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Advance Management Journal……………………………………………….Vol.

2 (6) June 2009

Nik Maheran Nik Muhammad Faculty of Business Management Universiti Technology Mara, Kelantan

Abstract Behavioral finance models often rely on a concept of individual investors who are prone to judgment and decision-making errors. This article provides a brief introduction of behavioral finance, which encompasses research that drops the traditional assumptions of expected utility maximization with rational investors in efficient markets. The article also reviews prior research and extensive evidence about how psychological biases affect investor 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 exhibit loss-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 to each other, and (8) Investors are influenced by historical high or low trading stocks. However, there are relatively lowcost measures to help investors make better choices and make the market more efficient. These involve regulations, investment education, and perhaps some efforts 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; Efficient Market Hypothesis; Investors psychology; Arbitrage; Rationality. 1.


According to economic theorists, investors think and behave “rationally” when buying and selling stocks. Specifically investors are presumed to use all available information to form “rational expectations” about the future in determining the value of companies and the general health of the economy. Consequently, stock prices should accurately reflect fundamental values and will only move up and down when there is unexpected positive or negative news, respectively. Thus, economists have concluded that financial markets are stable and efficient, stock prices follow a “random walk” and the overall economy tends toward “general equilibrium”. In reality however, according to Shiller (1999) investors do not think and behave rationally. In the contrary, driven by greed and fear, investors speculate stocks between unrealistic highs and lows. In other words, investors are misled by extremes of emotion, subjective thinking and the whims of the crowd, consistently form irrational expectation for the future performance of companies and the overall economy such that stock prices swing above and below fundamental values and follow a some what predictable, wave-like path. Investors behavior is part of academic discipline known as “behavioral finance” which explains how emotions and cognitive errors influence investors and the decisionmaking process. Behavior of the individual investors has long been the interest of academics and portfolio managers but not


Advance Management Journal……………………………………………….Vol. 2 (6) June 2009 the investors themselves since the herd mentality sometimes dominates over reasons. Human herding behavior results from impulsive mental activity in individuals responding to signals from the behavior of others (Prechter, 1999). The purpose of this article is to offer a brief survey of prior research and theory on behavioral finance and look at the behavior of the investors, their psychology and their investing style. Are they rational in their decision making or emotional and based on sentiment? The balance of the paper is organized as follows. Section 2 surveys on literature while Section 3, 4 and 5 will include implication, recommendations and conclusion. probability distribution is conformity with Bayes’ rule.




Behavioral finance is a study of the markets that draws on psychology, throwing more light on why people buy or sell the stocks and even why they do not buy stocks at all. This research on investor behavior helps to explain the various ‘market anomalies’ that challenge standard theory. This is because this anomaly is persistent. Therefore this behavior exists. Behavioral finance encompasses research that drops the traditional assumptions of expected utility maximization with rational investors in efficient market. The two building blocks of behavioral finance are cognitive psychology and the limits to arbitrage (Ritter, 2003). Cognitive refers to how people think and the limit to arbitrage when market is inefficient. There is a huge psychology literature documenting that people make systematic errors in the way they think: they always make decision easier (heuristics), overconfidence, put too much weight on recent experience (representativeness), separate decisions that should be combined (mental accounting), wrong presenting the individual matters (framing), tend to be slow to pick up the changes (conservatism), and their preferences may also create distortion when they avoid realizing paper losses and seek to realize paper gains (disposition effect). Behavioral finance uses models in which some agents are not fully rational, either because of preferences or because of mistaken beliefs. An example of an assumption about preferences is that people is loss averse. Mistaken beliefs arise because people are bad Bayesians. Much of the basic theories of behavioral finance concern with a series of new concept under the general heading of ‘bounded rationality,’ a term associated with Herbert Simon (1947, 1983). It relates to cognitive



