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Submitted by:
Ayesha Jamil Afrid 10-0922 Bs(af)

Assumptions of exhibition of classical behavioral finance theories by investors of Islamabad stock exchange: a literature research
Abstract This literature research paper begins by giving a brief background on the theories of conventional finance that gave birth to behavioural finance. Behavioural finance stands to try to explain the illogical behaviour of investors and the market anomalies that the modern finance theories could not explain. The paper focuses on three classical behavioural finance theories namely herding behaviour, gamblers fallacy and overconfidence bias and reviews relevant literature regarding the findings of impact of these theories in the Pakistani stock market and in the Asian stock market. more importantly the paper focus on finding the evidence of these theories in Pakistani stock markets other than Islamabad stock market namely Karachi stock exchange and Lahore stock exchange. after concluding the relevant literature gathered about Pakistani and Asian stock markets, the paper gives the notion that if these 3 theories are evident in the investor behaviour of Asian stock markets and also in lse and kse than it can be assume that the these three behavioural finance theories are also evident in investor behaviour of Islamabad stock exchange. Key words: Behavioral finance, gamblers fallacy, overconfidence bias, herding theory, Islamabad stock exchange, Lahore stock exchange, asian stock market Introduction The concept behind behavioral finance evolved after certain theories related to stock market where rejected first we will see what those theories were Random walk theory In 1973,burton malkiel wrote in his book about the random walk theory which stated that the past performance of a stock or overall market performance cannot be used to predict its future movements .originally Maurice kendall in 1953 examined this behavior of the stock market and concluded that stock price fluctuations does not dependent on each other and have the same probability distribution but generally prices exhibit and upward trend in essence, random walk states that stocks behave randomly and unpredictably. The chance of stock price going up in the future is same as its chance of going down. Random walk theory dismisses the notion that of an investor outperforming the market and not even technical and fundamental analysis will work Efficient market hypothesis Eugene fama gave the idea of efficient market hypothesis (EMH) in the 1960s.the efficient market theory stated that prices changes of securities are random and unpredictable and further states that it is not possible to outperform the market because the prices are already adjusted for all the relevant information so searching for mispriced securities as in fundamental analysis or predict patterns in the market based on past performance as in technical analysis is a waste of time. The efficient market hypothesis states that buying and selling of securities involves chance not skill and if as market is efficient and current it means that all securities prices are already adjusted for all the recent information and there is no way you would be able to buy a security that is under or over priced. Prices of securities only rise or fall in response to new information and that too which is unpredictable .if information is predictable than it would mean it is already adjusted for in the stock price

EMH has 3 versions depending on the notion all available information Weak form: The weak form of the efficient market hypothesis says that stock prices already reflect all information that can be taken from examining all market data,such as price history ,trading volume or short interest.this form of theory asserts that trend analysis is a waste of time and would not help predict the future prices because if by examining past trends one could predict the future prices,all investors would be doing it and earning abnormal gains as trading data is publicly available to all.thus the subtle signals of price increase or decrease would be widely known and there would be no opportunities for an abnormal gain Semi strong form: This form claims that stock prices in addition to reflecting all past information, reflects all information that is available to public about the firm as well such as fundamental data on the firms product line, quality of management, balance sheet composition, patents held, earning forecasts, and accounting practices. Strong form: Lastly the strong form versions of the EMH declares that stock price reflect all past data, all public information about the firm and also all the information that is available only to company insiders. This is the extreme form of efficient market hypothesis. The emergence of behavioural finance: for sometime, theoretical and empirical proof suggested that CAPM and EMH and other rational stock market theories were actually accurate in predicting and explaining certain events. However with increasing time, economic and financial academic began to find anomalies and behaviours that couldnt be explained by the rational theories of that time. Although these theories could explain certain ideal events it could not justify the irrational behaviour of investors who sometimes behaved as opposed to the wealth maximizing assumption provided by conventional economics and finance. the wealth maximizing assumption asserts that people seek to increase their own well being but it didnt confirm the behaviour of people in the real world. for example people spending countless dollars on lottery tickets when the chances of winning are so less. these irregularity forced academics to look into cognitive psychology to try to explain this illogical behaviour that modern finance theories couldnt explain and hence behavioural finance emerged. Daniel Kahneman and Amos Tversky are considered the fathers of behavioral finance and focused much of their work on cognitive biases and heuristics (i.e. approaches to problem solving) that cause people to engage in unanticipated irrational behavior. Their most popular and notable works include writings about prospect theory and loss aversion Our 3 theories a) Herding behavior b) Overconfidence bias c) Gamblers fallacy Herding theory Herd behavior explains the behavior of individuals in a group i.e. how they behave or act together without any specified direction it also further explains the tendency for individuals to mimic the actions (rational or irrational)

