Behavioral Finance Essay Sample
The efficient market hypothesis had been a broadly accepted model by all the financial economists and financiers decades ago. They believed that the markets for securities are efficient in reflecting stocks’ prices information. A common view was that, coming up of news would be known fast to be incorporated in securities prices. In that view, technical or fundamental evaluation could not help investors in choosing undervalued stocks, that could be useful for investors to make returns greater than those gained by stocks portfolios randomly selected; at least without comparable standard deviation. However, by start of 21st-century, the dominance by efficient market hypothesis was less significant across the globe. The majority of financial economists started believing that prices of a stock could be partially predicted. Some suggested behavioral as well as psychological aspects of determining price for securities, and then viewed the future securiies prices as predictable based on historical price patterns. Additionally, many of those economists made a claim that the predictability of the patterns help investors in getting excess return on their investments. Thus, behavioral finance came into the picture, and his report presents an explanation of the implications that behavior finance have had on the efficient market hypothesis.
2.1 Efficient Market Hypothesis
The Market Hypothesis efficient is based on the platform of the random walk theory that is used for characterization of price series, where all ensuing price change shows random departures from the previous prices. The random walk logic is that, if the information flow is unimpeded and news are direcly reflected in marke prices, future prices’ change will only reflect news of he fuure and will not depend on current changes. Further, news are assumed to be unpredictable. Thus, changes in price should not be predictable or random and price reflects all new information and even investors who are uninformed buy a portfolio that is diversified at market prices gaining a higher return as the one earned by finance experts (Shiller, 2001).
Fluctuations in stock prices are not interdependent and reflect an equal distribution while also being perceived as random. Malkiel (2003) suggesed that the market as well as securiies were random like a coin flip. On the other hand, Shiller (2000) says that prices have an approximate explainaion of the random walk over a period. Thus, change in securiies’ price are not predictable and only happens as a response to fresh and genuine news; that is always unpredictable. Economists argue that, efficient markets, limits investors’ ability to gain greater returns without taking greater risk (Malkiel, 2003). In more detail, Efficient Market Hypothesis always advocates efficiency of the securities market in terms of the news as well as information. Efficient markets are thus markets with huge numbers of investors who try to compete as well as forecast future securities’ value. In addition, it is where significant news are free for all those involved.
2.2 Behavioral Finance
It relates to the behavior of investors’ that is obtained from psychological aspects of decisions making process, in explaining investors practices of selling and buying securities. It is also related to behavioral, cognitive psychology that studies financial market economics and human decision-making. Its main focus is how investors interpret and act on information they get to make correct decisions. The new model emphasizes on investor’s characteristics that lead to several market imperfections. Shefrin`s (2001) indicates that, he new model is a study of psychology’s effect on securities markets as well as financial decisions. Further, Sewell (2005) notes behavioral finance as a study of the effect that psychology has on investors’ behaviors and on securities markets. Based on that, some effects are more dependent on the behavior of being irrational mainly resulting from psychological aspects and biases (Ross, Westerfield, Jaffe & Jordan, 2008).
The very most common reasons or cognitive heuristics that explains why Behavioral Finance results to irrational behavior are: First, the representativeness where people try to fit unknown and news events into an already existing one and, therefore, finds elements that are common in totally a different events. Secondly, anchoring is a cognitive heuristic that includes making decisions based on the first anchor. In several cases, estimates are made, beginning from initial value changed to yield the results. The problem formulation may suggest the starting point or the initial value, or could result from the partial computations. For both cases, changes are always typically inappropriate. Third, herding states that people have a need to be in groups in which they consequently reflect a herd behavior in decision making. Thus, individuals make decisions similar to those of the other group members instead of using own information in decision making. Fourthly, overconfidence refres to the naure of exaggerating own abilities and skills. It entails being sure of own knowledge, abilities as well as the received information. That results in incorrect investment decisions and mainly shows an arrogance attitude regarding the secriies market (Shiller, 2000).
Fifthly, a version of loss that means the tendency of individuals’ great fear for risk than for gains. Previous gains decrease risk, whereas a previous loss raises it while losses are assumed to loom longer than profits. Sixthly, mental accounting is the cognitive operations set used by households and individuals in evaluating, organizing and keeping financial activities track. That, means that it entails individual’s different mental accounts; depending on their behaviors experienced events. Lastly, aversion of regret is a means that involve the desire by investors to evade the pain caused by wrong investments and causes postponing of stocks’ selling so that they may not finalize their losses (Malkiel, 2003).
Individuals could anticipate emotions like regret when comparing possible results of a choice if a different choice had been made. Additionally, in Behavioral Finance, investing options as well as judgments greatly depend on individual’s biases that lead individuals to logical fallacies. Thus, Behavioral Finance resulted in a model that improved finance theories such as EMH by refuting some of their arguments. In a short while the model had become recognized as a significant and dominant tool for investors given its ability to academically as well as scientifically challenge the other models (Shiller, 2000).
2.3 Implications of Behavioral Finance Efficient Market Hypothesis
The greaest challenge to the EMH is from the behavioral finance which is a field of economics and finance applying findings from psychology, sociology as well as neuroscience for understanding invesors’ behavior (EkanshiGupta, 2014). Behavioral finance challenges EMH’s crucial implications in two areas: One being that a many of investors make decisions on basis of available information, and second being assumption that securities prices are is right. Behavioral finance Proponents mainly known as behaviorists, have a view that several factors including irrational as well as rational aspects end to determine investors’ behavior. In comparison to EMH theorists, it is believed by behaviorists that investors are mainly irrational in decision making and that for underlying fundamental value securities’ prices are not a reflection of fair estimates (Shefrin, 2001).
