Introduction
Behavioral finance is based on the concept that market inefficiencies can be identified and effectively exploited for making accurate predictions on future investment market movements. It is an alternative view of the efficient market hypothesis or EMH. “A growing field of research called behavioral finance studies how cognitive or emotional biases, which are individual or collective, create anomalies in market prices and returns that may be inexplicable via EMH alone.” (The efficient markets hypothesis (EMH) 2007).
Efficient Market Hypothesis (EMH) and its criticisms
An efficient market is representing a market situation in which a large number of rational investors, actively participating in the competition. In this market, information is freely available to all of the investors on a real-time basis. Investors use the available current information relating to the market for predicting the future market values on individual securities. Thus the actual prices of individual securities in the market should reflect the effects of information relating to events that have already occurred or are expected to occur shortly. “The Efficient Market Hypothesis asserts that at any time the price of a stock on a stock market reflects all information about that stock and that market, including future expectations.” (Blackthorn 2001).
There are certain limitations with the efficient market hypothesis. In case of inefficiency in the market, the stock prices would not influence the information available in the market and thus the stock prices indicate a flawed measure of value reflecting all past information. In the Weak form efficiency capital market, fundamental analysis can be applied for identifying the undervalued or overvalued stocks. “Traditional financial theorists have undertaken a strong defense of the EMH model. It has been suggested that observed market anomalies may arise, not because of behavioral issues, rather because of misspecified systematic risk.” (Brabazon 2000, p. 5).
Implications of Behavioural finance
As per the arguments of the behavioral theorists, the financing decisions are influenced by group pressures and they will follow the fashions. The confidence in rationality is reduced
Behavioral finance is based on the concept that the financial decisions of the investors would be affected by errors of judgment and errors of preferences. Errors of judgment are arising from the overestimates or underestimates of the investors regarding the probability of the events. It is reoffered as cognitive biases. It is resulting from the lack of information regarding the current market trend. Decision-makers are always analyzing the more representative outcomes independently. Several behavioral factors influence the decisions. They are as follows:
- Overconfidence: It may be shown by the investors and this will lead to overestimation of predictive skills.
- Anchoring: It is another feature stated in behavioral finance. In anchoring, the investor makes judgments regarding the market retained, by their own experience in the past. The inappropriate predictions of investors lead to the influence of gamblers.
- Availability bias: It is aroused from the provision of importance to easily available information for making an investment decision.
- Errors of preferences: It refers to the mistakes that people make in assigning values to future outcomes. An improper combination of probabilities and values will lead to errors of preference. These errors are related to the usage of available information for predictions.
- Loss aversion: Investors are aware of the losses in the market than gains. (Arguments of behavioral finance n.d., p. 402).
Behavioral finance can be used for making rational investment decisions in irrational economic conditions. In stock market investment decisions, the emotions of the individuals act as biases. The irrational behavioral pattern shown by the investors is of systematic and persistent nature. Thus it can be effectively used by informed investors for identifying the market opportunities. They can capitalize on the opportunities. The behavioral biases may lead to pricing anomalies in the market. Proper analysis of these trends may give rise to opportunities. The acts of irrational investors should cause inefficiency in the market and it will provide an opportunity for other investors.
Their poor decisions may be exploitable for making a profit. The mispricing of stock prices will provide an opportunity for trading above or below the actual value. “Behavioural finance seeks to consistently outperform the market by identifying and exploiting pricing anomalies that result from investor behavioral biases. Therefore, when added to a balanced portfolio behavioral finance funds can help boost overall performance over the long term.” (Behavioural finance 2007, p. 6)
Conclusion
Investors use subjective decision weights for taking decisions but they may suffer from losses accounting for errors in judgment and preferences. The experience will lead to a better understanding of financial markets. Errors of judgment may lead to deviation of market prices from fundamental values or market inefficiency. Overconfidence may lead to excessive trading and anchoring can lead investors to expect an experience. The combined effects of the errors in individual prediction may lead to investors’ process in a way different from the traditional theories leading to different market prices and different market anomalies. Thus behavioral factors influence the decision-making process.
References
Arguments of behavioural finance: efficient markets theory and evidence n.d. (Provided by customer).
Blackthorn 2001, Efficient market hypothesis, Everything2. Web.
Brabazon, T 2000, Behavioural finance: a new sunrise or a false dawn?: counter arguments of traditional financial theorists. Web.
Behavioural Finance: using behavioural finance as part of a diversified portfolio: increased return potential 2007, JPMorgan Asset management. Web.
The efficient markets hypothesis (EMH): an alternative theory; behavioural Finance 2007, Money Science: Financial Intelligence for the Business World. Web.