Behavioral finance is a relatively new field that seeks to combine behavioral and

cognitive psychological theory with conventional economic and finance to provide

explanations for why people make irrational financial decisions. It is very popular in
stock market across the world for investment decisions Behavioral finance is the
study of psychology and sociology on the behavior of the financial practitioners and
the subsequent effect on the security market. It helps to understand why people
buy or sell stock without doing fundamental analysis and behave irrationally in
investment decisions Forbes (2009) has defined behavioral inance as a science
regarding how psychology influences financial market. This view emphasizes that
the individuals are affected by psychological factors like cognitive biases in their
decision-making, rather than being rational and wealth maximizing.

V. TRADITIONAL FINANCE VS BEHAVIORAL FINANCE:

Based on efficient market hypotheses, traditional financial theories assume that

investors are rational and risk averse, and hold diversified, optimal portfolios. This
assumes how investors should act based on mathematical models and theories.
However, this does not always play out in practice. In contrast, behavioural
finance is based on understanding how people actually make financial decisions in
practice. Behavioral finance suggests cognitive errors and emotional biases can
impact financial decisions, often in a detrimental way. Cognitive errors are based
on faulty reasoning (belief perseverance), or due to memory errors (information
processing errors). Emotional biases stem from reasoning that is influenced by
feelings or emotions, not fundamental facts.

Behavioural finance challenges the assumptions of the traditional finance theory,

recognizing that many investors do not make decisions in a rational manner
Investors are generally loss averse, and because their fears can get in the way,
they do not necessarily hold optimal portfolios

VARIOUS BEHAVIORAL FACTORS WHICH AFFECTS THE DECISION OF INVESTORS

IN STOCK MARKET:

Some of the behavioral factors which affect the

investment decision of investors in stock market are as mentioned below.

1. Representativeness:
The investors’ recent success; tend to continue into the future also. The
tendency of decisions of the investors to make based on past experiences is
known as stereotype. Debont (1998)8 concluded that analyses are biased in
the direction of recent success or failure in their earnings forecasts, the
characteristic of stereotype decisions.

2 Overconfidence:

There are several dimensions to confidence. It can give more courage, and is
often viewed as a key to success. Although confidence is often encouraged and
celebrated, it is not the only factor to success. The investors who are cautious and
analytical can achieve success and others have to withdraw. Yet, confidence,
especially self-confidence, is often viewed as a positive trait. Sometimes, the
investors overestimate their predictive skills or assuming more knowledge then
they have. Many times it leads excessive trading.

3 Anchoring:

It describes the common human tendency to rely too heavily, or ‘anchor’ on one
trait or piece of information when making decisions. When presented with new
information, the investors tend to be slow to change or the value scale is fixed or
anchored by recent observations. They are expecting the trend of earning is to
remain with historical trend, which may lead to possible under reactions to trend
changes.

4. Gamblers fallacy:

It arises when the investors inappropriately predict that tend will reverse. It may
result in anticipation of good or poor end.

5. Availability bias:

The investors place undue weight for making decisions on the most available
information. This happens quite commonly. It leads less return and sometimes
poor results also.

6 Market Psychology
The overall sentiment or feeling that the market is experiencing at any particular
time. Greed, fear, expectations and circumstances are all factors that contribute
to the group's overall investing mentality or sentiment.

7 Market Sentiment

The feeling or tone of a market (i.e. crowd psychology). It is shown by the activity
and price movement of securities.

8 Media Effect

A theory that relates how stories published in the media influence or amplify
current trends. Borrowers or investors will read an article and be influenced to act
quickly on the news. The media effect is often seen in the mortgage market, when
prepayment rates can sharply increase following specific news stories.

