The volume of research in the field of Behavioural Finance has grown over recent years. The field 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 the influence of psychology on the behavior of financial practitioners and the subsequent effect on markets. The principal objective is to make money, and we usually assume that investors always act in a manner that maximizes their return rationally. The Efficient Market Hypothesis (EMH), the central proposition of finance 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 the emotions such as fear and greed often play an important role in poor decisions, there are other causes like cognitive biases, heuristics (shortcuts) that take investors to analyze new information about a stock or currency incorrectly and thus overreact or underreact. Behavioural Finance is the study of how these mental errors and emotions can cause stocks or currency 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 rational 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.
It is to be kept in mind that risk resides not only in the price movements of dollars, gold, oil, commodities, companies, and bonds. It also lurks inside us – in the way we misinterpret information, fool ourselves into thinking we know more than we do, and overreact to market swings. Information is useless if we misinterpret 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 of time. 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 held today and are designed to provide investors with higher returns in the next period when that private information is fully revealed to the market. This implies a positive correlation in returns as the market incorporates the information into prices. Trades due to portfolio rebalancing, or hedging, are not information-based and occurs when a trader may increase (or decrease) his stock holding by buying (or selling) a portion of his stock. This will be accomplished by increasing (or decreasing) the stock price to induce the opposite side of the trade.
FOCUS ON INTRINSIC VALUE
What are the implications for corporate managers? It is believed that such market deviations make it even more important for the executives of a company to understand the intrinsic value of its shares. This knowledge allows it to exploit any deviations, if and when they occur, to implement strategic decisions more successfully. Here are some examples of how corporate managers can take advantage of market deviations:
o 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.
o 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 as regards this aspect of market deviations.
Firstly, these decisions must be grounded in a strong business strategy driven by creating shareholder value.
Secondly, managers should be cautious of analyses claiming to highlight market deviations. Furthermore, the deviations 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 for strategic business decisions, the evidence strongly suggests that the market reflects intrinsic value.
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:
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 are shifting 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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