1. You have been offered the following two choices–
Choice A: £10,000 for certain;
Choice B: £20,000 with a 50% chance of occurring, £0 with a 50% chance of occurring.
Using behavioural finance, discuss and justify the choice that the majority of people would choose (i.e. choice A)
2. Outline the literature on Behavioural Finance to CRITICALLY EVALUATE whether such an assumption of rationality can be made.
3.Various theories exist to explain why long periods of growth in the price of shares are followed by sudden falls or market crashes. Evaluate the relevance of behavioural finance theory to the build up to the Dot.com bubble in 2000 and the subsequent market crash.
In this essay I will be talking about behavioural finance and its increased popularity in recent academic literature. First I will give a brief description of what behavioural finance is. Basically behavioural finance is the study and theory that looks into why investors sometimes choose to ignore more traditional investment theory, such as the Efficient Market Hypothesis (EMH), and invest into projects that do not look economically sound or do not offer the most attractive returns. Behavioural finance attempts to incorporate elements of psychology into finance to better understand investor behaviour. Essentially, behavioural finance operates under the assumption that all investors are not rational. A good quote to sum up behavioural finance is provided by Shleifer (2000) who observes that, ‘at the most general level, behavioural finance is the study of human fallibility in competitive markets.'
In this section I will attempt to explain why most investors would choose option A, as set out in the above question. I will also attempt to explain why some investors would not follow others and opt for option B.
The main reason why many people will undertake option A is simply because it is the most rational choice to make. Taking this choice will guarantee the investor a return of £10000. This is consistent with much of the traditional market theory. The assumption of investor rationality is essential to all the main market investment theories such as the Efficient Market Hypothesis (EMH) and the Arbitrage Pricing Theory (APT). Without this assumption the models would collapse.
Another reason why most investors will take option A is the absence of risk. It is 100% certain that the investor will get a £10000 return. Again, this is consistent with traditional market theory that states that investors will favour projects with the least amount of risk if the projects being considered all return the same amount of money.
Another reason why most investors will choose option A is that concerning ‘herd mentality’. Many authors have observed that some investors will simply invest in a project because that is what everyone else is doing. This leads to the assumption that these investors are not rational as none of the market data or theory is being considered in their investment decision. This leads into the area of behavioural finance to try to explain the actions of these investors.
I will now discuss why some investors choose option B. If all investors were rational then every investor would choose option A and they would choose it for the correct reasons. However, as I have already mentioned, not all investors are rational. This is the main reason for some investors choosing option B. It is also the main assumption behind the notion of behavioural finance. There are many reasons why an investor might not behave rationally and all these reasons are the basis of behavioural finance.
One reason for the irrational behaviour of some investors could be due to their own personal risk attitude. Some investors could have a risk-loving attitude to risk meaning that they go for risky options regardless of the danger. This goes against traditional theory, which states that investors are risk averse. The investors go for the more risky option because of the possibility of more money. This leads to another reason for irrationality; greed.
Another reason for the irrational behaviour is that of the notion of ‘herd mentality'. Many investors will invest purely because they think that others are investing there so it must be a good idea.
Other reasons for the irrational behaviour of the investor are that of over confidence, regret, misinformed, etc. All these reasons will alter the mental state of the investor causing him or her to make investment decisions that are not inline with traditional theory and that could prove to be the incorrect decision.
As observed by Shleifer (2000) ‘At the most general level, behavioural finance is the study of human fallibility in competitive markets.' Behavioural finance incorporates elements of cognitive psychology into finance in an effort to better understand how individuals and entire markets respond to different circumstances. Behavioural finance is based on the principle that all investors are not rational. Some investors can be over-confident, while other less knowledgeable investors might be prone to herding effects. Shefrin (1999) was one such author to talk about behavioural finance. He is one author who argues that ‘a few psychological phenomena pervade the entire landscape of finance.' Harrington (2003) agrees with the notion that overconfidence can lead to irrational behaviour. She states that ‘investors can become irrational and their irrational behaviour affects their ability to profit from owning stocks and bonds.'
Of course, behavioural finance does have its drawbacks. One of which is the fact that using instincts alone can result in a loss. This is due to human error. The person that is using their instincts in determining where to invest might not have the greatest financial knowledge in the first place. Also, this person might be having a bad day or be under a great deal of stress or be distracted in some other way. This could result in the wrong decision being made. Therefore, it is a good idea to use behavioural finance on top of the more traditional theories already in use today. This view is supported by an article by Malkiel (1989) who agrees with the notion that behavioural aspects have a great importance in stock market valuation. He argues that behavioural factors play an important role in stock valuation alongside traditional valuation theories. This is summed up by the following quote, ‘market valuations rest on both logical and psychological factors. The theory of valuation depends on the projection of a long-term stream of dividends whose growth rate is extraordinarily difficult to estimate. Moreover, the appropriate risk premiums for common equities are changeable and far from obvious either to investors or economists. Thus, there is room for the hopes, fears, and favourite fashions of market participants to play a role in the valuation process.' Another article from the Banker (2004) also supports the view that behavioural finance has a role to play alongside the traditional views.
