The Influence of Behavioural Finance on Stock Markets - Case Study Example

The Influence of Behavioural Finance on Stock Markets Bubbles and Crashes Introduction Behavioural finance has become one of the disciplines of great interest to investment firms, wealth management professionals and those interested in the stock market performance. Behavioural Finance is commonly understood as the application of psychological aspects of investors to financial planning and investment decision making. The growth and development of the theories and models of this special area of finance has led to new development in the stock market. Though, individual investors form an insignificant portion of the total stock market investment, the behaviour exhibited by them can have great influence on the performance of the stock market and trading. Human behaviour and personal investment decision making can influence the trading results of a stock market and therefore, it is relevant to discuss the role of behavioural finance in the investment decisions at stock market. With this background, this paper attempts to discuss the influence of behavioural finance on the stock market performance in general and on the market bubbles and crashes in particular. The essay takes a descriptive approach wherein the present literature on these issues is mainly covered and an attempt is made to incorporate the relevant theories of behavioural finance. Behavioural Finance Behavioural finance is one of the fast developing areas in the field of financial literature. This field of knowledge has developed a number of theories and theoretical models to explain the behavioural aspects of investment decision making. Most of the theories and models have been developed by borrowing insights from other branches such as psychology, sociology, and other behavioural sciences to analyze the behavioural aspects of investors and its influence on stock market performance. A good number of studies have been undertaken across the world to evolve behavioural theories and models so as to explain the association between the investor psychology and stock market performance. This area of knowledge tries to answer the influence of individual and collective behaviour exhibited by investors on the market prices. The rational finance which stems from neoclassical economics postulates that the economic decisions of investors are determined by the principles of perfect self-interest, perfect rationality, and perfect information (Ware2000). This is not going to be a logical view point as described by behavioural finance. Behavioural finance states that people are neither perfectly rational nor perfectly irrational; they possess diverse combinations of rational and irrational characteristics that govern their decisions on investment. This behaviour has been experienced and documented from the practical experience of investment management and stock market professionals. Thus, demographic profile and investor personality cab be key determinants of investor psychology and hence on the stock market performance (Daniela 2001). Behavioural Finance and Stock Market Performance The financial system of any country is composed of a vibrant stock market that mobilises and channelizes the savings of individual as well as institutional investors. The other participants in the financial system also have a bearing upon the stock market as it is often considered as the economic barometer. Stock market all over the world exhibits different behaviour depending upon the local economic developments and issues. Of course, international issues also contribute to the way stock market performs at a particular point of time. The flow of funds from different parts of a country and from different parts of the world is determined by how individual and group investors behave at different time points as a result of the information gained from time to time. The behaviour of stock market at times cannot be explained by rational theories and models. . This vulnerability made the nature of stock market uncertain and unpredictable. The movement in the stock prices does not follow any fundamentals and nor technical analysis tool can predict what exactly is happening in the market. The dramatic fluctuations in the prices of stocks overrule the concept of intrinsic value and rational theories. All the irregularities in the market behaviour cannot be interpreted by the assumptions and theories of rational investment behaviour, efficient market etc. It is believed conventionally that investors in the stock market are rational and if any irrational behaviour exhibited by them is quite random. This traditional misconceptions and belief on the stock market behaviour fails at times to illustrate how market fluctuates over time. Finally, it became surprising that the underlying premises of rational finance became immaterial and investors are found irrational and no traditional financial theory illustrates the market behaviour and stock prices completely (Hong 2003). At this juncture, behavioural finance attempts to provide alternative solutions on the above key puzzles of stock market as to why stock prices deviate from their intrinsic values. The basic underlying principle of behavioural finance is that human behaviour and perceptions represent two crucial elements of financial decision-making (Hirshleifer, 2001). This has paved that way for further research in the area to evolve new theories and models that can explain and predict stock market fluctuations from psychological view point. Thinkers of behavioural finance borrow insights from various behavioural subjects to develop models that can explain the complex behavioural aspects in the context of investment and stock market. One of the important contentions of this theory is that investors do not completely exhibit rationality in their investment decisions. Consequently, market shows inefficiencies in the form of under pricing or over pricing phenomenon. This phenomenon is collectively known as mispricing and it implies that there are deviations between the current stock prices and the calculated intrinsic values according to the traditional models. The literature on behavioural finance documents that the major