A brief note on behavioural finance

A study of the behavior of individual stocks or markets as a whole have brought into light phenomena which are difficult to explain assuming that market participants are rational and that markets operate efficiently. Shiller ‘s (1981) work revealed that market prices are farther from being volatile than that could be forecasted by a model where prices equal the expected NPV of future dividend streams. De Bondt and R. Thaler (1985) provide evidence of reversal of returns in the long-term in financial markets. They found that a group of companies backed by several years of poor news flow tend to earn on an average extremely high subsequent returns compared to another group of companies backed up by several years of superior news flow. N. Jegadeesh and S Titman (1993) provide illustrations of short-term trends or momentum play in stock prices. Stock prices are observed to overreact to corporate announcements (earnings) or events (stock repurchases, follow-on public offerings, mergers/acquisitions). The effects of the announcements seem to persist for a significant time period, although there is no evidence of changes in systematic risk following corporate announcements. Many a time sharp moves in the prices of stocks do not appear to be as a consequence to the release of any significant news. Werner F. M. De Bondt and Richard H. Thaler (1990) have examined fifty largest one-day stock price movements in the U.S. after World War II and observed that many of them came on days of no major announcements. R. Roll (1984) reached similar conclusions about futures on orange juice and associated stocks.

One of the primary foundations of behavioral finance is the ‘limited arbitrage’ hypothesis. This explains the fact that if irrational trading activities result in deviations from the fundamental value of an asset, rational traders will often have no defence against it. This is because real-world markets are far from perfect. Frictions, such as transaction costs, margin payments, etc make it unviable to replicate an asset. Further, perfect substitutions do not exist for most of the securities traded in the market. Due to short investment horizon and other restrictions, arbitrage becomes a risky activity and many a time it would not be undertaken.

For getting a foothold on the exact form of the agents’ irrational behavior, models based on experimental evidence are compiled by cognitive psychologists around the beliefs and preferences of people.

The following is a summary of the findings of D. Kahneman, P. Slovic, and A. Tversky (1982) and N. Barberis and R. Thaler (2001).

Representativeness is the tendency of decision-making personnel to view an event as a representation of some specific pattern, when perhaps there does not exist any. As a consequence, investors often seek stocks which are in the news and avoid those which have been laggards as per recent trading experience. Overconfidence leads investors to overestimate the information that they have gathered on their own and their ability to forecast market movement. One of the observed effects is that of excessive trading. The phenomenon of anchoring leads investors leads investors to estimate that a share will continue to trade in a pre-defined range. They may also expect a company’s earnings to fall in line with previous track record.

Under the Prospect Theory, a totally descriptive framework of the way investors make their decisions with a given level of risk and uncertainty is presented. The key concepts addressed by the theory include: loss aversion – Individuals are inclined to exhibit a greater sensitivity to losses than to gains. This implies that investors may be reluctant to realize losses. They may be willing to take chances in an endeavour to steer away from a losing position. regret aversion – this arises from investors’ desire to avoid regret resulting from a bad investment decision. They may be less willing to invest new money in stocks that have provided suboptimal returns or losses in the in the recent past. J. Koening (1999) has suggested that the desire to avoid regret may give rise to herding behavior. Mental accounting – it refers to the process by which decision-makers frame problems for themselves. Mental accounting leads to narrow framing, which leads investors to treat each portion of their portfolios separately. This may lead to inefficient decision making. Investors may be risk-averse in their downside protecting investments and risk-seeking in their more speculative ones.

References  (in order in which they appear in the text)

R. Shiller,(1981) Do stock market prices move too much to be justified by subsequent changes in dividends?, American Economic Review 71

W. F. M. De Bondt and R. Thaler, Does the stock market overreact?, The Journal of Finance 40

(1985), no. 3

N. Jegadeesh and S Titman, Returns to buying winners and selling losers: Implications for stock

market efficiency, The Journal of Finance 48 (1993).

Werner F. M. De Bondt and Richard H. Thaler (1990), Do security analysts overreact?, American Economic Review 80 (1990), no. 2

R. Roll, Orange juice and weather, American Economic Review 74 (1984)

N. Barberis and R. Thaler, A survey of behavioral ¯nance, Handbook of the Economics of Finance

(G.M. Constantinides, M. Harris, and R. Stulz, eds.), Elsevier, 2001.

D. Kahneman, P. Slovic, and A. Tversky, Judgment under uncertainty: Heuristics and biases,

Cambridge University Press, Cambridge, 1982.

J. Koening, Behavioral Finance: Examining thought processes for better investing, Trust & Invest-

ments 69 (1999)