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Behavioral Finance

Behavioral Finance

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Published by Sagheer Muhammad
Finance
Finance

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Published by: Sagheer Muhammad on Apr 30, 2013
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Advance Management Journal……………………………………………….Vol. 2 (6) June 2009
1
BEHAVIORAL FINANCE vs TRADITIONAL FINANCE
Nik Maheran Nik MuhammadFaculty of Business ManagementUniversiti Technology Mara, Kelantannmaheran@gmail.com 
Abstract
 Behavioral finance models often rely on a concept of individual investors who are prone to judgment and decision-makingerrors. This article provides a brief introduction of behavioral finance, whichencompasses research that drops the traditional assumptions of expected utility maximization with rational investors inefficient markets. The article also reviews prior research and extensive evidence about how psychological biases affectinvestor behavior and prices. The paper found that the most common behavior that most investors do when making investment decision are (1) Investors often do not participate in all asset and security categories, (2) Individual investors exhibitloss-averse behavior, (3) Investors use past performance as an indicator of future performance in stock purchase decisions,(4) Investors trade too aggressively, (5) Investors behave on status quo, (6) Investors do not always form efficient portfolios, (7) Investors behave parallel toeach other, and (8) Investors areinfluenced by historical high or low trading stocks. However, there are relatively low- cost measures to help investors make better choices and make the market moreefficient. These involve regulations,investment education, and perhaps someefforts to standardize mutual fund  advertising. Moreover, a case can be made for regulations to protect foolish investors by restricting their freedom of action of  those that may prey upon them.
Keywords
: Behavioral finance; EfficientMarket Hypothesis; Investors psychology;Arbitrage; Rationality.1.
INTRODUCTION
 According to
economic theorists
, investorsthink and behave “rationally” when buyingand selling stocks. Specifically investors arepresumed to use all available information toform “rational expectations” about the futurein determining the value of companies andthe general health of the economy.Consequently, stock prices shouldaccurately reflect fundamental values andwill only move up and down when there isunexpected positive or negative news,respectively. Thus, economists haveconcluded that financial markets are stableand efficient, stock prices follow a “randomwalk” and the overall economy tends toward“general equilibrium”.In reality however, according to Shiller(1999) investors do not think and behaverationally. In the contrary, driven by greedand fear, investors speculate stocks betweenunrealistic highs and lows. In other words,investors are misled by extremes of emotion,subjective thinking and the whims of thecrowd, consistently form irrationalexpectation for the future performance of companies and the overall economy suchthat stock prices swing above and belowfundamental values and follow a some whatpredictable, wave-like path.Investors behavior is part of academicdiscipline known as “behavioral finance”which explains how emotions and cognitiveerrors influence investors and the decision-making process. Behavior of the individualinvestors has long been the interest of academics and portfolio managers but not
 
Advance Management Journal……………………………………………….Vol. 2 (6) June 2009
2
the investors themselves since the herdmentality sometimes dominates overreasons. Human herding behavior resultsfrom impulsive mental activity inindividuals responding to signals from thebehavior of others (Prechter, 1999).The purpose of this article is to offer a brief survey of prior research and theory onbehavioral finance and look at the behaviorof the investors, their psychology and theirinvesting style. Are they rational in theirdecision making or emotional and based onsentiment? The balance of the paper isorganized as follows. Section 2 surveys onliterature while Section 3, 4 and 5 willinclude implication, recommendations andconclusion.
2. LITERATURE REVIEW
2.1 TRADITIONAL FINANCE
The proposition that has dominated financefor over 30 years is efficient markethypothesis (EMH). There are three basictheoretical arguments that form the basis of the EMH. The first and most significant isthat investors are rational and by implicationsecurities are valued rationally. Second isbased on the idea that everyone takes carefulaccount of all available information beforemaking investment decisions. It is relatedto internal consistency. Each decision has tobe made in a systematic way such that it isin agreement with one another whatever thesubject is.The third principle is that the decision makeralways pursues self-interest. Most widelyapplied in finance is the expected utilitymodel of choice under risk, proposed byVon Neumann and Morgenstern (1947) inDeBondt (1998). Its rationality is based onaxioms underlying expected utilitymaximization as the optimal rule. Theaccumulation and processing of informationand the formation of expectations occurefficiently, yielding possible outcomes (of total wealth) and corresponding possibilities.In the case of new information, theprobability distribution is adjusted inconformity with Bayes’ rule.
2.2 BEHAVIORAL FINANCE
Behavioral finance is a study of the marketsthat draws on psychology, throwing morelight on why people buy or sell the stocksand even why they do not buy stocks at all.This research on investor behavior helps toexplain the various ‘market anomalies’ thatchallenge standard theory. This is becausethis anomaly is persistent. Therefore thisbehavior exists.Behavioral finance encompasses researchthat drops the traditional assumptions of expected utility maximization with rationalinvestors in efficient market. The twobuilding blocks of behavioral finance are
cognitive psychology
and the
limits toarbitrage
(Ritter, 2003). Cognitive refers tohow people think and the limit to arbitragewhen market is inefficient.There is a huge psychology literaturedocumenting that people make systematicerrors in the way they think: they alwaysmake decision easier (heuristics),overconfidence, put too much weight onrecent experience (representativeness),separate decisions that should be combined(mental accounting), wrong presenting theindividual matters (framing), tend to be slowto pick up the changes (conservatism), andtheir preferences may also create distortionwhen they avoid realizing paper losses andseek to realize paper gains (dispositioneffect). Behavioral finance uses models inwhich some agents are not fully rational,either because of preferences or because of mistaken beliefs. An example of anassumption about preferences is that peopleis
loss averse
. Mistaken beliefs arisebecause people are bad Bayesians.Much of the basic theories of behavioralfinance concern with a series of new conceptunder the general heading of ‘
bounded rationality
,’ a term associated with HerbertSimon (1947, 1983). It relates to cognitive
 
Advance Management Journal……………………………………………….Vol. 2 (6) June 2009
3
limitations on decision-making. As a result,human behavior is made on the basis of simplified procedures or
heuristics
(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.
Prospect theory
 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 “
loss aversion
”.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.
 Regret theory
” (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.
 Anchoring
(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,

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