of a larger group. Individually, however, most people would not necessarily make the same choice. There are two major reasons why herd behavior happens Social pressure Assumption that majority of people cannot be wrong

Social pressure Most of the people are very social and because of this they wish to be accepted by a group, rather than be branded as an outcast. Therefore, for them doing what others are doing is the best way of becoming a member of their group. Majority cannot be wrong Herd behavior tends to exists because of the reason that most of the people think that it's impossible that a large group could be wrong. Suppose if you are certain that a particular idea or track or action is irrational or inaccurate, you may still follow the herd, believing that they know something that you don't. This frequently happens in situations in which a person has very slight familiarity. Exhibition of herd behavior Herd behavior was shown by people in the late 1990s when venture capitalists and private investors started investing large amounts of money into internet-related companies, even though at that time most of these dotcoms did not have financially good models for businesses The motivating force behind that which was compelling investors to invest their money into such an vague undertaking was the reassurance they got from seeing so many others doing the same thing. Herd behavior in financial markets It decreases the stability and efficiency of financial markets .When prices adjust to order flow there is less chance that herding will takes place but if there is no mechanism for price to flow then it becomes likely that herding would takes place .There is some probability for herding to takes place even when there is a mechanism for price because of uncertainty in the markets. Herd way of thinking can also influence financial professionals. The purpose of a money manager is to pursue an investment strategy that maximizes wealth which has been invested. The problem lies in the amount of scrutiny that money managers receive from their clients whenever a new investment fashion pops up its attractive for a money manager to follow the herd of investment professionals. After all, if he succeeds his clients would be happy and if he is unable to do that he can justify his poor decision by mentioning that others are also the same way.

Herd behavior --- Not a very profitable investment strategy. Just because of the reason that a majority of people or a group of people are following a particular trend it is not necessary that it would be right and profitable so its good for investor and as well as money managers to do their homework before following any trend and check that whether the investment is profitable or not .Remember,

specified investments favored by the herd can easily become overvalued because the investment's high values are usually based on hopefulness and not on the underlying fundamentals .

Herding behavior in Indian mutual fund industry A research paper was published in June, 2012 in India revealing the herd behavior in Indian mutual fund industry and to find out whether the mutual fund managers in India adopts herding behavior or not .The study found strong evidence of herding in overall market of mutual funds. Managers herd when they had to trade in large capitalization stocks and stocks that belong to the most famous indices. The herding effect affects purchases as well as sales of stocks. The percentage of herding is high in Indian stock market as compared to mature markets. The Indian mutual funds tend to herd more often when purchasing than when selling a stock, and when trading large stocks.

Herding behavior of institutional investors in Taiwan stock market A research was done in Taiwan stock market to see that institutional investors in Taiwan exhibit herd behavior or not .Three major institutional investors in Taiwans stock market are foreign institutional investors, domestic mutualfunds investors, domestic securities dealers The results of the study showed that institutional investors would follow their own trades as well as the institutional trade .The domestic mutual-funds investors show the strongest capability to herd. The foreign institutional investors also have an obvious tendency to herd but there was little evidence that domestic securities dealers exhibit herding behavior. The institutional herding in Taiwans stock market is not determined primarily by emotion or impulse rather the investors are momentum traders .in addition to that the study also showed that the herding has a negative relation with firm size herding increases as firms size decreases and vice versa the herding in Taiwans stock market is motivated by informational cascades. Investor herding in Chinese stock market The research done by Chuanchan Ma* Juan Yao* finds that due to information asymmetry investors show different herding behavior in different markets .herding in china primarily existed in B share markets only ( two kinds of markets A share markets and B share markets ) The herding behavior has strong tendency at industry level and more prevalent or growth stocks relative to value stocks. The study also revealed that during market decline the tendency of herding is stronger in A share markets as well as B share Markets Herding in Japan markets

