LITERATURE REVIEW OF
Behavioural finance is a new area of research which
recognizes the psychological element in financial decision making and thus
challenges the traditional theories of finance and economics.
Behavioural ?nance research can contribute to the ?nancial
industry, but at the same time there is an evident discrepancy between the
academic and the professional world when it comes to utilising behavioural
Behavioural ?nance is a fully developed discipline that has
its own theory base as well as methods and methodology; and ranging from
ethnographic research to experiments.
Behavioural ?nance, therefore, contributes three major
intuition is fragile – basic investment principles are not studied by everyone
who makes investments. That is why, they are biased and fall in predictable
of the major insight in behavioural finance is the decision-making process. The
decision-making process is important anything we buy or cell. In this, ?nancial choices are analogous to
medical, consumer and structured other choices. Traditional ?nancial economics
puts emphasis on the “homo-economicus” (fully rational reasoning) and it is
important that we study decision making in ?nance because this rationality is
not always the case in real life.
personal beliefs of individuals are very relevant in ?nance. Their personal
beliefs could provide hindrances towards rational investment.
Behavioural ?nance is informed by three strands of
or behavioural psychology, where the focus is upon how our minds undertake the
requisite calculations required to maximise wealth
responses to the intensity of trading, where the focus is on decision-making
being more than a strictly calculative process.
psychology, which recognises the need to ?nd acceptance and even encouragement
of our acts.
Theories of ?nancial decision making, such as the ef?cient
market hypothesis and the capital asset pricing model have had an impact on the
way practitioners perceived the world around them.
The proposition that has dominated finance for over 30 years
is Efficient Market Hypothesis (EMH). EMH is based on three basic theoretical
are rational and thus they value securities rationally
consider all the available information before making investment decisions
always pursues self-interest.
However, it has been noticed that investors are exposed to a
range of decision making biases that negatively affect their investment
performances. Investors in the stock market are inclined towards behavioural
biases, which make them to commit cognitive errors. While trading in liquid
assets one needs to be aware of the ideas such as market sentiments,
resistance, support etc.
There is no unique model of behavioural finance that exists.
One theory does not provide answers to all the questions. Any change in the
input data or model assumptions significantly changes the result. Thus,
behavioural finance is not a way to increase returns on our investment but
rather a way using the knowledge to understand the decisions that we make.
The investors, who are not literate enough to do the detailed
financial analysis base their decisions on various biases such as heuristics,
fear, anger etc. Fear helps investors in taking precaution in financial decision-making
process, while affect anger have negative impact on the decision-making process
of the investors.
The different biases that are recognized by behavioural
economists are :
Heuristics: Heuristics are mental shortcuts that
we utilize in our decision process to navigate through this complex world. Heuristics
are not helpful apart from making decisions easier and they usually result in
poor investment decisions. They can mostly lead to biases, especially when
things change. These usually leads to decisions that are not optimal. Example
is that many people spread their savings evenly across several investment
products which lead to them losing their funds because they do not consider the
risks involved in the alternate.
Anchoring: Anchoring arises when a value scale
is fixed or anchored by recent observations. An example an investor may be
tempted to evaluate the ‘worth’ of the share by reference to the old trading
range. As an example, take a company whose stock is trading at Rs. 100 a share.
The organization announces an increase in earnings but the stock price moves
only to Rs. 108 a share. The small rise occurs because investors are
“anchored” to old price and tend to believe that the earnings
increase is temporary when the truth is that it might not be true.
Gambler’s fallacy: Gambler’s fallacy occurs when
investor believes that the current trend will not last long. It comes from a
gambler playing a fair roulette table who has seen seven black outcomes in a
row may think that the next spin ‘must’ produce a red outcome. This illusion
may encourage an investor to purchase or sell a share on the grounds that a
recent bad/good luck is going to change.
Overconfidence: People are overconfident about their
abilities. Every investor tends to believe that they can make the best possible
decisions. Entrepreneurs are most likely to be overconfident. One example of
overconfidence is too little diversification. Investors tend to invest too much
in what they are familiar with. Overconfidence makes people over estimate their
ability to predict and attempt to ‘time’ the market by buying or selling shares
in advance of an anticipated share movement. One side effect of this can be to
cause excessive trading, leading to increased trading costs. Research shows that men tend to be more
overconfident than women.