The proposition that has dominated finance for over 30 years is efficient market hypothesis (EMH). There are three basic theoretical arguments that form the basis of the EMH. The first and most significant is that investors are rational and by implication securities are valued rationally. Second is based on the idea that everyone takes careful account of all available information before making investment decisions. It is related to internal consistency. Each decision has to be made in a systematic way such that it is in agreement with one another whatever the subject is. The third principle is that the decision maker always pursues self-interest. Most widely applied in finance is the expected utility model of choice under risk, proposed by Von Neumann and Morgenstern (1947) in DeBondt (1998). Its rationality is based on axioms underlying expected utility maximization as the optimal rule. The accumulation and processing of information and the formation of expectations occur efficiently, yielding possible outcomes (of total wealth) and corresponding possibilities. In the case of new information, the


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 heuristics (Tversky and Kahneman, 1974). This is consistent with the study done by Slovic (1972) on investment risk-taking behavior. He found that, man has limitations as a processor of information and shows some judgmental biases which lead people to overweight information. People also tend to be overreact to information (De Bondt and Thaler, 1985, 1987). Shiller (1999) surveys some of the key ideas in behavioral finance, including Prospect theory, Regret theory, Anchoring, and Overand under-reaction. Prospect theory introduced by Khaneman and Tvernsky (1979, 1981, 1986) suggests that people respond differently to equivalent situations depending on whether it is presented in the context of a loss or a gain. Investors typically become distressed at the prospect of losses and are pleased by possible gains: even faced with sure gain, most investors are risk-averse but faced with sure loss, they become risk-takers. Thus, according to Khaneman, investors are “loss aversion”. This “loss aversion” means that people are willing to take more risks to avoid losses than to realize gains. Loss aversion describes the basic concept that, although the average investors carry an optimism bias toward their forecasts (“this stock is sure to go up”), they are less willing to lose money than they are to gain. “Regret theory” (Larrick, Boles, 1995) is another theory that deals with people’s emotional reaction to having made an error of judgment. For example, investors may avoid selling stocks that have decreased in value to avoid the regret of having made a bad investment or embarrassment of reporting a loss. The embarrassment may also contribute to the tendency not to sell losing investments. Some researchers theorize that investors follow the crowd and conventional wisdom to avoid the possibility of feeling regret in the event that their decisions prove to be incorrect. Many investors find it easier to buy a popular stock and rationalize it going down since everyone else owned it and thought so highly of it. Buying a stock with a bad image is harder to rationalize if it goes down. Anchoring (Yates, 1990) is a phenomenon in which in the absence of better information, investors assume current prices are about right. In a bull market, for example, each new high is ‘anchored’ by its closeness to the last record, and more distant history increasingly becomes an irrelevance. People tend to give too much weight to recent experience, extrapolating recent trends that are often at odds with long-run averages and probabilities. Market over-or under-reaction (DeBondt and Thaler, 1985) is the consequence of investors putting too much weight on recent news at the expense of other data. 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 environment. Most investors think they can beat the market although evidence is overwhelming that they cannot. Based on the study done by Kahneman and Odeon (1999) on the behavior of buying and selling stock, they found that when an investor sells a stock and immediately buys another, the stock that is sold does better in the following year, by 3.4% on average. They also pointed out that people are prone to “cognitive illusions”, like becoming rich and famous or being able to get out of the market before a bubble breaks. People exaggerate the element of skill and deny the role of chance in their decision making process. People are often unaware of the risk they take. Add loss aversion to the mix and it is no wonder the average investor panics in a market downturn, a time perhaps to buy rather than sell.

