone down in order to avoid the regret of having made a bad investment and the embarrassment of reporting the loss.

They may also find it easier to follow the crowd and buy a popular stock : if it subsequently goes down ,it can be rationalized as everyone else owned it.

EXAMPLE

Sales professionals typically attempt to capitalize on this behavior by offering an inferior option simply to make the primary option appear more attract.

ANCHORING

Anchoring 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

EXAMPLE

According to a survey by Wall Street journal, at the peak of the Japanese market, 14% of Japanese investors expected a crash, but after it did crash, 32% expected a crash. Many believe, defying logic, that when high percentage of participants becomes overly optimistic or pessimistic about the future it is a signal that the opposite will occur.

OVER-AND-UNDER REACTION

"The market does not reflect the available information as the professor tells us. But just as the funhouse mirrors don't always accurately reflect your weight, the markets do not always accurately reflect the information. Usually they are too pessimistic when it's bad and too optimistic when it is good". 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.

EXAMPLE- Contemporary financial situation is the best example of this theory. In the month of May, 2008 when Sensex was touching 22000 still investors were predicting that it will touch 25000 or 30000 without realizing it was the extreme situation. Investors were putting too much weight on current situation and became optimistic.

CRITICISM TO B.F.:

Behind every successful thing, there is always criticism. Behavioral Approach to financial market has many critics. Critics of behavioral finance concede that systematic errors of judgment i.e. bias do exist. Because judgments can be systematically wrong in various ways. But there is a limit to actual impact of this systematic judgment as people actively search out opportunities to exploit such behavior.

(1) Eugene F. Fama is the most cited critic of behavioral finance, who typically supports the efficient market theory.

In his writing "Market efficiency, long term returns and behavioral finance" he focused that behavioral finance is more of a collection of anomalies that are actually just enhance results and support for the anomalies tend to disappear with changes in the way they are measured.

(2) According to Goedhart, Koller and Wesels, in behavioral finance significant discrepancies between market value of investment and intrinsic value of investments are rare. They stated mispricing is an uncommon and temporary phenomenon that occurs only under very special circumstances and when those circumstances shift "rational investors will step in to drive share prices back to intrinsic value."

(3) Lo in 2005 stated "while all of us are subject to behavioral biases from time to time, traditional economic theorist argue that market forces will always act to bring prices back to rational levels, implying the impact of irrational behavior on financial market is generally negligible and therefore irrelevant".

(4) Curtis pointed out a no. of methodological limitations to behavioral finance studies that use experimental designs. These are as follows –

(i) Participants of the experiments knew that they were in an experiment and behave accordingly because of an unnatural environment of try to please (displease) the researcher.
(ii) They do not always follow the instructions.
(iii) The term "statistically significant" does not necessarily mean that an effect is significant in magnitude.
(iv) Experience and education often matter once the investors realize their biases they are likely to change and finally the experimenter's expectations of the outcome may impact how participants behave.

CONCLUSION:

The field of modern financial economics assumes that people behave with extreme rationality, but they do not. The two common mistakes investors make i.e. excessive trading and the tendency to disproportionately hold on to losing investments while selling winners have their origins in human psychology. Because the tendency for human beings to be over confident causes the first mistake and the human desire to avoid regret prompts the second. So, psychological research teaches as about the true form of preferences, allowing us to make finance more realistic within the rational choice framework. This is the reason today Behavioral finance is a rapidly growing area that deals with the influence of psychology on the behavior of financial practitioners. The above-mentioned arguments are provided for why movements towards greater psychological realism in finance will improve mainstream finance. Apart from these things this particular area also collectively predict some outcomes where the traditional models failed along with reaches, the same current predictions as the traditional models.

REFERENCES:

1. Curtis's, Gregory. (2004). Modern Portfolio Theory and Behavioral Finance. 16-22.       
2. Fama. Eugene F., October 1997. Market efficiency, long term returns and '   behavioral finance'. Journal of Finance and Economics 49(1998) 283-306.
3.  Goedhart, Marc H, Koller, Timothy M. Wessels, David. (2005). What really drives the market? MIT Sloan Review, 47(1), 21-24.
4. Lo, Andrew W. (2005). Reconciling efficient markets with behavioral Finance: The adaptive markets hypothesis. The Journal of Investment Consulting, 7(2), 21-44.
5.  Sewel Martin, May 2007, Behavioral-Finance.
6. Sharp. William F., Alexander Gordon J., Bailey Jettery V., Sixth Edition 2006, Investments.
7.  www.wikipedia.org
8.  www.persionsatwork.com/scholarly-work.
 


Ms. Shradhanjali Panda
Lecturer (Finance)
Global Institute of Management
Hanspala, Bhubaneswar-752101
 

Source: E-mail March 24, 2009

          

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