Other authors talk about some of the factors that cause investors to become irrational. On such author are Johnsson, Lindblom and Platan (2002). In their masters dissertation they talk about the various factors of irrationality. One of these is the observation that investors will hang on to losing shares longer than market theory dictates. They say that this is because they are waiting for the performance of the share to change for the better. This is referred to as loss aversion. This is an example of a psychological factor that is effecting the investment decision.
Another psychological factor that affects investors, causing irrational behaviour is that of the feeling of regret. Authors argue that past bad decisions cause investors to feel regret and this alters their behaviour in such a way as to become irrational.
Another factor that causes irrational behaviour is that of when the investor uses mental shortcuts in investment decisions. These shortcuts usually make investors choose the right decision but occasionally cause the investor to make the wrong decision. Optical illusions are a good example of how shortcuts can cause mistakes. A paper on www.undicoveredmanagers.com is one such paper that covers this point.
The literature I have outlined in this section can lead me to say that the assumption of rationality or lack of rationality does occur. This leads to the theories on behavioural finance having a good solid basis. I can say this because there have been many authors who have observed that certain psychological factors do influence the investment decision. These factors include over confidence and the fear of regret. These arguments seem to empirically explain the anomalies that seem to occur in the investment world.
In this section I will be looking at the anomaly of dot.com bubble in 2000. I will attempt to see if behavioural finance can explain the fall and rise of this bubble. First I will briefly explain what the dot.com bubble was. The dot.com industry was comprised of companies that have started up to sell goods and services over the Internet. They were given the name dot.com due to the fact that many website addresses ended with a ‘dot' and the word com. At first, these companies were very successful and when floated on the stock market did very well financially. However, in 2000 this industry suffered a massive collapse. Many of these companies subsequently did not survive.
I will now attempt to see if behavioural finance can explain this bubble. Many authors have argued that the new communication technology of the 1990's was exaggerated. By this I mean that the new innovation is by some corners, i.e. the media and governments, over triumphed. This can lead to irrational behaviour of investors. This can lead to investors becoming over confident in the technology or industry.
Another factor of this over enthusiasm is that it could attract herding behaviour. The irrational investor will be more likely to invest in something that is being hyped up as they feel that others are doing the same thing. They will feel that if others are doing it then it must be a good idea for them to do it as well.
A factor that will have led to the dot.com bubble is that of speculation. One such author that observed the speculation effect on the dot.com boom was Giombetti (2000). Many informed investors will have probably over invested in the technology industry going against market theory. They will have done this on the hope that their investment will pay off. Even if their investment was initially at a loss they would have stayed with it. Authors of behavioural finance outline this behaviour. This behaviour of these investors would have distorted the market conditions for other investors. Also, the herding effect would have been greater due to this.
These factors would have led to the stock prices of the dot.coms being vastly over priced. This meant that when the bubble burst stock prices would have fell rapidly, causing investors to lose vast sums of money. This would cause them to pull out of the industry, which, in turn, cause the companies themselves to collapse. If it were not for irrational investment then investors might have pulled out earlier, before the collapse. This might have even meant that the collapse would not have happened.
In conclusion, behavioural finance attempts to prove the assumption that investors do not always act rationally. It combines elements of psychology and financial to attempt to understand investment decisions. This helps explain why not all investors would choose the less risky option A with a guaranteed return. Factors that precipitate the irrational behaviour are over confidence, fear of regret and loss aversion. These factors cause investors not to take the correct investment decisions. This can go some way to explaining the dot.com bubble and its eventual collapse.
www.UndiscoveredManagers.com (1999) Introduction to Behavioral Finance
Giombetti R. (2000) The Dot.com Bubble. www.EatTheState.org Vol 4, Issue 23
Harrington C. (2003) Head games: Helping quell investors’ irrational antics. Accounting Today, v17 i11 p5(2)
Johnsson M., Lindblom H. & Platan P. (2002) Behavioral Finance - And the Change of Investor Behavior during and After the Speculative Bubble At the End of the 1990s
Malkiel B. G. (1989) Is the stock market efficient? Science, v243 n4896 p1313(6)
Shefrin H. Beyond Greed and Fear. (1999) Understanding Behavioral Finance and the Psychology of Investing. Harvard Business School Press
Shleifer A. (2000) Inefficient Markets. An introduction to behavioural finance. Oxford university Press
The Banker (2004) Cover feature: how much risk can you manage? - Banks have a huge range of resources available to aid risk managers, but human nature can still result in a bad decision. Behavioural finance and prospect theory lifts the veil on poor investment judgement
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