Recent studies in Japan have showed that institutional investors have fewer restrictions as compared to United States, when it comes to equity shareholdings. Resultantly, Japanese institutional investors are usually longterm shareholders that are active and influential toward the firms in which they own shares hence herding is less in Japan as compared to US Herding in Pakistan (Karachi stock exchange) A research was done on herding behavior in KSE by Tariq Javed, Nousheen Zafar, and Bilal Hafeez, -Mohammad Ali Jinnah University, Islamabad on monthly returns and it was depicted that there is no proof of herding behavior in the market, but there are an attention-grabbing indications about investors actions that investors herd in an excessive descending market situations The negative value of 2(not statistically significant) exhibits likelihood of subsistence of herding to some extent

Herd behavior (overall) in Asia Various studies and research works has shown that institutional investors are most of the times informed traders and they show herding behavior rationally on the basis of information. Institutional investors' herding has inverse relation with trading noise. Their buy (sell) herding predicts positive (negative) future market returns. By contrast, the herding of individual investors tends to contain limited information, as it increases trading noise; the buy (sell) herding of individuals is negatively correlated with future market returns. herding is present in both up and down markets .herding asymmetry is more deep in Asian markets during rising markets. facts suggests that crisis triggers herding activity in the crisis country of origin and then produces a negative effect due to which it spreads to neighboring countries. Conclusion By analyzing financial markets of different Asian countries we can conclude that as herd behavior is in attendance in all of the financial markets of Asia so it would be also exhibited by investors of Islamabad stock exchange Overconfidence theory There is a relatively new field in finance called behavioral finance. According to this field no matter how much investors do the calculations and no matter how much data they collect to make sound decisions while investing there is still a little part of them which behaves on emotions. One theory which Im going to discuss here is overconfidence: There are 2 components of this theory, one is overconfidence in the quality of information investors have gathered from different sources. They are completely sure that the information available in market is perfect. Second component is confidence on your ability to act on said information at the right time for maximum gain. There was a study conducted in California and researchers found strong evidence that when investors tend to invest they have behavioral biases that strongly effect there investing decisions. Overconfidence and control illusion: Overconfidence is basically overestimating and hyperbolizing your ability to perform something. Some studies show that people who overrate their skills in investing usually choose trading as their career. There is one more thing about overconfident investors, they stay in market for longer time period like they dont back out easily.

Robert shiller (2000) explained this part of behavioral finance by saying people think they know more than they do. Research proves that overconfidence is one of the traits of decision makers in which the investors consider themselves to be the expert. Over confidence investing: Investigations have shown that showing overconfidence while picking up the stocks or securities can be harmful in the long-run. A research was conducted in 1998 named as "Volume, Volatility, Price, and Profit When All Traders Are above Average" In this research, the researcher Terrence Odean found that overconfident investors trade more than investors who are less confident about the given information and their trading ability in securities. Overconfidence Bias, Trading Volume and Returns Volatility: Evidence from Pakistan In stock markets all over the world including Pakistani stock market investors and fund managers overconfidence is responsible for different unexplained, unusual, unexpected events. The facts in security markets like excessive trading and return volatility has captured many investors interest and then researchers have done some work in developing theoretical models assuming investors overconfidence as the variable to justify this anomaly in stock market. The research paper I have selected is saying that High (low) trading activity following market gains (losses) and excessive volatility are the two testable implications. We test these implications in Karachi Stock Exchange, Pakistan. First testable implication: First testable implication which is overconfident traders show high (low) trading activity following high (low) market returns. I.e., past returns are positively correlated with current turnover. Second test implication: The second test implication was overconfident traders, being overconfident about their skills do aggressive trading and this is responsible for excessive returns volatility. There are two general assumptions while doing the research: 1) Investors are overconfident about the inside information they get from different private sources. 2) The level of investor overconfidence varies with realized market returns due to biased self-attribution. This study which was conducted on the data gathered form Karachi stock exchange wants to study how investors overconfidence is related to trading volume. The framework which this research used is VAR (i.e., vector auto regression). There are other previous studies which have focused purely on predictions of overconfident investors and trading activities of those individual investors. These studies found that there is positive relationship of trading activities of individual overconfident investors and their past returns. Researchers found this by using dataset of individual investors from the individual investors account since the data on individual investors is not available in Pakistan so this research is based on market level data to test and analyze overconfidence predictions.