It has long been recognized that a source of judgment and decision biases, such as time,


Advance Management Journal……………………………………………….Vol. 2 (6) June 2009 memory, and attention are limited, human information processing capacity is finite. Therefore, there is a need for imperfect decision-making procedures, or heuristics (Simon, 1955, Tversky and Kahneman, 1974). Hirshleifer (2001) argues that many or most familiar psychological biases can be viewed as outgrowths of heuristic simplification, self-deception, and emotionbased judgments. Study done by Kent, Hirshleifer and Subrahmanyan (2001) found the evidence for systematic cognitive errors made by investors and these biases affect prices. According to Kent, et al. (2001), 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 exhibit loss-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 to each other, and (8) Investors are influenced by historical high or low trading stocks. Investors often do not participate in all asset and security categories According to Kent et al. (2001), investors tend to focus only in stocks that are ‘on their radar screens’. That is related to familiarity or ‘mere exposure’ effects, e.g, a perception that what is familiar is more attractive and less risky. According to Kent et al., their findings were consistent with Blume and Friend, (1975) on the study of participation of U.S stock market, where they found that many investors entirely neglect major asset classes (such as commodities, stocks, bonds, real estate), and omit many individuals securities within each classes. The same situation occurred for ‘Kelantanese’ investors where they are strongly biased in choosing stocks and choose only stocks that are highly popular (Nik Maheran et. al., 2003). Individual investors exhibit lossaverse behavior Kent et al. (2001) also noted that the stocks that investors choose to sell subsequently outperform the stocks that investors retain. According to them, home sellers also appear to be loss-averse in the way that they set prices. They are reluctant to sell at a loss relative to past purchase price. This helps to explain the strong positive correlation of volume with price movement. This finding was consistent with the theory of Odean (1998) who showed that individual investors are more likely to sell their winners than their losses. Tversky and Kahneman, (1991) also noted that these psychological effects explain the disposition effect, as confirmed by several studies of behavior in field and experimental markets, that is investors are more prone to realizing gains than losses. Investors use past performance as an indicator of future performance in stock purchase decisions. Investors frequently based their decisions on historical performance of stock prices using so call ‘technical analysis’. This relates to a tendency to judge likelihood based upon naive comparison of characteristics of the event being predicted with characteristics of the observed sample (Representativeness). This suggests that investors will sometimes extrapolate past price trends naively. Investors trade too aggressively Kent et al. (2001) found that investors are overconfident in their decision making process. Consistent with overconfidence, traders in experimental markets do not place enough weight on the information and action of others and they also tend to overreact more to unreliable than to reliable information. Stronger support for overconfidence is provided by evidence suggesting that more active investors earn


Advance Management Journal……………………………………………….Vol. 2 (6) June 2009 lower returns as a result of incurring higher transaction costs (e.g., DeBondt and Thaler, 1995). Odean (1999) noted that males trade more aggressively than females, incur higher transaction costs, and consequently earn lower (post-transaction) returns. According to Kent et al. (2001), Barber and Odean (1999) find that investors who have experienced the greatest past success in trading will trade the most in the future. This evidence is consistent with selfattribution bias, meaning that the investors have likely attributed their past success to skill rather than to luck. Investors behave on status quo Kent et al. (2001) found that investors gave limited attention and processing power to their decision-making. This is due to their status quo since they interpreted that the status quo option is an implicit recommendation. Therefore according to Kent et al., their findings were consistent with Madrian and Shea (2000) where they found that investors are subject to status quo bias and tend to stick to their prior decisions in their investment decisions. Investors do not efficient portfolios always form stock analysts (Welch, 2000), and in investment newsletter (Graham, 1999). According to Kent et al. (2002), people tend to behave parallel with each other, regardless of whether the decisions are smart or not. Investors are influenced by historical high or low trading stocks. According to Kent et al. (2001), investors were very much influenced by historical performance of the stock price. These findings were consistent with Daniel, Hirshleifer, Teoh (2002) where they suggest that investors may form theories of how the market works based upon irrelevant historical values, somewhat analogous to making decisions based upon mental accounting with respect to arbitrary reference points. This also relates to the idea of anchoring suggested by Tvernsky and Karneman (1974) where investors set an initial value for future prices.