9 Reflexivity

The idea that a person's thoughts and ideas tend to be inherently biased. In other
words, the values and thoughts of a person will be represented in their work. In
the context of finance, the theory of reflexivity states that investors' and traders'
biases can change the fundamentals that assist in determining market price

BEHAVIORAL FINANCE AND INVESTMENT DECISIONS

Behavioral finance seeks to find how investor’s emotions and psychology affect
investment decisions. It is the study of how people in general and investors in
particular make common errors in their financial decision due to their emotions. It
is nothing but the study of why otherwise rational people take some really thumb
investment decisions. Decision making is a process of choosing best alternatives
among a number of alternatives. This decision has come out after a proper
evaluation of all the alternatives. Decision making is the most complex and
challenging activity of investors. Every investor differs from the others in all
aspects due to various factors like demographic factor, socioeconomic
background, educational level, sex, age and race. An optimum investment
decision plays an active role and is a significant consideration. Investor is a
rational being who will always act to maximize his financial gain. Yet we are not
rational being; we are human being; an integral part of this humanness is the
emotion within us. Indeed, we make most of our life decisions on purely
emotional considerations

In the financial world, investor’s sometimes base their decisions on irrelevant

figures and statistics, e.g., some investor may invest in the stock that have
witnessed considerable fall after a continuous growth in recent past. They believe
that price has fallen which is only due to short term market movements, creating
an opportunity to buy the stock cheap. However, in reality, stocks do quite often
also decline in value due to changes in their underlying fundamentals.

Cognitive dissonance is the perception of incompatibility between two cognitions,

which can be defined as any element of knowledge including attitude, emotion,
belief or behavior. The theory of cognitive dissonance holds that contradicting
cognition serve as a driving force that compels the mind to acquire or invent new
thoughts or beliefs or to modify existing beliefs, so as to reduce the amount of
dissonance (conflict) between cognition. Festinger theory of cognitive dissonance
states that individual attempts to reduce inner conflict in one of the two ways: (i)
he changes his past values, feelings or options; and (ii) he attempts to justify or
rationalize his choice. This theory may apply to investors and traders in the stock
market who attempt to rationalize contradictory behaviors, so that they seem to
follow naturally from personal values or view point.In “Financial Cognitive
Dissonance”, we change our investment styles or beliefs to support our financial
decisions. For instance, investors who followed a traditional investment style
(fundamental analysis) by evaluating companies using financial criteria such as,
profitability measures, especially, profit/earning ratios, started to change their
investment beliefs. Many individual investors purchased retail internet companies
in which these financial measures could not be applied. Since these companies
has no financial track record, very little revenues and no net losses. These
traditional investors rationalized the change in their investment style (past
beliefs) in two ways: the first argument by many investor is the belief (argument)
that we are now in a “new economy” in which the traditional financial rules no
longer apply. This is usually the point and the economic cycle in which the stock
market reaches its peak. The second action that displays cognitive dissonance is
ignoring traditional form of investing and buying these internet stock simply
based on price momentum.
Regret theory states that an individual evaluates his or her expected reactions to
a future event or situations. Psychologists have found that individuals who make
decision that turn out badly have more regret when that decision was more
unconventional. This theory can also be applied to the area of investor psychology
within the stock market, whether an investor has contemplated purchasing a
stock or mutual fund which has declined or not, actually purchasing the intended
security will cause the investor to experience an emotional reaction.

Behavioral finance provides explanations for why investors make irrational

financial decisions. It demonstrates how emotions and cognitive errors influence
investors in the decision making process. The various causes that led to
behavioral finance are anchoring, overconfidence, herd behavior, over and under
reaction and loss aversions. In ssence, behavioral finance approach investigates
the behavioral patterns of investors and tries to understand how these patterns
guide investment decision. Behavioral finance offers many useful insights for
investment professionals and thus, provides a framework for evaluating active
investment strategies for the investor From this study it is clearly found out that
demographics like age, gender, income, experience and education plays a major
role in risk appetite of individual investors and in their confidence level also. This
study identified the major factors responsible for determining the attitudes and
trading behavior of stock market investors. The most important factors that
affects the attitude and trading behavior of stock market investors as obtained
from factor analysis is as below: confidence level that an investors has in
himself/herself as compared to forma sources, risk taking ability, more
expectation and return oriented and conservative mentality.