Hypothesis and empirical frame work::

Investor overconfidence and trading volume: Overconfident investors believe that if their past returns on stocks are too high it means that they have very good skills in picking up stocks. The stocks they will pick in future will provide high returns too because their analytical

ability in choosing the firm is better than other investors in the market. When the return from their past investments is high their trading volume increases dramatically because they think the same about the future. When they suffer loss in their investment their confidence starts to lose but it relatively takes longer time because it is difficult to break this perception of overconfident investors that they always choose the best. This shows that high trading volume even when the returns are not too much on particular stock continue for a long time due to overconfident investors in the market.

Hypothesis 1: Investors are overconfident therefore the current trading activity is positively related to past market returns and this relationship persist for a longer period of time. For the first hypothesis, the models employed were: the Vector Auto regression (VAR) and associated impulse response functions (IRF). Results of first study: We found significant positive response of turnover to market return shock after controlling for concurrent and lagged return dispersion and returns volatility. This response was persistent for quite a long time for both monthly and weekly IRF. Thus, results confirm the presence of investor overconfidence at KSE Research also found significant positive relationship between turnover and returns volatility in our VAR analysis .In the research related to revising the portfolio over the time period we saw that investors responded to cross sectional variations but it takes them about 2 months to respond to that. Excessive trading of overconfident investors and returns volatility Many research shows that increased volatility in price is due to overconfident investors in market. We will see this assumption in Karachi stock exchange. Overconfident investors trade aggressively and more than normal investors and they depict their large private information to public hence there is price volatility. Hypothesis 2: Excessive trading of overconfident traders positively relate to returns volatility. Some researchers categorize the whole security market (traders in stock market) into different types of investors like liquidity traders, market makers, rational traders and overconfident traders. First of all we will separate the contribution of overconfident investors from the other type of investors mentioned above then we will see that whether volatility increases due to overconfident investors or not. Results of 2nd hypothesis: The turnover was split into 2 parts for the second hypothesis: First was linked with past market return (overconfidence) and the other unassociated with past market returns. The interaction between the conditional volatility of market returns and these two parts of turnover was investigated using EGARCH and TARCH models. Overall there was no evidence of positive contribution of overconfidence related trading to conditional volatility of returns for both weekly and monthly data. Investors in Taiwan Now we will see whether overconfidence relate to performance and behavior of investors in Taiwan. Research shows that overconfident investors in Taiwan invest more aggressively and excessively as compare to normal investors. The excessive trading of overconfident traders result in excessive volatility. Research shows that in Taiwan overconfidence effect exist only when there is a situation in stock market where prices of share are rising. As investors become overconfident about the available information and their skills to invest so they underestimate risk and they trade heavily in riskier stocks which results in unexpected situation in stock markets.

Overconfident investors in china believe that they can earn high profit by outperforming the market. This research is done by collecting the brokerage data from china to study the effect of behavioral finance specifically overconfidence in Chinese investors. The research shows that Chinese investors suffer from two behavioral biases: 1) They are usually overconfident about their investment decisions. (they seem more confident than US investors) 2) They believe that the return they have gained in past they will get more or less the same return. We studied a unique behavior of Chinese investors that they hold fewer stocks yet they trade very often. They keep few stocks but trade stocks more frequently. We also found that inexperienced trades are usually the ones who trade by emotions and overconfidence bias and trade on riskier trade but experienced traders less behave as described by behavioral finance. Conclusion: It is concluded from our literature review that overconfident traders believe that they are better than other traders in choosing the best time to start and close the position. It is also found traders who trade the most (i.e., overconfident traders) receive significantly lower yield than the market most of the time so thats why investors should avoid overconfidence.

