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Hailey College of Commerce, University of the Punjab, Pakistan. Naveed_hailey@yahoo.com
M. Sarfraz Khan
Hailey College of Commerce, University of the Punjab, Pakistan.
Investors in the stock market are supposed to act according to the rationalism provided by the financial theories but in reality it is not so. This papers tries to investigate the same phenomenon by looking into the decision making process of the small investors in Lahore Stock Exchange. Survey methodology was used to seek the responses of randomly selected 300 small investors trading in Lahore Stock Exchange. Simple descriptive are applied to draw the conclusion out of a total 147 valid responses. We found that the decision making process of the small investors also seem to be influenced from the behavioral finance rather the conventional financial theories. Our findings confirm the realities put forward by the prospect theory and regret aversion theory while heuristics also seem to play their role in decision making process of the small investors in Lahore.
KEYWORDS: Small Investor, Lahore Stock Exchange, Behavioral Finance. __________________________________ Corresponding author (firstname.lastname@example.org)
limits to arbitrage provides the explanation why rational investor in the market place don‟t act according to the theory so that asset prices are reset on their fundamental values while argument of investor‟s psychology rests on the behavior of „noise traders‟ term used by Kyle (1985) and Black (1986). 1974. Regret Aversion. Behavioral finance is further subdivided under the four main concepts i. Festinger. behavioral finance that provides the new models to understand the functioning of the markets in case some participants in the market are not fully rational. 1990). This irrational behavior could be. Expectation Theory. Over Confidence and Cognitive Dissonance (Sevil. limits to arbitrage and investor‟s psychology (Shleifer and Summers. behind the behavioral finance is that investors are not rational figures as they are supposed to be under traditional finance and are under some sort of influence (Rabin. 1912. . Sen and Yalama. 1988) and over reacting to the new information while avoiding base rates (Tversky and Kahneman. 1979) and ultimately the whole sentiment in the market. 2007).0 Introduction Perspective on how the financial markets function has largely been shifted from the notional assumption about the rationality of the investor and holistic explanation provided by Efficient Market Hypothesis to a new dimension i. that does not fit in the bounds of rationality which is fully justified by reliable information.e. There have been many attempts to explain the behavior and mental attitude of the people in general that may affect the decision making process of the investors in particular within the marketplace e. 1956.e.1. Riecken and Schachter. taking more risk due to being overconfident (Alpert and Raiffa. This paper tries to access and understand the behavior of the small investor within the frame work provided by behavioral finance as opposed to traditional financial theories. The main concept however. 1998). Kahneman and Tversky. Behavioral finance is based on two dimensions. using the survey methodology. Tversky and Kahneman. chasing past trends (Andreassen and Kraus. Pratt. 1982). 1964. 1982). (Selden.g.
Slovic and Lichtenstein. accuracy of their possessed knowledge (Fischhoff. Uncertainty is a common phenomenon which is encountered by almost every investor in the stock market. Good past performance may boost the future expectation of the investor there by instigating him to be overconfident and that might lead to a complete disaster as DeBondt and Thaler (1985) found that there is a tendency of past winners to face loss to become future losers and vice versa.2. a new dimension. Barber and Odean (2001) provide the gender explanation by finding that men trade as much as 45% more than women thereby reducing their yields and overconfidence was the only explanation that could be provided for this behavior of men. Moreover. Fischhoff and Phillips. 2009). that causes the investors to trade too much in the stock market (Barber and Odean. Lichtenstein. Odean. 1935). One of the explanations is overconfidence hypothesis which states that normally people have active psychological bias about their abilities. Barber and Odean (2008) also confirm that individual investors prefer to buy attention grabbing stock that is in news or that has experienced higher unexpected trading volume or stocks which have provided some excessive one day returns and that behavior also signals towards the good expectation relative to the past performance or publicity of that particular stock. Prospect theory also helps to explain the disposition effect (Barber and Odean. 1999). 1999. which is the tendency of the investors to realize the gains quickly while holding the loss yielding investments (Shefrin and . For several decades expected utility dominated as the sole explanation for the behavior of people under uncertainty but after the work of Kahneman and Tversky (1979). 1997) as opposed to traditional theories of rational decision making. 1982) and either acquired information or ability to interpret these information. 1999). Moreover. They either overestimate their abilities or underestimate other ability or difficulty of the task (Johnson and Fowler. prospect theory has been evolved that states that people actively strive to averse the loss then they are interested in gains (Kahneman and Tversky. 1979) and that explains the inclination of people to take more risks to avoid losses rather than to gain more profits (Laver.0 Literature review Much work has been done on the phenomenon to provide alternative explanations for the irrational behavior of the investors and in this regard many theories of behavioral sciences have been lent to justify this irrational behavior. 1997. So they are overconfident about their abilities (Frank.