Odean (2001) analysed the trading activities of people with discount brokerage
accounts. They found that the more people traded, the worse they did, on
Mental Accounting: Mental accounting is a term given to
the propensity of individuals to organize their world into separate ‘mental
accounts’. This can lead to inefficient decision-making, for example, an
individual may borrow at a high interest rate to purchase a consumer item,
while simultaneously saving at lower interest rates for a child’s college fund.
Framing: Framing in behavioural finance is
the choosing of particular words to present a given set of facts which can
influence the choices investors make.
Kahneman and Tversky developed “Prospect Theory” in 1979 using
framed questions. They also found that individuals are much more distressed by
prospective losses than they are happy by equivalent gains. Some have concluded that investors typically
consider the loss of a particular amount twice as painful as the pleasure
received from the gain in the same amount. Framing is important to understand
as it reflects the tendency of people to make different choices based on how
the decision is framed. For example,
restaurants may advertise “happy hour” specials other time-based discounts, but
they never use peak-period “surcharges.”
Representativeness: Representativeness refers to the
tendency of decision-makers to make decisions based on stereotypes, to see
patterns where perhaps none exist. An example of this is decision making based
on the ‘law of small numbers’, whereby investors tend to over-reach and assume
that recent trends will continue. In effect, people underweight long-term
averages. People always tend to weigh recent experience more as compared to
Conservatism: When things change, people to pick
up on these changes very slowly. In other words, they fixate on the things were
normally. The conservatism bias is at war with the representativeness bias.
When things change, people tend to underreact because of this conservatism bias
but if there were a longer pattern, then they usually adjust to it and more
often than not tend to overreact, underweighting the long-term average.
Disposition effect: The disposition effect refers to the
pattern that people avoid realizing paper losses and seek to realize paper
gains. For example, most people tend to keep their falling stock until it gets
back to the buying price. The disposition effect manifests itself in lots of
small gains being realized, and few small losses. The disposition effect is
reflected in aggregate stock trading volume. During a bull market, trading
volume tends to grow. If the market then turns south, trading volume tends to
fall. As an example, trading volume in the Japanese stock market fell by over
80% from the late 1980s to the mid-1990s. The fact that volume tends to fall in
bear markets results in the commission business of brokerage firms having a
high level of systematic risk.
10. Loss Aversion:
Loss aversion is based on the idea of prospect theory. The loss associated with
an amount is more painful than the pleasure in the gain of a similar amount.
Now people tend to hold onto stocks which are falling in the hope that it will
eventually rise and they would be able to avoid any loss.
11. Regret Aversion: Regret aversion arises due to the desire of any individual to avoid
feeling the pain of regret that arises from a poor investment decision. It includes
more than just the pain of financial loss, but also includes the pain in
feeling responsible for the poor which gave rise to the loss. Again, regret
aversion usually makes the investor take decisions where he/she holds on to
stocks that have performed poorly.
Overtrading is a very common anomaly among stock investors.
Jensen, early in 1968, found that the returns of the most actively traded
mutual funds were lower than the market rate of return. Overtrading is a negative relationship
between trading volume and investment returns. When returns of an investment is
negatively influenced by the trading volume then overtrading occurs and otherwise,
overtrading is not present.
A research has been done to find out if the Big five
personality traits and investment situation affect overtrading. The following
were the Hypotheses that were developed and tested in the research.
Hypothesis 1: Overtrading exists in situations with
unilaterally rising markets and fades in situations with unilaterally falling
Hypothesis 2: Investors with high extroversion scores are
unlikely to trade excessively.
Hypothesis 3: Investors with high agreeableness scores are
likely to trade excessively.
Hypothesis 4: Investors with high conscientiousness scores
will not trade excessively.
Hypothesis 5: Investors with high neuroticism scores are
likely to trade excessively.
Hypothesis 6: Investors with high openness scores are
reluctant to trade excessively impact of gender on trading behaviour.
The results show that Hypothesis 2 and 5 were
not valid while the rest holds true. This means that investors with high
extroversion scores trade excessively in unilaterally price-rising situations.
Also, investors with high neuroticism scores are not likely to trade excessippprp