Behavioural Finance Essay Example for Free

Behavioural Finance EssayHypothesis and the extent to which they can be explained by behavioural pay theories Finance that is based on rational and logical theories, such as thecapital asset pricing model(CAPM) and the efficient martplace hypothesis (EMH). These theories get hold of that people, for the closely to part, be harbor ration ally and predictably. The Efficient merc gainise hypothesis assumes that financial markets incorporate all public in kindation and assets that sh ar determines reflect all applicable to the firm study (Fama, 1970). Relevant information includes past information, publicly addressable information and private information. Efficient market is divided into three categories. Weak form efficiency is when stock prices reflect only the past information, semi-strong form is when past information and all publicly available information is reflected and strong form is when all the past, publicly available and information only available to company i nsiders is reflected on the stock prices. However, there are some anomalies and looks that couldnt be explained by EMH. Market participants lots behaved very unpredictably. However there is a new study called behavioral finance that is trying to explain all these anomalies.Behavioral finance studies the irrational behavior of the investors. Weber (1999) makes the totaling observation Behavioral Finance closely combines individual behavior and market phenomena and uses the knowledge taken from both the psychological field and financial theory. Behavioral finance attempts to identify the behavioral biases commonly exhibited by investors and also provides strategies to overcome them. Some of the main enigmas with EMH may be cause by heuristic responses to new information, psychological anchors, overconfidence, social fads, framing and sorrowfulness escape and herd behavior.Overconfidence According to Nevins (2004), overconfidence suggests that investors overestimate their ability to predict market events, and because of their overconfidence they often take risks without receiving commensurate returns. Odean (1998) finds that investors tend to overestimate their ability, unrealistically optimistic about future events, too positive on self-evaluations, over-weight attention getting information that is consistent with their existing beliefs, and over-estimate the precision of their own private information.Overconfidence about private signals causes respondion and hence phenomena like the book/market cause and long reversals whereas self-attribution maintains overconfidence and allows prices to continue to overreact, creating momentum. In the longer-run there is reversal as prices revert to fundamentals. Psychological Anchors, Overreaction Good news should raise a business share price accordingly, and that gain in share price should not decline if no new information has been released since. Reality, however, tends to contradict this theory.Oftentimes, parti cipants in the stock market predictably overreact to new information, creating a larger-than-appropriate opinion on a securitys price. Furthermore, it also appears that this price surge is not a permanent trend although the price change is normally sudden and sizable, the surge erodes over time. Heuristic responses to new information Availability heuristic is used to evaluate the frequency or likelihood of an event on the basis of how quickly instances or associations come to mind. When examples or associations are easily brought to mind, this fact leads to an overestimation of the frequency or likelihood of this event.Example People are overestimating the divorce rate if they can quickly find examples of divorced friends. People tend to be biased by information that is easier to recall. They are swayed by information that is vivid, well-publicized, or recent. People also tend to be biased by examples that they can easily retrieve. ( Tversky and Kahneman, 1974) Confirmation biasis a cognitive bias whereby mavin tends to notice and look for information that confirms ones existing beliefs, whilst ignoring anything that contradicts those beliefs. It is a type of selective thinking.The reason for overconfidence may also have to do with hindsight bias, a leaning to think that one would have known actual events were coming before they happened, had one been present then or had reason to pay attention. Hindsight bias encourages a view of the world as more inevitable than it really is (Shiller, 2000). This is the characteristic of investors, when looking back, seeing events that took place in the past as having been more predictable than they seemed before they happened. Likewise, things that didnt happen seem, with hindsight, much less likely to have happened than they did beforehand.Self-attribution bias occurs when people attribute successful outcomes to their own skill but cull unsuccessful outcomes on bad luck (Shefrin, 1999). Availability bias is the avail ability deviation is a general rule or a mental cutoff which lets people guess the probability of a result and to what percent it may appear in their daily life. Those who commit such a deviation turn the easily recalled events more probable than those they can hardly imagine or perceive. Availability bias declares the persons tendency toward deciding and judging based on available and easily accessible data (Tversky and Kahneman, 1982).Herd behavior which is the tendency for individuals to mimic the actions (rational or irrational) of a larger group. Blackmore (1991) states Within an hour of birth , humans concern in imitation. in that location are a couple of reasons why herd behavior happens. Its unlikely that a large group could be wrong. later on all, even if you are convinced that a particular idea or course or action is irrational or incorrect, you might still follow the herd, believing they know something that you dont. Recency bias is the tendency for people to place gr eater importance on more recent data or feel.This is the problem of putting too much weight on current events or data and not adequacy weight on past, historic trends. Many investors appear the market to continue rising in a current bull market likewise, these same investors often expect a current bear market to get worse. Recency is shown in momentum investing when investors buy hot stocks simply on the basis of their recent