More generally, Kent et al.(2001) found the evidence that investors sometimes fail to form efficient portfolios. Several experimental studies examined portfolio allocation when two risky assets and a riskfree asset and returns are distributed normally. People often invest in inefficient portfolios that violate two-fund separation. Investors behavior is parallel to each other This phenomenon, called herding, is consistent with rational responses to new information, agency problems or conformity bias. Herding behavior has been documented in the trading decisions of institutional investors, in recommendation decisions of

Since a generation ago, stock market analysts have come to recognize that psychological factors can play a more crucial role in determining the direction of the share prices. However studies have found that psychological factors alone cannot send the share price to the “moon” and then push them down to the “Precipice”. Economic factors, as well as political factors also play a crucial role in determining the share price. Kahneman (1974) pointed out that people are prone to “cognitive illusions”, like becoming rich and famous or being able to get out of the market before a bubble breaks. People exaggerate the element of skill and deny the role of chance in their decision


Advance Management Journal……………………………………………….Vol. 2 (6) June 2009 making process. People are often unaware of the risk they take. Add loss aversion to the mix and it is no wonder the average investor panics in a market downturn, a time perhaps to buy rather than sell. According to him, human beings are born optimists. This is precisely the reason why the casino is crowded twenty-four hours a day with luck-seekers. It is the optimistic human nature that tempts investors to buy stocks and shares when their market prices have reached historic high. At this euphoric market condition, investors should be selling their stock and shares. Kent, Hirshleifer and Siew (2002), in their study found that research on the psychology of investors was done by looking at the relationship between stock returns and variables on factors such as the weather (Hirshleifer and Shumway, 2001), biorhythms (Samstra, Kramer and Levi, 2001) and societal happiness (Boyle and Walter, 2001). These diverse investigations are motivated by emerging theories in psychological economics on visceral factors and the ‘risk-as-feeling” perspective. Visceral factors are the wide range of emotions, moods and drive states that people experience at the time of making decision. The “risk-as-feeling” perspective argued that these visceral factors could affect, and even override, rational cogitations on decisions involving risk and uncertainty. This creates predictable patterns in stock returns because people in good moods tend to be more optimistic in their estimates and judgments than people in bad moods (Wright and Bower, 1992, in Kent et al, 2002). In relation to stock pricing, the optimistic or pessimistic judgment about the future prospects from the business direction are widespread, stock prices should be predictably higher at times when most investors are in good moods than times they are in neutral or bad moods. It was found that weather variables affect an individual’s emotional state or mood, which creates a predisposition to engage in particular behavior. It is also found that people have mood variations based on the seasonal variations in the hours of sunlight in the day; the so-called Seasonal Affective Disorder (SAD) (Rosenthal, 1991 in Kamstra, Kramer, and Levi, 2001). Kent et al. (2002) in the study of investors psychology also found that it is particularly important to note that the fast movement of prices of the stocks and shares in the stock market is largely due to the investors’ perceptions such as (i) investors’ perceptions of the stochastic process of asset prices; (ii) investors perceptions of value; (iii) investors perception on the management of risk and return; and (iv) investors trading practices. Perceptions of price movements In the equity markets, investors have tried to spot trends and turning points in stock prices. It is the ‘art of technical analysis, a model used to identify trend changes at an early stage and to maintain an investment posture until the weight of the evidence indicates that the trend has reversed. Investors’ sentiment is found to depend on market performance during the last 100 trading days, possibly much longer. The evidence overwhelmingly shows that people’s subjective probability distributions are too tight, particularly, for difficult tasks like predicting stock prices. Tversky and Kahneman (1974) suggest that the overconfidence results from forecasters anchoring too much on their most likely prediction. Moreover, according to De Bondt (1993), past price level is their anchor and representativeness. Perceptions of Value Perceptions of value depend on mental frames that are socially shared through stories in the news, media, conversation, and tips from friends or financial advisors (Shiller, 1990). Many people cannot distinguish good stocks from good companies. Thus, companies that appear on the cover of major business magazines are