Forces That Move Stock Prices

Fundamental Factors
In an efficient market, stock prices would be determined primarily by
fundamentals, which, at the basic level, refer to a combination of two things:

1. An earnings base, such as earnings per share (EPS)

 2. A valuation multiple, such as a P/E ratio

An owner of common stock has a claim on earnings, and earnings per share (EPS)
is the owner's return on his or her investment. When you buy a stock, you are
purchasing a proportional share of an entire future stream of earnings. That's the
reason for the valuation multiple: It is the price you are willing to pay for the
future stream of earnings.

Part of these earnings may be distributed as dividends, while the remainder will
be retained by the company (on your behalf) for reinvestment. We can think of
the future earnings stream as a function of both the current level of earnings and
the expected growth in this earnings base.

As shown in the diagram, the valuation multiple (P/E), or the stock price as some
multiple of EPS, is a way of representing the discounted present value of the
anticipated future earnings stream.

The Earnings Base

Although we are using EPS, an accounting measure, to illustrate the concept of
earnings base, there are other measures of earnings power. Many argue that
cash-flow-based measures are superior. For example, free cash flow per share is
used as an alternative measure of earnings power.

The way earnings power is measured may also depend on the type of company
being analyzed. Many industries have their own tailored metrics. Real estate
investment trusts (REITs), for example, use a special measure of earnings power
called funds from operations (FFO). Relatively mature companies are often
measured by dividends per share, which represents what the shareholder actually
receives.

The Valuation Multiple

The valuation multiple expresses expectations about the future. As we already
explained, it is fundamentally based on the discounted present value of the future
earnings stream. Therefore, the two key factors here are:

1. The expected growth in the earnings base

2. The discount rate, which is used to calculate the present value of the future
stream of earnings

A higher growth rate will earn the stock a higher multiple, but a higher discount
rate will earn a lower multiple.

What determines the discount rate? First, it is a function of perceived risk. A

riskier stock earns a higher discount rate, which, in turn, earns a lower multiple.
Second, it is a function of inflation (or interest rates, arguably). Higher inflation
earns a higher discount rate, which earns a lower multiple (meaning the future
earnings are going to be worth less in inflationary environments).

In summary, the key fundamental factors are:

 The level of the earnings base (represented by measures such as EPS, cash
flow per share, dividends per share)
 The expected growth in the earnings base
 The discount rate, which is itself a function of inflation
 The perceived risk of the stock

Technical Factors
Things would be easier if only fundamental factors set stock prices. Technical
factors are the mix of external conditions that alter the supply of and demand for
a company's stock. Some of these indirectly affect fundamentals. For example,
economic growth indirectly contributes to earnings growth.

Technical factors include the following:

Inflation
We mentioned it earlier as an input into the valuation multiple, but inflation is a
huge driver from a technical perspective as well. Historically, low inflation has had
a strong inverse correlation with valuations (low inflation drives high multiples
and high inflation drives low multiples). Deflation, on the other hand, is generally
bad for stocks because it signifies a loss in pricing power for companies.

Economic Strength of Market and Peers

Company stocks tend to track with the market and with their sector or industry
peers. Some prominent investment firms argue that the combination of overall
market and sector movements—as opposed to a company's individual
performance—determines a majority of a stock's movement. (Research has
suggested the economic/market factors account for 90 percent of it.) For
example, a suddenly negative outlook for one retail stock often hurts other retail
stocks as "guilt by association" drags down demand for the whole sector.

Substitutes
Companies compete for investment dollars with other asset classes on a global
stage. These include corporate bonds, government bonds, commodities, real
estate, and foreign equities. The relationship between demand for U.S. equities
and their substitutes is hard to figure, but it plays an important role.
Incidental Transactions
Incidental transactions are purchases or sales of a stock that are motivated by
something other than belief in the intrinsic value of the stock. These transactions
include executive insider transactions, which are often pre-scheduled or driven by
portfolio objectives. Another example is an institution buying or shorting a stock
to hedge some other investment. Although these transactions may not represent
official "votes cast" for or against the stock, they do impact supply and demand
and, therefore, can move the price.