strong performance. Kahneman and Tversky (1973) find that people ordinarily forecast future uncertain events by focusing on recent explanation and pay less attention to the possibility that such short history could be generated by chance.It is believed the net effect of the gains and losses involved with each excerption are combined to present an overall evaluation of whether a choice is desirable. However, research has found that we dont actually process information in such a rational way. In 1979, Kahneman and Tversky presented an idea calledprospect t heory, which contends that people value gains and losses differently, and, as such, will base decisions on perceived gains rather than perceived losses.Thus, if a person were given two equal choices, one expressed in terms of possible gains and the other(a) in possible losses, people would choose the former even when they achieve the same economic end result. Regret annulance is the tendency to avoid actions that could create discomfort over prior decisions, even though those actions may be in the individuals best interest. Researchers have argued that one of the reasons that investors are reluctant to sell losing positions is because to do so is to admit a bad decision. This reluctance can be linked to both regret avoidance and belief perseverance.To avoid the stress associated with admitting a mistake, the investor holds onto the losing position and hopes for a recovery. According to prospect theory, losses have more emotional impact than an same amount of gains. Prospect theo ry also explains the occurrence of the disposition effect, which is the tendency for investors to hold on to losing stocks for too long and sell winning stocks too soon. The most logical course of action would be to hold on to winning stocks in order to further gains and to sell losing stocks in order to prevent escalating losses.The leaf side of the coin is investors that hold on to losing stocks for too long. Investors are willing to assume a higher level of risk in order to avoid the negative utility of a prospective loss. Unfortunately, many of the losing stocks never recover, and the losses incurred continued to mount, with often disastrous results. The January-Effect is where the average monthly return for small firms is consistently higher in January than any other month of the year in the UK this is observed in April. This contradicts with EMH, as EMH predicts that stocks should move at a random walk.January returns are greatest due to yearend tax loss selling of shares dis proportionally (Branch 1977). Another anomaly of this type is the Weekend-Effect, where Fama (1980) found that returns on Mondays tend to be negative if compared to any other week day, but this has disappeared in the UK by the 1990s. Some theories that explain the effect attribute the tendency for companies to release bad news on Friday after the markets close to depressed stock prices on Monday. Others state that theweekend effect might be linked to short selling, which would affect stocks with high short interest positions.Alternatively, the effect could simply be a result of traders fading optimism between Friday and Monday. Index effect is a phenomenon where the addition to, or deletion from, a stock baron causes a change in the price, trading volume, volatility or operating performance of the stock concerned. A stock entering an index will automatically receive increased demand from institutional investors principally index tracker funds and exchange trade funds (ETFs) whil e a deleted stock will experience reduced demand.The fact that a stock jumps in value upon inclusion is once again clear evidence of mispricing the price of the share changes even though its fundamental value does not. Another anomaly is P/E effect from CAPM model portfolios with low P/E ratios outperform those with high. The low price-earnings ratio effect occurs because stocks with low price-earnings ratios are oftenundervalued and their prices eventually rise because investors become pessimistic about their returns after a bad series of earning or bad news.A company with high price to earning tends to overvalued (De Bondt and Thaler, 1985). Winner-Loser anomaly De Bondt and Thaler (1985) found that shares which initially earn extreme positive return (winners) or extreme negative returns (losers) experience lengthened reversals in their performance over long horizons. De Bondt and Thaler (1985) suggested the overreaction hypothesis as an explanation of their result. This hypothesi s claims that the market overreacts to information. That is, the market overweights the most recent information and underweights earlier information.However, this phenomenon is change by reversal when it is recognized that the markets expectations were indeed an overreaction to the information released. This hypothesis also offers an explanation of the P/E effect. Fama and French (1992) showed that a precedentful predictor of returns across securities is the ratio of the book value of the firms equity to the market value of equity. After controlling for the size and book-to-market effects, beta seemed to have no power to explain average security returns. One explanation is that investors overreact to growth aspects for growth stocks, and value stocks are therefore undervalued.According to some academics, the ratio of market value to book value itself is a risk measure, and therefore the larger returns generated by low MV/BV stocks are simply a compensation for risk. embarrassed MV/BV stocks are often those in some financial distress. All of these anomalies may be explained by behavioral finance. Behavioural finance is the study of the learn of psychology on the behavior of financial practitioners and the subsequent effect on markets. Behavioural finance is of interest because it helps explain why and how markets might be inefficient.There are series ofbehavioural biases strange twists in human nature that cause us to act irrationally and against our own interests. On the other hand all of these anomalies may instead be an artifact of data mining. After all, if one reruns the computer database of past returns over and over and examines stock returns along enough dimensions, simple chance will cause some criteria to appear to predict returns. May be this is why some anomalies appear to be lost at some point of time e. g. the weekend effect during the 90s.