Advance Management Journal……………………………………………….Vol. 2 (6) June 2009 seen as excellent investments while companies that report losses seem inherently unattractive. On average, highly reputed companies seem overpriced. According to De Bondt (1998), the underlying problem is that too many people are short-term orientated and ‘judge a book by its cover’. Therefore, their valuation always leads to mispricing. Managing risk and return Studies found that small individual investors avoid the danger of risk by keeping hefty portion of their financial wealth in risk-less assets even though equity shares offer more impressive long-run return. This is usually related to risk aversed individuals. However, it is commonly believed that ‘aggressive investors’ ought to hold a higher ratio of stocks. Trading practices Many investors have a psychological disposition to realize gains on past winner stocks early and an aversion to realize losses. Traders use a variety of rules and commitment techniques to control emotion. Many individuals trade shares on impulse or on random tips from acquaintances, without prior planning. One reason is that people are unjustifiably optimistic about almost everything that concerns with their personal life (Weinstein, 1990 in Kent et al., 2002). Another problem, mentioned earlier, is that trader sentiment trails the market. As a result, investors are inclined to buy shares in bull markets and sell shares in bear markets. Finally, reference points play a major role in trading behavior. They are performance benchmarks. The original purchase price can be their salient reference point. . 2.2.3 INVESTING STYLE From the observation of Kelantanese investors, Nik Maheran et al. (2003) found that most of them usually make their first purchase based on the recommendation of a relative or friend. This first trade is usually for a small amount of shares. If it is successful, the person typically follows the friend’s or relative’s next recommendation and buys more share than the first time. Eventually this cycle comes to an abrupt end when the person losses a substantial portion, if not all, of the money invested. This finding is consistent with the previous research showing that a rational, long-term investment plan is often undermined by the desire for quick profits. Indeed, investing in shares is usually less exciting than speculating them. For the average investor, a long-term view will usually involve less anxiety and less need to follow the investment daily. Peterson (1999) pointed out that the behavior of the investors when making investment decision is “Buy on the rumor and sell on the news” (BRSN). According to the EMH theory, investors quickly price security-relevant news. For the BRSN pattern to represent price inefficiency, news about the positive future event must have a delayed impact on investing behavior. News about future events is often more rapidly disseminated and widely publicized as the events approach in time. Hameed and Ting (2000) found from the evidence of Malaysian market that the returns from a “contrarian portfolio” strategy are positively related to the level of trading activity in the Malaysian securities which involves buying and selling stocks when they become relatively under and over valued.

Based on the descriptive analysis of investment decision making behavior, it shows that economic factor is the most influential factor in determining their investment buying behavior followed by financial and frame of references.


Advance Management Journal……………………………………………….Vol. 2 (6) June 2009 However, in terms of relying on emotions (i.e. gut-feeling, over-reaction), most respondents rate that they are unlikely in doing so. Table2: Behavioral profile N=147 Std. Variables Mean Deviation Rational Behavior Environment 3.00 .847 Financial 3.69 .942 Economy 3.80 .628 Irrational Behavior Emotion 2.95 1.057 Frame of 3.1850 .76143 references help the investors to avoid many investors’ common behavioral mistakes. Many people do not begin investing by setting goals and do not put enough emphasis on their specific time horizon. Many people buy stocks or fund because it did well in the past, rather than studying what it may do in the future. Investors often do not focus enough on diversifying their portfolios. According to Charles Heath, President of Roller Coaster Stocks, there are four rules before investing in stock market. (1) do not invest with the crowd, (2) get emotional out of the way, (3) be patient, and (4) take profit – do not give them back. Researches have shown that many investors are overconfident. The majority of investors believe they can beat the market, despite historical evidence to the contrary. One reason that investors may feel overconfident is that the Internet provides quick access to information and leaves people feeling empowered to make decisions. However, information does not lead to good decisionmaking, unless we know how to interpret it. Investor credulity and systematic mispricing in general suggest a possible role for regulation to protect ignorant investors, and to improve risk sharing. The potential benefits of government policy and regulations can help investors make better decisions, and can improve the efficiency of the market prices. Investors’ education, standardization of mutual fund advertising, disclosure rules and reporting rules in making financial reports consistent and easy to process, may be helpful for investors to make decision and also limit their freedom of action.