Gamblers fallacy
The gambler's fallacy, also identified as the Monte Carlo fallacy or the fallacy of the maturity of chances, originates from the most famous example of this occurrence, which happened in Monte Carlo Casino in 1913. It is the incorrect certainty that if something happens more regularly than usual during some period, then it will happen less regularly in the future. In situations where what is being observed as strictly accidental (i.e. independent trials of a random process), this belief though exciting is wrong. This fallacy is usually associated with gambling where players make such mistakes as they think that the gambling result are the outcome of their own talent. They reject the idea that chance could overrule cleverness. The gambler's fallacy can also be attributed to the mistaken belief that gambling (or even chance itself) is a fair process that can correct itself in the event of streaks, otherwise known as the just-world hypothesis. Other researchers believe that individuals with an internal locus of controli.e., people who believe that the gambling outcomes are the result of their own skillare more prone to the gambler's fallacy because they reject the idea that chance could overcome skill or talent
An example of this can be , if a series of 30 coin flips have all resulted with the "heads" side up than under the perception of gambler's fallacy, a person might expect that the next coin flip would result with the "tails" side up. This thinking represents an incorrect understanding of odds because the chance of a fair coin turning up heads is always 50%. This leads to the perception that that each coin flip is a random event that has no affect on future flips of the coin

Gambler's fallacy arises out of a conviction in the law of small numbers which is the believe that a small sample can resemble the parent population from which it is drawn Known as the law of small numbers, or the faulty certainty that small samples must be representative of the larger population.

Literature review
Gamblers fallacy and behavioural finance in the financial markets (a case study of Lahore stock exchange)

Gamblers fallacy exists in one form or another among the investors of Lahore stock exchange .a number of investors investing in the Lahore stock exchange invest on wrongly assumed probability of a trend that is factious number of reasons have led to this was seen that due to existence of gamblers fallacy, investors made biased decisions. The research conducted a test in which investors where given a hypothetical situation and their behaviour regarding the hypothetical situation was examined so as to see it gamblers fallacy exists within their thinking. they were given past record or data and were asked to predict the chance that a fair coin was to land on a head or a tail by asking this fundamental question it could be established what sort of assumptions and predications investors make before investing in a stock i.e they predict that a stocks price will either wont change or will increase. it was seen from the results the 82.60% of investors gave an unbiased answer stating that a fair coin had a 50% chance of either landing on the head or tail they gave this unbiased answer when they were not given any past data or historical trends and the unbiased answer was not different from the probability of the event actually happening i.e 50% this shows that investors behave rationally when they dont have any past data or historical trends. Similarly 73% investors thought that there was an equal chance of stock price going up or down if they dont have any additional information about the stocks historical or past data. this shows that gamblers fallacy exists usually when some sort of pattern and trend exists due to availability of past informations and the happening of a serious of random events .60% of investors said that there is 75 percent chance of getting tail and 17% said that the probability of another tail is unlikely. This shows that majority of investors exhibit gamblers fallacy in their thinking because they assumed the result keeping in mind some sort trend or pattern that existed before. Some investors follow a type of gamblers fallacy referred to as run of luck which is a belief that one event will not occur simply because it has been occurring too many times before. In both cases investors fail to realize that the chance of getting a tail or head each time remains the same regardless of the repetition of occurrence of one single outcome. another question asked in this research was more specifically related to the stock market prices, investors of Lahore stock exchange were asked to predict the stock price, if the stock prices having being rising by 5 points for the past few weeks.70% responded by saying that if stock prices are rising by 5 points they will continue to rise in the following weeks too. to see whether longer time spent trading in stock market led the investors to realize they were a victim of gamblers fallacy and whether they will correct their mistakes, a question was designed that asked investors that if they were losing a lot of money following a pattern of investments and choices, many investors still made the same mistakes over and over again regarding their investments. people get influenced a lot by friends and other people advice while making investments decisions a question was asked just to see that whether they rely on their on perceptions or the advice of friends,70% said they take a friends advice into serious consider while making an investment decision and only 12% of investors actually take into account the past trends and long term historical data while making investments. Also investors were very confident about the decisions they took and that too contributes to gamblers fallacy. thus we can conclude that gamblers fallacy does exist and affect investors expectations and behaviour in stock markets Behavioral Finance: Shaping the Decisions of Small Investors of Lahore Stock Exchange The belief that a small sample can resemble the parent population from which it is drawn is known as the law of small numbers which may lead to a Gamblers fallacy More specifically, in stock market, Gamblers fallacy arises when people predict incorrectly the patterns of stock prices and think that the increase or decrease trend would become reserved i.e increasing prices will start decreasing and decreasing price will start increasing. In addition, when people start to relate to the status quo bias, they tend to select the alternative that was probably chosen previously The Factor Model for Determining the Individual Investment behavior in India Dr.S.Jayaraj (sep oct 2013).A gambler's fallacy is a belief in which a person acts upon a artificial believe that the likelihood of an outcome has changed, when actually, it has stayed the same. In the gambler's fallacy, a person incorrectly believes that the arrival of a certain random event is less likely to happen following an event or a series of events. This line of thinking is wrong and biased because past events do not change the likelihood that certain

