Behavioral finance is a hypothetical insight into behavioral and psychological aspects that are involved in evaluating investment decisions. In light of the above statement, the outcome of any investment decision largely depends on two variables namely psychological and behavioral. Behavioral finance encapsulates two variables majorly cognitive psychology and the limits to arbitrage. The former entails thought process and the latter involves speculation.
Behavioral finance is a relatively new concept that attempts to decipher the behavioral and psychological aspects of investors that influence their decision-making process hence determining the final outcome. To facilitate an in-depth understanding of the aspects of behavioral finance, an insight into the two variables but not limited to the two and how they influence the decision-making process of investors is paramount.
Arriving at a particular investment decision calls for confidence but overconfidence leads investors to misjudge their knowledge and abilities. Overconfident investors hold the belief that they know more than what the other investors know. There is a huge chunk of information availed through different platforms to the market. Several platforms exist for disseminating information to the required sources the only difference being the frequency of access. The bulk of information is availed through the internet.
Decision building is an intricate process. A number of factors come into play that will eventually affect the final outcome. Arriving at a particular investment decision call for confidence but certitude might make investors misjudge their knowledge and abilities. Overconfidence stems from the fact that some investors are more knowledgeable than others. A huge chunk of information is availed through different media and those who access their subject of interest become overconfident in their ability to select securities or apply investment tools. If the success is instant they base it on their ability to analyze the market. The high return fuels their urge to take higher risks.
The manner in which information is presented to investors will influence their final decision. This is an aspect of cognitive psychology. How information is presented will influence investors’ perception and will not only dictate what to contemplate about the issue at hand but also how to contemplate it. The investment decision is a mutually exclusive event. Loss evasion is more prevalent among investors as the majority of investors perceive a loss has far-reaching effects than a gain of equal magnitude (Tversky & Kahneman 1986).
The possibilities of monthly effects coming into play are greater. Overall monthly effects dictate the investment trends and decisions among investors. Depending on the day of the week, day of the month or even year the stock market would experience a buzz of activities. Existence of abnormal patterns of returns dictating investment decisions is prevalent. Investors will behave in a predetermined behavior depending on the day of the week or month. It is fueled by speculation hence the tendency to either acquire or dispose of their investments (Thaler 1987).
There are some concrete beliefs and assumptions that individual investors perceive that they hold some water. It encompasses an individual’s perception of the world around him and how they selectively pick and structure information. They are these assumptions and beliefs that end up influencing the investment decisions that they eventually make. Collectively they are referred to as cognitive dissonance. Conventional wisdom dictates that we reverse decisions that result in undesirable effects but this is contrary to investment decisions whereby negative effects might actually decision-makers to further commit more resources and undergo the risk of high undesirable outcomes (Hastie & Dawes 2001).
Investors’ inverse perception of risks and benefits dictates investment decisions. This is commonly referred to affect heuristics. Occasionally investors tend to associate their decisions based on emotion and optimism sometimes being conscious of what they are doing. Availability is another aspect of heuristics that affects and determines investor evaluation of rate of recurrence, likelihood and causality is a correlation that determines how information is recalled from memory. Similarity heuristics are evident in financial facts and stock market forecasts. These heuristics have an impact on the eventual decisions concluded by an investor (Gillovich & Griffin 2002).
The tendency of an investor to look for information that is in tandem with one’s beliefs and be oblivious of anything that contradicts an investor’s belief also plays major role in influencing the decision taken by an investor. Investors’ reactions to news shape up the decisions arrived at by an investor. the difference in reaction to information is based on a number of factors like overconfidence or bounded rationale. Heuristics facilitate easier decision-making. Consequently, it may lead to biases especially when things are dynamic. It has the long-run effect of leading to suboptimal investment decisions. Generally the tendency of men to be overconfident is higher. Overconfidence has the effect that it may lead to an investor making some rational decisions, which translate to poor investments (De Bondt & Thaler 1987).
With regard to investment, investors display the aspect of conservatism. This is in regard to being slow to absorb relatively new fundamentals and aspects of investments. Put in other terms investors tend to base their investment decisions on the old ways of doing things and which they are accustomed to. In view of this investors might underreact due to their conservative nature. In the event of a long enough pattern investors will gradually react to it possibly overreacting in the long run. This has the effect of underweighting the long-run average (Loomes & Sugden 1982).
Another aspect of investment is the disposition effect. Disposition effect is a term that denotes the pattern that investors avoid to realize paper losses and seek to recognize paper gains. The disposition effects manifest themselves in terms of the realization of small gains a small number of losses. Following a purchase of a security an investor would readily dispose of it if it rises above the purchase price but if it falls below the purchase price small gains are significant (Thaler 1993).
The concept of the limit to arbitrage is common during investment decisions. Misvaluation of securities is a commonplace occurrence but contrary to expectations the probability of realizing abnormal profits out of these misvaluations is generally low. Generally speaking misevaluation can be categorized into two namely those that are non-recurring and long term in nature and those that are recurring. Hedge fund is a classic example of investors who try to make money by capitalizing on these misevaluations (Kahneman & Tversky 2000).
Arbitrage generally refers to simultaneously purchasing and selling of the same or essentially the same security in a dissimilar market for advantageously dissimilar prices. Quite often it involves acquisition and disposal of security hence it entails risks and sometimes there are no risks involved. The essence of arbitrage is that it plays a major role in the market analysis of securities. This in turn has the overall effect of influencing the investor decisions (Shefrin 2000).
Behavioral finance takes into account several factors that come into play when assessing the impact of behavioral finance on investment decisions. It’s worthy to acknowledge that it encompasses two core branches namely the cognitive and the limit to arbitrage. How information is presented is critical in the conclusions arrived at by investors. Documented evidence has shown that the manner in which information is relayed will determine what investors will think about. The calendar effects cannot be ignored as they also influence the decision arrived at by investors. Calendar effects characterize efficient market hypothesis. Investors have a tendency to search for information that is tandem with their past knowledge and their reluctance to absorb relatively new information even when such information is contradictory. The limit to arbitrage also comes into play in arriving at decisions. It’s a commonplace occurrence to misvalue securities consequently leading to smart investors making gains.
References
De Bondt, W.F. M. & Thaler, R.,(1987) Further Evidence on Investor Overreaction and Stock Market Seasonality, Papers and Proceedings of the Forty-Fifth Annual Meeting of the American Finance Association, Journal of Finance, 42. 3, pp. 557- 581.
Gilovich, T, Griffin, D. & Kahneman, D. (2002).Heuristics and Biases: The psychology of intuitive judgments. Cambridge. Cambridge University Press.
Hastie, R. & Dawes R.M,(2001) Rational Choice in an Uncertain World: The Psychology of Judgment and Decision Making.Carlifornia.Sage
Kahneman, D., and Tversky, A., (2000). Choices, Values and frames. Cambridge. Cambridge university press.
Loomes, G., & Sugden, R. (1982). Regret Theory: An Alternative Theory of Rational Choice under Uncertainty, The Economic Journal, 92.368 pp. 805-824.
Shefrin, H., (2000). Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing. New York. Oxford University Press.
Thaler, R., H.(1987) Anomalies: The January Effect, The Journal of Economic Perspectives, 1.1 pp. 197-201.
Thaler, R.H. ( 1993). Advances in Behavioral Finance. New York. Russel sage foundation.
Tversky, A & Kahneman D. (1986). Rational Choice and the Framing of Decisions: The behavioral Foundations of Economic Theory. Journal of business 59 (4.2) pp.251-278.