Why does it matter if small individual investors do not behave as we think they should? There are two reasons according to De Bondt (1998). The first is that substantial financial management directly affects people’s well-being and the second reason is that investor behavior is likely to affect what happens in markets. With costly arbitrage, psychological factors become relevant and it would be unsound to model market behavior based on the assumption of common knowledge of rationality. As stated by Graham and Dodd, in De Bondt (1998), ‘ – the (stock) market is not a weighing machine, on which the value of each issue is recorded by an extent and impersonal mechanism – rather – the market is a voting machine, where countless individuals register choices which are the product partly of reason and partly of emotion’.



With these financial theories in mind, here are some investment tips and tools that can

From prior research, it is found that there is persuasive evidence that investors make major systematic errors and there is evidence that psychological biases affect market prices substantially. Furthermore, there are some indications that as a result of


Advance Management Journal……………………………………………….Vol. 2 (6) June 2009 mispricing, there is substantial misallocation of resources in the economy. Thus, there are some suggestions to the economists to study how regulatory and legal policies can limit the damage caused by imperfect rationality. Emotions and psychological biases in judgment and decision seem to have important effects on public discourse and the political process, leading to mass dilutions and excessive focus on transiently popular issues. If individuals were fully rational in their market and political judgments, therefore, government can intervene to remedy informational externalities in capital markets. The case against such intervention comes from the tendency for people in groups to fool themselves in political sphere, and for pressure groups to exploit the imperfect rationality or political participants. However, it is a suggestion to help investors make better choices and make the market more efficient. These involve regulations, investment education, and perhaps some efforts to standardize mutual fund advertising. Limits on how securities are marketed and laws against market manipulation through rumor spreading can also protect foolish investors and restrict the freedom of action of those that may prey upon them. References Chan, K. C. (1988), On the Contrarians investment strategy. Journal of Business, 61, 147-163. Bazerman, M. (1984) The Relevance of Kahneman and Tversky’s Concept of Framing to Organization Behavior. Journal of Management, 10, 333-343 DeBondt F.M. W. and Thaler H.R. (1985), Does the stock market overreact?, The Journal of Finance, Vol. XI no. 3, 793-807. Kent D., Hirshleifer., and Siew Hong Teoh. (2001). Investor psychology in capital markets: evidence and policy implications, Journal of Monetary Economics, 49(1), 139-209. Kent, D., Hirshleifer, D. and Subrahmanyam, A., (2001). Overconfidence, Arbitrage, and Equilibrium asset pricing. Journal of Finance 56,. 921-965 De Bondth Werner F.M., (1991), What do economists know about the stock market? Journal of Portfolio Management 18, 84-91 De Bondth Werner F.M., (1993), Betting on trends: Intuitive forecasts of financial risk and return. International Journal of Forecasting 9, 355-371 De Bondth Werner F.M., (1991), Behavioral Economics; a portrait of individual investors. European Economic Review 42, 831-844. Herbert A Simon (2001); Rational Decision Making in Business Organizations Hirshleifer, D., (2001). Investor Psychology and Asset Pricing. Journal of Finance, 56, 1533-1597 Kamstra, M. J., Kramer, L. A. and Levi, M. D., (2000). Losing sleep at the market; the daylight savings anomaly. American Economic Review 90, 10051011. Kenney, Derrick, (2003). Investor psychology plays key role in market plays, forth worth, Business Press, December, 5-11.

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