Academic level: Undergraduate
Number of pages: 10
Paper format: MLA
Stock market refers to a market for buying and selling stocks. People show interest in stocks mainly due to three reasons - long term growth opportunity for capital, dividends and an ensured hedge against the reduction of purchasing power owing to inflation. Another feature making the stock market a lucrative investment option for many is its liquidity. Majority of the people invest in stocks with the desire to accrue a benefit upon the payment of dividends and increase of stock price. There are many people buying stocks because of winning control over the companies. Shareholders of many companies are required to buy shares regularly so that they can be a part of the board of directors and can make important decisions regarding the future of the companies. Stock markets are divided into three categories - 1) developed markets like UK, USA, Japan and EU, 2) developing markets like India, China and Mexico, 3) pre-developed markets like Kenya, Vietnam and Estonia (Luong & Ha 2011). The developed stock markets have huge impacts on global security markets, and the dependence and influence of one stock market on the others makes a strong impact on the economy. Therefore, any natural calamity, terrorist actions and energy crisis in any part of the world may make a strong influence on all the security markets in the world, especially in the UK, Japan and USA. Stock market can be considered as a yardstick for economic development and strength. Any movement in the share market trend influences the economy of the world. The rise in share prices indicates a healthy economy and an increase in investment whereas the drop in share prices is an indication of falling economy and decrease in investment. Since stock market and global economy are co-related, any growth in stock market positively impacts the economy and similarly any downslide in stock market poses a threat to the economy. Therefore, the investment decisions undertaken by the investors for stock market have a huge influence in directing the course of the market trend which in turn affects the economy. This paper will make an analysis of various investment behavioral theories and will then explain how the theories can be applied to describe investors’ behavior.
Types of Investors
Primarily, there are two types of investors - institutional investors and individual investors. Institutional investors refer to organizations and bigger investors who contribute to maximum financial transaction in the stock markets. Institutional investors could be investment banks, hedge funds, pension funds, mutual funds, insurance companies and investment advisors. Individual investors also known as retail investors are small investors who could be a wealthy individual or an individual with an average earning. Institutional Investors are the group of investors who take a serious interest in investing and are in many cases not interested in short term gains. These investors are often unbiased as the decisions of investment are taken based on some predetermined objective criterion like company performance, economic indicators, etc. Also in case of institutional investment the investment decision is not taken by a single individual. A group of individuals looks at different parameters to arrive at the final investment decision. This helps in decision making that is less emotional and biased. However, the same cannot be said for individual investors. Many individual investors are as well informed as the institutional investors but follow a pattern of investment stemming from individual behavioral characteristics. There are individual investors making investments based on partial information and making emotional decisions.
Before going into the details of the behavioral pattern of the investors, it is important to take a look at the Efficient Market hypothesis (EMH). EMH assumes that all the investors in the market have access to information and over time they invest in such a way that any market inefficiencies are nullified. But we all know that a perfect market exists only in a theory. To understand the inefficiencies created in the market by the investors, let’s first have a look at the Efficient Market theory.
Efficient Market Hypothesis
We need to understand the basic theory which guides most of the financial market theories. Efficient market hypothesis is the basic assumption that guides most of the financial and economic theories. However, when it comes to investor behavioral theories then the assumptions do not work efficiently. Before going into the investor behavioral theory, let’s first discuss the efficient market hypothesis.
Efficient Market Hypothesis (EMH) assumes that the financial market is informationally efficient. In simpler words, one investor cannot go on making same kind of profit based on a single information available at the time of investment. Over a period of time market will also understand the information and correct itself. There are three different types of EMH - Weak, Semi-Strong and Strong. Weak EMH argues that the price of traded assets like stocks already reflects all the available information in the market. Semi strong EMH argues that prices not only reflect all past market information but also change immediately to new information. Strong EMH makes claims that even insider information is reflected immediately (Malkiel 2003). There are many critics to this theory and many believers also started questioning the theory after the 2000 and 2008 global financial crisis.