Lastly. 2005). people are biased towards the strength of the source and this let them ignore the statistical explanations at hand. Mitchell and Volkman. availability heuristics that is the tendency of people to make decision on the basis of the relevant cases previously observed by the person. 1992). Moreover. 2003). Meanwhile. 2001. heuristics.e. later version of prospect theory also proposes a fourfold pattern with regard to attitude that people seek risk aversion for gains. In order to averse the regret the investor may also be willing to pay certain amount as guarantee for a risky portfolio (Muermann . Shapira and Venezia. may also lead towards logical and predictable error in decision making (Tversky and Kahneman. Several studies document this disposition effect (Locke and Mann. As there is also a tendency to sell the losers as well that indicate towards the findings of Apart from uncertainty people cry over spilt milk. Sen and Yalama (2007) found that in order to avoid the regret of pain people try to justify their bad investment decisions by putting responsibility on some other reference point. Kliger and Kudryavtsev (2010) confirm the prevalence of availability heuristic in the decision making process of the investors. .Statman. They experience regret when they feel that their past decisions were wrong and try to avoid the pain arising out of the poor decision (Yahyazadehfar. Odean.1985). Griffin and Tversky (1992) also found that while deciding about the future investments. Sevil. 1974). Tversky and Kahneman (1973. Wermers. Sen and Yalama (2007) also found that heuristics play a vital role in affecting the decisions made by inventors in the stock exchange. are inclined to take risks for losses with high probability and also seek risk for gain and try to averse the risk arising from losses of less probability (Tversky and Kahneman. Sevil. there rule of thumbs or simplifying strategies i. Ghayekhloo and Sadeghi). Gollier and Salanie (2006) proposed that regret may change the optimal portfolio selection of the regret sensitive investor in a way that favors the assets which have performed well particularly when the probability for such performance was low. people use to jump on decisions without processing the explanatory information available at hand.e. 2000. Wickham (2003) explains that due to representative heuristics people fall into a decision bias that encourage them to overestimate low probability events thus leading to wrong decisions especially decision relating to investment in new ventures. 1998 . 1974) also provided another type of heuristics i.
4.3 18.4% of the total respondents provided that intuition is ineffective in such a decision that response clearly affirms the propositions put forward by (Rabin.2 25. Table 4.9 16. Sen and Yalama (2007).0 Percent 8.0 Table 4.0 Valid Percent 8. which group of stock would you prefer to sell? Cumulative Frequency Percent Valid Percent Percent .2 25. 2007).0 Analysis and discussion Table 4. Results would provide the insight regarding the investor‟s behavior with regard to application of theories put forward by discipline of behavioral finance.9 16.0.3 18.0 Methodology Survey methodology was used to collect the data from the small investors of Lahore Stock Exchange.1 provides the answers to the question: what do you think is the role if institution while deciding about purchasing a stock? The results clearly indicate that investors are not rational figures as only 18.3. Sen and Yalama.4 31.3 100.3 68.2 34. Simple descriptive are used to analyze the data using software SPSS 16.4 31.2 Disposition effect: In period of uncertainty.0 50. 1998) and also in accordance with Sevil.3 100. The sample was drawn randomly and Questionnaire was partially adopted from (Sevil.7 100.1 Rationality of investors: What do you think is the role of intuition while deciding about purchasing a stock? Cumulative Frequency Valid They are little Effective They are Effective They are Very Effective They are Not Effective It depends on situation Total 12 38 24 27 46 147 Percent 8. A total of 300 questionnaires were distributed out of which 147 generated valid responses yielding a response rate of 49% which is quite satisfactory.
4 Percent 44.7 100.3 Regret: Comparison of gratification of 50% increase in stock price with regret of 50% decrease in stock price for stocks purchased by individuals Cumulative Frequency Valid Magnitude of gratification > Magnitude of regret Magnitude of Gratification < Magnitude of regret Total Missing Total System 64 Percent 43.0 49. Wermers.0 . 1998 .0 49.7 . Table 4.0 100.7 98. 1992).7 99.6 100. 1997) and of disposition effect like several other studies (Odean. it is obvious that people try to avoid regret Barber and Odean (1999).4 80 144 3 147 54.0 49.Valid The one which yielded a profit The one which yielded a loss Depend on situation Total 72 72 1 145 2 147 49. Summerville and Roese (2008). So.3 100.0 55.6 1.2 provides the reposes of the subjects with regard to disposition effect and it seem to prevail in the behavior of investors as almost 50% of the respondents provide that they would prefer to sell the winners in period of uncertainty to realize the profits and would keep the losers this confirms the propositions of prospect theory that investors also take risks to avoid losses rather apart from the risk taken to gain profits (Laver.0 100.0 Missing Total System Table 4.5 Valid Percent 44. Table 4.3 provides the same that people feel more regret from a 50% decrease of stock price than the gratification of an equal .0 2. 2003).0 People feel regret when they experience disappointment of past decisions and that regret is a stronger emotion then other negative emotions Saffrey.4 98.7 49.4 100. The fact that equal people almost 50% also show their inclination to dispose of the loss bearing investment indicates that modified version of prospect theory holds the reality that investors are inclined to take risks to averse losses with high probability and for gains as well (Tversky and Kahneman.
