The volume of research in Behavioural Finance has grown over recent years. The area merges finance, economics, and psychology to understand human behavior in the financial markets and form winning investment strategies.
THE CONCEPT OF BEHAVIOURAL FINANCE
Behavioral finance is the study of psychology’s influence on financial practitioners’ behavior and the subsequent effect on markets. The principal objective is to make money, and we usually assume that investors always act rationally to maximize their return. The Efficient Market Hypothesis (EMH), the central finance proposition for the last thirty-five years, rests on an assumption of rationality. But it has been proved that people are ruled as much by emotion as by cold logic and selfishness.
While emotions such as fear and greed often play an important role in poor decisions, other causes like cognitive biases and heuristics (shortcuts) take investors to analyze new information about a stock or currency incorrectly and thus overreact or underreact. Behavioural Finance studies how these mental errors and emotions can cause stocks or cash to be overvalued and create investment strategies that give a winning edge over the other investors. I want to bring out the behavior pattern of a rational investor. This sensible investor is assumed to act rationally in the following ways:
o Makes decisions to maximize the expected utility.
o Fully informed with unbiased information.
o The absence of any distortion of judgment based on emotions.
Remember that risk resides not only in the price movements of dollars, gold, oil, commodities, companies, and bonds. It also lurks inside us – how we misinterpret information, fool ourselves into thinking we know more than we do, and overreact to market swings. Knowledge is useless if we twist it or let emotions sway our judgment. Human beings are irrational about investing. Correct behavior patterns are essential to successful investing – so to be financially successful, one has to overcome these tendencies. If we can recognize these destructive urges, we can avoid them. Behavioural Finance combines the disciplines of economics and psychology specifically to study this phenomenon Graet News Network.
THE CONCEPT OF BUBBLES IN THE STOCK MARKET
A speculative bubble occurs when actions by market participants result in stock prices deviating from their fundamental valuation over a prolonged period. Speculative bubbles are difficult to explain by rational trading behavior and behavioral finance theories have been put forward to explain market psychology. They propose that when the market’s significant proportion of trading activity is characterized by positive feedback behavior, it may result in asset prices shifting away from their fundamental valuation. This price deviation encourages rational investors to trade in the same direction.
Speculative traders are based upon investors’ private information today. They are designed to give investors higher returns in the next period when that personal information is fully revealed to the market. This implies a positive return correlation as the market incorporates the data into prices. Trades due to portfolio rebalancing, or hedging, are not information-based and occur when a trader may increase (or decrease) his stock holding by buying (or selling) a portion of his store. This will be accomplished by advancing (or reducing) the stock price to induce the opposite side of the trade.
FOCUS ON INTRINSIC VALUE
What are the implications for corporate managers? Such market deviations are believed to make it even more important for a company’s executives to understand its shares’ intrinsic value. This knowledge allows it to exploit any deviations to implement strategic decisions more successfully if and when they occur. Here are some examples of how corporate managers can take advantage of market deviations:
Issuing additional share capital when the stock market attaches too high a value to the company’s shares relative to their intrinsic value.
o Repurchasing shares when the market underprices them relative to their intrinsic value.
Paying for acquisitions with shares instead of cash when the market overprices them relative to their intrinsic value.
Two things must be kept in mind regarding this aspect of market deviations. Firstly, these decisions must be grounded in a strong business strategy that creates shareholder value. Secondly, managers should be cautious of analyses claiming to highlight market deviations. Furthermore, the variations should be significant in both size and duration. Provided that a company’s share price eventually returns to its intrinsic value, in the long run, managers would benefit from using a discounted cash-flow approach for strategic decisions. It can thus be summarized that the evidence strongly suggests that the market reflects intrinsic value for strategic business decisions.
INVESTING IRRATIONALITIES
Often, turbulence in the market isn’t linked to any perceivable event but investor psychology. A fair amount of portfolio losses can be traced back to investor choices and reasons for making them. I want to point out some of the ways by which investors unthinkingly inflict problems on themselves:
Herding
This is a cardinal sin in investing, and this tendency to follow the crowd and depend on the direction of others is exactly how problems in the stock market arise. Two actions are caused by herd mentality:
o Panic buying
o Panic selling
Holding Out for a rare treat
Some investors, praying for a reversal for their stocks, hold onto them; others, settling for limited profit, sell the stock with great long-term potential. One of the big ironies of the investing world is that most investors are risk-averse when chasing gains but become risk lovers when trying to avoid a loss. If we shift our non-risk capital into high-risk investments, we contradict every rule of prudence to which the stock market ascribes and asks for further problems.
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