Behavioral Theories of Investors' Behavior
Beyond the market information there is another factor called investor who influences the market. Investors are not perfect and often are responsible for market deviation from perfect market standards due to different behavioral pattern of investment. In order to understand the decision-making parameters of investors, we need to focus on the behavioral theories that best describe the psychology behind the investment pattern. There are two theories which describe investors' behavior - heuristic theory and prospect theory.
As per Kahneman and Tversky, who are the first people who studied behavioral factors influencing investors' behavior, heuristics are some basic principles which reduce the complexity of decision making process. They emphasized on three factors namely representativeness, anchoring and availability bias while explaining heuristic theory (Kahneman and Tversky 1974). Representativeness implies the degree of resemblance of an event with its population. Representativeness may involve some biases in which people are ignoring the average long-term rate put too much importance on recent experience. For instance, investors many a time come to a conclusion about a company's long term growth rate on the basis of its short term success. Representativeness also leads investors to make investment decisions on the basis of few representatives' stocks and not by researching the whole gamut.
Anchoring refers to a situation in which estimation is made on the basis of some initial values. Anchoring in the financial market is related to the value scale which is determined on the basis of recent observations. Investors are into the habit of quoting the initial purchase price while analyzing and selling shares. This way current share prices are often determined by those of the past (Luong & Ha 2011). Anchoring like the representativeness indicates that people often make decisions based on recent observations showing optimism with the rise of the market and pessimism with the fall of the market.
Availability bias takes place when people rely on the available information inordinately for making decisions. This kind of bias shows up when investors show their preference for making investments in local companies that they are familiar with or can easily garner information about.
Prospect theory expounds the decision-making process that is influenced by the value system of the investors. It delves deeper into the mental states of investors behind making a decision. This theory takes into consideration three factors - regret aversion, loss aversion and mental accounting. Regret is an emotion that emerges from the guilt feeling of having made a mistake. When investors are required to sell a stock, they determine the selling price on the basis of its purchasing price. Regret aversion also shows in the investors’ behavior of refusing to sell shares that are decreasing in price and willing to sell shares that are increasing in price.
Loss aversion suggests a different level of emotions exhibited by people towards loss and gains. It is seen that people feel more distraught by the prospect of loss than they feel happy at the prospect of equal amount of gains (Luong & Ha 2011). Investors often try to avoid making losses at the cost of huge risks and these risks they would have never taken to get profits of the same proportion. That explains why investors are reluctant to sell their losing stocks because they believe that the market might bounce back to normal and the stock price will increase.
Mental accounting refers to the process in which people reflect upon and evaluate their financial trading. In the financial market, mental accounting is best described when investors show hesitation in selling a share or investment which previously had lucrative gains but now mediocre gains. In ever-changing economic conditions, investors prefer to wait for the gains to bounce back again to its earlier gainful period and, therefore, they feel hesitant in selling shares or stocks at smaller profit.
Investor Behavior: Overconfidence
Overconfidence is a very common emotion among investors. It triggers a wide variety of market investment related decisions for individual as well as institutional investors. It is a behavior that may subject an individual as well as an institutional investor susceptible to financial fraud (Elan & Goodrich 2010). The main variety of overconfidence comes from the belief of the investor that he or she knows more than actually he or she does. This is called ‘miscalibration’ or ‘overprecision’ (Barber 2011). Second variety of overconfidence stems from the belief of investor that he or she is better than the average investor in the market. This is also called ‘better than average’ effect. In both cases the investor shows a tendency to overestimate his or her own ability. There are several people like Kyle, Wang, Xiong, Odean and Grossman who wrote theories about how overconfidence leads to poor decision making for investors. This effect is more predominant among individual investors. Some studies found that overconfident investors tend to trade more in the market and also lose more.
Investor Behavior: Asymmetric Information
There is a huge difference in behavior between institutional and individual investors. Institutional investors never feel less confident that they have less information. However, many individual investors feel that they are at an informational disadvantage. Still, this behavior does not contribute massively to any major emotional investment decisions. This may sometimes lead to lower investment behavior or this behavior sometimes makes an investor to come out of the stock market.