Table 4.5% 20 31. Table 4.0 % 9 11.4% 78 100. We try to explore the phenomenon by cross tabulating the question of comparison of regret and gratification from 50% price change and the factors that help the investor to decide about the purchase of the stock that earned a profit table 4.2% 29 45. Sen and Yalama.6% 4 5.3% 142 100.8 .3% 3 4.5 Representative heuristics: Blue Chip Fallacy The Stocks of Well Known Companies are less Risky than the Stocks of Small Companies Cumulative Frequency Valid Strongly Agree 35 Percent 23.7% 4 6.0 % People try to avoid the pain of regret by shifting the responsibility to other reference points (Sevil.9% 9 6.0 % gratification of 50% gratification > incresae in stock Magnitude of price with regret of regret 50% decrease in stock price you purchased Magnitude of Gratification < Magnitude of regret Total 17 12. That regret also explains disposition effect to a larger extent (Shiller.3% 34 43. 1999).4% 63 44.6 % of the respondents who feel regret more than gratification accepted the responsibility that the reason for the stock purchase was their own decision other pointed towards different reference points to share the responsibility of the stock purchase.4 and found that only 43.1% 5 6.4 Regret Aversion: Shifting of responsibility Most Important Factor in Making a Decision of Stock Purchase That Earned a Profit Your own Friend's Advice Row Professional Advice Row analysis and evaluation Row Suggestion made in Media Row Your intuition Row Total Row Count N % Count N % Count N % Count N % Count N % Count N % Compare Magnitude of 8 12.4% 7 4.2% 64 100. 2007).8 Valid Percent 23.5% 26 33.increase in the stock price as provided by 80 (54%) respondents.8 Percent 23.0% 46 32.
When asked about this from investors 61.4 42 147 28. told you that the price of a certain stock would rise.2 18 12.5. Table 4.2% of the total investors.0 38.6 Availability heuristics: Effect of past similar cases A friend of yours by the suggestion of whom you made a profit before. as indicated by table 4. 1973).1 Valid Percent 15.1 59.4 27.2 88.4 95.1 Percent 15.8 4.1 9 6.0 100.0 37.8 100. What would be your decision regarding purchasing that stock? Cumulative Frequency Valid I would purchase it at once I would research it first and purchase it I would consider similar cases I would consider purchasing it I would decide according to the trend in the market Total 22 56 Percent 15.0 38.2 6.2 100.8 100.0 28. Table 4. This behavior of investor is consistent with representative heuristics (Tversky andKahneman.Agree Disagree Strongly Disagree No Opinion Total 55 40 10 7 147 37. 1974).2 12.0 53.1% people provide the rational answer that they would research the stock first and then purchase it if . seem to believe that stocks of well known companies are less risky which is another indication causing the irrational behavior from the investor side and that also cause the under reaction to the news relating to such stocks primarily due to underestimation of higher probability events relying on the sole justification that the stock relates to a blue chip which is too big to fail.6 provides that only 38.0 61.6 100.4 27.8 4.0 While making a decision people consider their past experience of the similar cases that is called representative heuristic (Tversky andKahneman.1 6.6 100.2 71.0 Normally it is considered that stocks of blue chip and well known companies are less risky and due to that belief people tend to keep investing in these companies due to doctrine of too big to fail.2 6.
Financial Analysts Journal. Cambridge University Press. H. (1988).a friend advice them to purchase a stock on advice of whom you have earned a profit before. We propose that behavioral aspect of the human nature could not be avoided while providing the explanations with regard to stock market functioning and volatility as human are the participants and drives of these markets. Harvard University Mimeo. (1982). and Kraus. We confirm that explanations provided by the behavioral finance hold to the truth and investors in Lahore Stock Exchange don‟t conform to the principles of rationality while making an investment related decision. there is an indication that people act according to trend of the market as well provided by 28. Nov/Dec. Moreover. S. 41-45. We call for more research in the field so that alternative models could be devised to better access and understand the functioning of the stock market in the light of behavioral sciences as behaviors provide strong evidences with regard to how things are being done in the markets. M. and Raiffa. Moreover.. Barber. 5. Judgmental Predictions by Extrapolation. regret aversion. .6% of the response for this option this is consistent with the noise trading approach that the investor‟s reaction is largely determined by the sentiment in the market (Shleifer and Summers. and Odean. T. the realities put forward by prospect theory. Andreassen. Bibliography Alpert. A progress report on the training of probability assessors. P. The Courage of Misguided Convictions. (1999). disposition effect and heuristics seem to play their role in shaping the cognitive behavior of the investors. B.0 Conclusion This research is an attempt to access the small inventor behavior of Lahore Stock Exchange with in the bound of rationality. M. 1990).
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