Demographics
Some important research has been done about the demographics of investors.
Much of it concerns these two dynamics:

Middle-aged investors, peak earners who tend to invest in the stock market

Older investors, who tend to pull out of the market in order to meet the demands
of retirement

The hypothesis is that the greater the proportion of middle-aged investors among
the investing population, the greater the demand for equities and the higher the
valuation multiples.

Trends
Often a stock simply moves according to a short-term trend. On the one hand, a
stock that is moving up can gather momentum, as "success breeds success" and
popularity buoys the stock higher. On the other hand, a stock sometimes behaves
the opposite way in a trend and does what is called reverting to the mean.
Unfortunately, because trends cut both ways and are more obvious in hindsight,
knowing that stocks are "trendy" does not help us predict the future.
Liquidity
Liquidity is an important and sometimes under-appreciated factor. It refers to
how much interest from investors a specific stock attracts. Wal-Mart's stock, for
example, is highly liquid and therefore highly responsive to material news; the
average small-cap company is less so. Trading volume is not only a proxy for
liquidity, but it is also a function of corporate communications (that is, the degree
to which the company is getting attention from the investor community). Large-
cap stocks have high liquidity—they are well followed and heavily transacted.
Many small-cap stocks suffer from an almost permanent "liquidity discount"
because they simply are not on investors' radar screens.

News
While it is hard to quantify the impact of news or unexpected developments
inside a company, industry or the global economy, you can't argue that it does
influence investor sentiment. The political situation, negotiations between
countries or companies, product breakthroughs, mergers and acquisitions and
other unforeseen events can impact stocks and the stock market. Since securities
trading happens across the world and markets and economies are
interconnected, news in one country can impact investors in another, almost
instantly.

Market Sentiment
Market sentiment refers to the psychology of market participants, individually
and collectively. This is perhaps the most vexing category. Market sentiment is
often subjective, biased, and obstinate. For example, you can make a solid
judgment about a stock's future growth prospects, and the future may even
confirm your projections, but in the meantime, the market may myopically dwell
on a single piece of news that keeps the stock artificially high or low. And you can
sometimes wait a long time in the hope that other investors will notice the
fundamentals.

Market sentiment is being explored by the relatively new field of behavioral

finance. It starts with the assumption that markets are apparently not efficient
much of the time, and this inefficiency can be explained by psychology and other
social science disciplines. The idea of applying social science to finance was fully
legitimized when Daniel Kahneman, PhD, a psychologist, won the 2002 Nobel
Memorial Prize in Economic Sciences (the first psychologist to do so). Many of the
ideas in behavioral finance confirm observable suspicions: that investors tend to
overemphasize data that come easily to mind; that many investors react with
greater pain to losses than with pleasure to equivalent gains; and that investors
tend to persist in a mistake.

Some investors claim to be able to capitalize on the theory of behavioral finance.

For the majority, however, the field is new enough to serve as the "catch-all"
category, where everything we cannot explain is deposited.

Hong Kong Stock market

The Stock Exchange of Hong Kong (SEHK, also known as Hong Kong Stock

Exchange) is a stock exchange based in Hong Kong. It is Asia's third-largest in
terms of market capitalization behind the Tokyo Stock Exchange and Shanghai
Stock Exchange, and the fourth single largest stock market in the world. As of
2018, it has 2,315 listed companies with a combined market capitalization
of HK$29.9 trillion. It is reported as the fastest growing stock exchange in Asia.