Investor Behavior: Sensation Seeking
Another behavior noticeable among many investors is sensation seeking. This behavior can be paralleled with gambling behavior. Sensation seekers often look at the process of investment not as an informed process but as a pure gambling opportunity. Needless to say, many studies have shown people with this type of behavior often lose money in the market. However, people with this type of behavior get influenced by one gambling success story, ignoring hundred other stories of failure (Barber 2011). Based on the observations of empirical studies, it is seen that people who get a thrill out of speed are often sensation seekers in stock market. For this type of investors, stock market is a type of the avenue for gambling. If any parallel channel for gambling is created then the activity of this type of investors in stock market may reduce substantially. For example, a study conducted by Barber, Liu & Odean in Taiwanese market has shown that a launch of government jackpot reduced the total activity in the stock market by 25% (Barber et. al. 2009).
Investor Behavior: Familiarity Bias
There is information skew to all types of investors, be it institutional or individual. Especially, individual investors have a huge skew in information about the market. Individual investors are more familiar about the industry in which they work or about the companies that are located near to them. Even some of the investors are interested in a typical segment of the industry and possess more information in that area than others. This behavior leads to more investment to the companies and stocks they are familiar with. There are two schools of thought on this behavior. The first school of thought states that people invest in a certain type of industry or stock because they know about them or are more familiar with them than other stocks. The second type of theorists argues that familiarity effect leads investors to make an investment in local stocks and companies about which they can easily collect information. However, in both cases the major drawback is that investors do not diversify their portfolio and often their portfolio underperforms below market average, and portfolio is exposed to higher risk due to less diversification.
Investor Behavior: Disposition Effect
This is an effect first observed and established by Shefrin and Statman in 1985. It was observed that there is behavioral tendency among many investors to sell high performing stocks after the investors get a certain amount of return. On the other hand, it is also observed that investors tend to hold on to the stocks which are underperforming with the hope that those stocks will give them profit in the near future. This effect is known as ‘Selling Winners and Holding Losers’ (Shefrin & Statman 1985). This effect is most pronounced among the financially unsophisticated investors. It is observed in many empirical studies that more wealthier and professional investors tend to hold on to winners and sell losers while occasional individual investors sell winners and hold on to losers more often.
Investor Behavior: Mania & Panics
Mania is enthusiasm around a rapidly growing stock. On the other hand, panic is the depression around a rapidly plunging asset. In many cases, market mania precedes panic. The bursting of dotcom bubble of 2000 and the housing crisis of 2008 are two big examples of mania followed by panic. An average investor often gets influenced by the market trend and jumps into a trend which is already a good growth prospect. This often makes the growth of the asset/stock more than it should be. However, when that optimism is found to be on less solid ground than it was expected a panic strikes the investors causing a huge erosion of value (Elan & Goodrich 2010).
Investor behavior was always a very interesting study for the financial and economic theorists. Starting from the days of great depression till today there are many theories which tried to explain the decision making behavior of investors. Theories like Prospect Theory, Heuristic Theory and Greater Fool Theory highlights the social, emotional and cognitive behaviors influencing the decision-making pattern of the investors. These theories also help in understanding the psychology that guides a particular investor. There are a number of behaviors including overconfidence, familiarity bias, mania, panic and gambling which often influence investors in a direction that is not suitable for long term benefit. Due to different behavioral patterns influencing the decisions of the investors, financial markets often behave differently from time to time than expected and suggested by efficient market hypothesis. In a typical market, there are investors who sell their winners and hold on to their losers, generating unnecessary tax liabilities. There are investors who hold on to a very poorly diversified portfolio because of familiarity to that portfolio. They generate diversification risk and low return than the market return. There are investors who are influenced by news and past trend, and invest in stocks without doing any homework, often causing a bubble in the market. All these types of market inefficiencies will continue to exist as different types of investors will always be present in the market.
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