Availability of information and information access: According to the EMH, securities’ markets are efficient information wise. Every person can access available information resulting to exploitation of news by some being impossible. However, the behavioral finance model challenged the two concepts: information availability as well as access. According to the theoretical point of view, all individuals can get access to investing information; while in practice and line with behavioral finance, they cannot. Different lifestyles and daily routine imply availability of varying time as well as methods of accessing information. Further, markets globalization, fast change in events and the increasing variety of investment models results to investors being unable to catch up with information. News is released via varying channels such as blogs, websites, TV, and audio, but individuals are unable not only to assimilate, but also to elaborate the available information (Shefrin, 2000).
Even groups of people or persons involved in analyzing and monitoring the stock market are not 100% competent. As a result, increasing information regarding varying investment contexts is viewed as a battle for investments with losses as well as gains where there are winners and losers. Availability of information is an additional weakness of EMH. Information is limited to a group of investors, or before it becomes available to general public, it is available to speculators long before. Therefore, the people who had access to information like this can take complete advantage of it. Apart from the availability importance, methods of communicating the information area also a significant aspect. With that the market analysts or impartial financial journals role is very significant. Notably, rating of the stock has been a part of a promotion project for companies. Behavioral Finance treats the market efficiency in terms of both information availability and access (Ritter, 2002).
Behavioral Finance states that, as investors are a human being, they are inseparable with their past investments as well as the actions of the past that are vital parts of one’s history. Past prices and previous years fundamental values affect and guide their decision making in this perspective. Investors are enabled by the model to encounter a number of investing conditions based on a number of disciplines. Investing rationality and efficient markets are perceived as imaginary constructs that reassure conscience. When the cause is profit making, the effect is avarice and envy, for some investors. Thus, the Efficient Market Hypothesis weakness, perceived as non-evolutionary and conservative paradigm, are the theoretical fundamental principles of B.F. evidence against market functions is provided by EMH’s efficacy as well as the new investors profile encourages the perspectives of the theoretical model. In conclusion, Behavioral Finance’s emerged as a tool that successfully attempted to refute as well as challenge the old theories. Ritter (2002) indicated that Cognitive Psychology is the basis of behavioral finance; a way of people’s thinking. In Cognitive Psychology, the systematic errors are explained by various theories and factors of human behavior made by the way they think of the people and their decision-making regarding their stock selection. Thus, behavioral finance addresses the EMH anomalies such as over and Under Reaction, Overconfidence and Mental Compartments (Shiller, 2001).
Overconfidence is common in entrepreneurs given the nature of their practices as well as expectations (Ritter, 2002). It symbolizes little diversification as a result of investors perception of being knowledgeable as well as having preference for some securities. The phenomena is associated with investors’ psychology as well as the decision making complexity such as inadequate allowance causing uncertainty in one’s view tied up with multiple mental processes (Lo, 2005).
Investors form an expectation by looking at the stock's past performance. It is also known that stocks are listed by firms as a means of capitalizing on overreaction arising from their recent past good performance. An alternative explanation of overreaction by an investor with respect to Price/Earnings is the price-ratio hypothesis in which high P/E ratios are viewed as overvaluation of a company. In addition, investor’s overreaction is possibly among the causes of the security prices frequent movement following stock’s initial public offerings and splits. The security Prices frequent movement also known as stock volatility is found evident in the literature. Thus, one of the Efficient Market Hypothesis anomalies is an overreaction, as it has been idenified that people tend to overreact as a result of unexpected news (Anastasios, Androniki, George & Maria, 2012).
Underreaction is a visible response to a security’ price that can persist until annual earnings are announced. The fact that people undereacs in securiies markets provided a basis for what the psychological model idenified as the Principle of Conservatism; in which a change resulst o individuals taking time to adjust to those changes hence under reacts (Ritter, 2002). Thus, it can be said that due to the investors slow reaction to either announcement of earnings or any event such as stock splits and mergers, markets are disrupted hence increasing their inefficiency.
Effect of Disjunction
It refres to investors’ abiliy to wait for a better understanding of everything regarding a subject or a market; whether the involved information has importance or not and if any difference could resul from that information in the decision making process or not (Shiller, 2001). Disjunction contradicts the rational behavior featured in the EMH. In the research by various researchers, disjunction effect is identified to explain speculative stock prices volatility before or after any announcement occurs.
Compartments depend upon an activity’s nature. That human nature easily visible in activities such as budgeting as well as planning for households by allocating available funds to restaurants eating as well as to buying of groceries. It’s argued that on the safe investment part, people tend to think naturally hence being protected against the downward risk as well as from risky investment to become rich by earning higher abnormal returns (Lo, 2005). A price increase of the new securities in the S&P index results from people’s prejudice influenced by the mental compartments. Further, behind those anomalies is also the reason January effect happens as the month in which stock prices appreciates to the maximum. It happens as January is treated by individual as a start of investments that are researched across several countries (Shiller 2003).
There is an acceptance of weaknesses in behavior by the new model asserting that failures in investing are a result of human behavior and their traits. Behavioral theory’s key aspect is that an investor is humans and not a machine. Thus, the framework treats investors as humans and also highlights that bias, illusions and emotion are not rational. It also notes information as inefficient. Finally, securities prices are neither predictable nor random as the reaction of new information by people is unpredictable, as well.
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