Advance Management Journal……………………………………………….Vol. 2 (6) June 2009
limitations on decision-making. As a result,human behavior is made on the basis of simplified procedures or
(Tverskyand Kahneman, 1974). This is consistentwith the study done by Slovic (1972) oninvestment risk-taking behavior. He foundthat, man has limitations as a processor of information and shows some judgmentalbiases which lead people to overweightinformation. People also tend to beoverreact to information (De Bondt andThaler, 1985, 1987).Shiller (1999) surveys some of the key ideasin behavioral finance, including Prospecttheory, Regret theory, Anchoring, and Over-and under-reaction.
introduced by Khaneman and Tvernsky(1979, 1981, 1986) suggests that peoplerespond differently to equivalent situationsdepending on whether it is presented in thecontext of a loss or a gain. Investorstypically become distressed at the prospectof losses and are pleased by possible gains:even faced with sure gain, most investors arerisk-averse but faced with sure loss, theybecome risk-takers. Thus, according toKhaneman, investors are “
”.This “loss aversion” means that people arewilling to take more risks to avoid lossesthan to realize gains. Loss aversiondescribes the basic concept that, althoughthe average investors carry an optimism biastoward their forecasts (“this stock is sure togo up”), they are less willing to lose moneythan they are to gain.“
” (Larrick, Boles, 1995) isanother theory that deals with people’semotional reaction to having made an errorof judgment. For example, investors mayavoid selling stocks that have decreased invalue to avoid the regret of having made abad investment or embarrassment of reporting a loss. The embarrassment mayalso contribute to the tendency not to selllosing investments. Some researcherstheorize that investors follow the crowd andconventional wisdom to avoid the possibilityof feeling regret in the event that theirdecisions prove to be incorrect. Manyinvestors find it easier to buy a popular stock and rationalize it going down since everyoneelse owned it and thought so highly of it.Buying a stock with a bad image is harder torationalize if it goes down.
(Yates, 1990) is a phenomenon inwhich in the absence of better information,investors assume current prices are aboutright. In a bull market, for example, eachnew high is ‘anchored’ by its closeness tothe last record, and more distant historyincreasingly becomes an irrelevance. Peopletend to give too much weight to recentexperience, extrapolating recent trends thatare often at odds with long-run averages andprobabilities.
Market over-or under-reaction
(DeBondtand Thaler, 1985) is the consequence of investors putting too much weight on recentnews at the expense of other data. Peopleshow overconfidence. They tend to becomemore optimistic when the market goes upand more pessimistic when the market goesdown. Hence, prices fall too much on badenvironment. Most investors think they canbeat the market although evidence isoverwhelming that they cannot. Based onthe study done by Kahneman and Odeon(1999) on the behavior of buying and sellingstock, they found that when an investorsells a stock and immediately buys another,the stock that is sold does better in thefollowing year, by 3.4% on average. Theyalso pointed out that people are prone to“cognitive illusions”, like becoming rich andfamous or being able to get out of themarket before a bubble breaks. Peopleexaggerate the element of skill and deny therole of chance in their decision makingprocess. People are often unaware of therisk they take. Add loss aversion to the mixand it is no wonder the average investorpanics in a market downturn, a time perhapsto buy rather than sell.
2.2.1 THE BEHAVIOR OF INVESTORS
It has long been recognized that a source of judgment and decision biases, such as time,