The Hong Kong securities market can be traced back to 1866, but the stock
market was formally set up in 1891, when the Association of Stockbrokers
in Hong Kong was established.[4] It was renamed The Hong Kong Stock
Exchange in 1914.
By 1972, Hong Kong had four stock exchanges in operation. There were
subsequently calls for the formation of a unified stock exchange. The Stock
Exchange of Hong Kong Limited was incorporated in 1980 and trading on
the exchange finally commenced on 2 April 1986. Since 1986, a number of
 major developments have taken place. The 1987 market crash revealed
flaws in the market and led to calls for a complete reform of the Hong Kong
securities industry. This led to significant regulatory changes and
infrastructural developments. As a result, the Securities and Futures
Commission (SFC) was set up in 1989 as the single statutory securities
market regulator.
The market infrastructure was much improved[how?] with the introduction
by the exchange of the Central Clearing and Settlement System (CCASS) in
June 1992 and the Automatic Order Matching and Execution System (AMS) in
November 1993. Since then, the framework of market rules and regulations,
both exchange-administered or otherwise, have been undergoing
continuing review and revision to meet changing market needs while
ensuring effective market regulation.
The Exchange Listing Rules have been made more comprehensive, and
other existing regulations have been improved or new regulations
introduced to enhance market development and investor protection.
Enhancements were also made to the system infrastructure, including the
launch of off-floor trading terminals in brokers’ offices in January 1996. The
third generation of the trading system, AMS/3, will be launched in 2000. It
will provide enhanced functionality and a platform for a straight-through
transaction process.

In respect of market and product development, there are the listing of the
first derivative warrant in February 1988, the listing of the first China-
incorporated enterprise (H share) in July 1993; and the introduction of
regulated short selling in January 1994 and stock options in September
1995. Furthermore, the exchange introduced the Growth Enterprise Market
(GEM) in November 1999 to provide fund raising opportunities for growth
companies of all sizes from all industries, and to promote the development
of technology industries in the region.

 It is perfectly normal for Hong Kong stocks of even well-known companies

to trade at prices that correspond to less than HK$4 a share. A Hong Kong stock
would not be considered a penny stock unless its price was less than about
HK$0.50.
 Each stock has its own individual board lot size (an online broker will
usually display this along with the stock price when you get a quote); purchases in
 amounts which are not multiples of the board lot size are done in a separate "odd
lot market".
 There is a close-in-price rule for limit orders, which must be within 24 ticks
of the current price. Individual brokers may impose an even stricter rule; for
instance, HSBC requires limit orders to be within 10 ticks of the current price.
Broker support for triggered order types such as market-if-touched orders would
allow placing orders further away, which would be sent to the exchange when the
price condition was established.

A stock market crash is a sudden dramatic decline of stock prices across a

significant cross-section of a stock market, resulting in a significant loss of
paper wealth. Crashes[1] are driven by panic as much as by underlying
economic factors. They often follow speculative stock market bubbles.

Stock market crashes are social phenomena where external economic

events combine with crowd behavior and psychology in a positive feedback
loop where selling by some market participants drives more market
participants to sell. Generally speaking, crashes usually occur under the
following conditions:[1] a prolonged period of rising stock prices and
excessive economic optimism, a market where P/E ratios (Price-Earning
ratio) exceed long-term averages, and extensive use of margin debt and
leverage by market participants. Other aspects such as wars, large-
corporation hacks, changes in federal laws and regulations, and natural
disasters of highly economically productive areas may also influence a
significant decline in the stock market value of a wide range of stocks. All
such stock drops may result in the rise of stock prices for corporations
competing against the affected corporations.

There is no numerically specific definition of a stock market crash but the

term commonly applies to steep double-digit percentage losses in a stock
market index over a period of several days. Crashes are often distinguished
from bear markets by panic selling and abrupt, dramatic price declines.
Bear markets are periods of declining stock market prices that are
measured in months or years. Crashes are often associated with bear
markets, however, they do not necessarily go hand in hand. The crash of
1987, for example, did not lead to a bear market. Likewise, the Japanese
bear market of the 1990s occurred over several years without any notable
crashes. There will be more to come, but there hasn’t been mentioned a
specific day yet..