events will occur in the future. It is not difficult to visualize that under certain conditions, investors or traders can easily fall into the trap of gambler's fallacy. For example, some investors believe that they should liquidate or sell off their trading position after it has gone up in a series of previous trading sessions because they don't believe that the current status of the market is likely to continue going up. On the other hand, other investors might hold on to a stock that has fallen in several sessions because they view further declines as not prevailing. Just because a stock has gone up on six consecutive trading sessions does not mean that it is less likely to go up on during the next session.. This indicates that the Indian investors are influenced by gamblers fallacy. Conclusion: By viewing the literature gathered that is relevant to gamblers fallacy being observed by the investors in stock markets of Asia and Pakistan namely Lahore stock exchange we can conclude by saying that since gamblers fallacy prevails in the stock markets of asia and Pakistan then it must also be exhibited by investors of Islamabad stock exchange. Referencing Naveed Ahmed, Zulfqar Ahmad and Sarfaraz Khalil Khan Behavioural Finance: Shaping the Decisions of Small Investors of Lahore Stock ExchangeInterdisciplinary Journal of Research in Business Vol. 1, Issue. 2, February 2011(pp.38-43) 38 Dr.S.Jayaraj The Factor Model for Determining the Individual Investment behaviour in India IOSR Journal of Economics and Finance (IOSR-JEF) e-ISSN: 2321-5933, p-ISSN: 2321-5925. Volume 1, Issue 4 (Sep. Oct. 2013), PP 21-32 21

Amjad amin,sehrish shoukat,zahoor khan GAMBLERS FALLACY AND BEHAVIORAL FINANCE IN THE FINANCIAL MARKETS (A CASE STUDY OF LAHORE STOCK EXCHANGE) Abasyn University Journal of Social Sciences Volume 3, No. 2, July-December 2009

Gongmeng Chen, Kenneth A. Kim,*, John R. Nofsinger, Oliver M. Rui, Trading performance, disposition effect, overconfidence, representativeness bias, and experience of emerging market investors, Journal of Behavioral Decision Making 20(2007) 425-451, accessed November 20, 2013, doi/10.1002/bdm.561. Tim parker, 4 Behavioral Biases And How To Avoid Them, investing, May 08.2013 Mei-Chen Lin, Returns and investors behavior in Taiwan: does overconfidence explains this relationship?, review of Pacific Basin Financial Markets and Policies.,08, 405 (2005), accessed November 21,2013 Doi: 10.1142/S0219091505000476


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