studies in this area were undertaken by thinkers in the financial literature such as Weber (1999), Schiller (2000), and Shefrin (2000). Martin Weber, a leading European behavioural economist contributed important research insights in the year 1999. He observed that stocks with high performance in the past five years often tend to become under-performers in the next five years. Through his empirical study, it is examined that the investors who possess under performing stocks are experiencing difficult to dispose of the same owing to the behavioural problems. R. J. Shiller firmly supports the behavioural finance by arguing that stock market is influenced by the information in the stock market; which can have a direct impact affects on the investors’ decision making. Stock Market Crashes and Bubbles Irregularities are common phenomenon in the stock market. The rational theories and mathematical models have been found insufficient at certain times. The Peso crisis in Mexico, for instance, in the year 1994 experienced a sudden hike in the lending rate by 400% over four months period (Hernandez 1996). Behavioural factors are found to have an important bearing on the market behaviour in such situations. However, a full-fledged mechanism to explain such behaviour has not yet been fully researched. It has also been found from the prior studies that market behaviour is subject changes in fundamentals triggered by changes in the behavioural aspects of investment decisions by virtue of market information. These factors, according to R. J. Shiller, are herding, market rumours, fear of contagion or panic or combination of one or more of these (Shiller, 2000). It is also notable that no single factor can be said to be the sole determinant at a particular time point. What all an analyst can do is that he can opine that every psychological factor has played a role in the market crash and also the magnitude of the crash. Thus, it is generally believed that wide changes in the anticipation about the fundamentals are primary determinants of crash. The Behavioural Approach to Crashes and Bubbles The above market anomalies, according to behavioural approach, happen on account of the fact that investors often is influenced by under- or overreaction to information. The under reaction condition exhibits that stock prices under react to intrinsic/ fundamental information such as dividend or bonus announcements. This depends upon whether the information is good or bad to the investor. When the information is favourable to the investor, stock prices tend to increase; and when the information is bad, prices tend to coming down. Naturally, stocks that have a history of good information would be overpriced and vice versa. W. F. M. De Bondt and R. Thaler plead that investors are expected to respond like representativeness heuristic and tend to be optimistic on the past winners in the stock market and pessimistic on past losers (Bondt 1985). On the other hand, extreme “winners” are companies with several years of good news, inviting thus temporary overvaluation and subsequent reversal. In this respect another view put forward by K Daniel, D Hirshleifer, and A Subrahmanyam, in their work entitled ‘Investor Psychology and Security Market Under-and Overreactions’. The authors observed that the bias in the market may be explained as excessive volatility anomaly. Also they claim that the sources of information for investment decision by investors and analysts might be any or combination of the one or more of financial statements; verifying rumours; interviewing management, etc (Daniel et al., 1998). In another significant study by A Shleifer entitled ‘Do Demand Curves for Stocks Slope Down’ the author advocates that when stock market investors get some information about the company from any of the above sources, they have a tendency not to react to the information. Consequently, this behaviour leads to under reaction to profit and other bonus announcements. Conclusion Behavioural finance is a nascent but growing are of interest to investors as well investment professionals. The main contention of this burgeoning area of study is that man makes investment decisions using insights not only from standard finance but certain irrational theories as well. The present essay is an attempt to measure the influence of behavioural finance on investment selection. The analysis of how an investment choice gets affected by the demographic variables and personality profile could help the financial advisors to give better suggestions to their clients. The investment preferences are dynamic due to the changes in social, economic and political atmosphere, as well as introduction of new investment avenues. The models of behavioural finance, incorporating behavioural, psychological, agency, and institutional factors as well as risk factors, are now beginning to challenge modern finance models in terms of explanatory and predictive power. References A Shleifer (1986) ‘Do Demand Curves for Stocks Slope Down?’ The Journal of Finance, 41 , 579-590. Bondt W F M De and R Thaler (1985), ‘Does the Stock Market Overreact?’ The Journal of Finance , 40:. 3, 793-805 Daniel K, D Hirshleifer, and A Subrahmanyam (1998) ‘Investor Psychology and Security Market Under-and Overreactions’, The Journal of Finance, 53:6, 1839-1885. Hernandez A and Santos M (1996), ‘Competitive Equilibria for Infinite-Horizon Economies with Incomplete Markets’, Journal of Economic Theory, 71, 102-130 Hirshleifer D (2001), ‘Investor Psychology and Asset Prices, Journal of Finance, August, 56: 4, 1533-1598. Hong H and Stein J (2003), ‘Differences in Opinion, Short-Sales Constraints and Market Crashes’, Review of Financial Studies, 16, 487-525. Shiller R J (1984), ‘Stock Prices and Social Dynamics’, The Brookings Papers on Economic Activity, Fall, 2, 457-510. Shefrin Hersh (1985) ‘The Disposition to Sell Winners too Early and Ride Losers too Long’, Journal of Finance, 40, 777-790 Ware James (2000), The Psychology of Money, Wiley Finance Series, New York Weber Martin (1999), ‘Behavioural Finance’, Research for Practitioners, University of Mannheim. Zunino Daniela (2001), ‘El Mercurio, Economia y Negocios’ Santiago de Chile, Tuesday November 20 Read More