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Behavioral science is a finance field that puts forward theories based on psychology in order to explain stock market anomalies. The assumption in behavioral science is that the information structure and market participants’ characteristics have a systematic influence on individuals’ investment decisions and market outcomes. The paper argues in favor of an empirical approach to explore investor behavior and biases, and impacts of irrational decisions on market performance. It goes ahead to show that behavioral finance is related to herding behavior, thought contagion, risk aversion, investor sentiment, affect pricing model, social responsibility in investment decisions, charts and the effect of past performance over future uncertainty, analysts: unbiased experts or self-serving opportunists, and the case for behavioral finance. This essay gives summarizes these research findings discussed in the paper and analyzes its conclusion.
Unconscious Herding Behavior
Human behavior function ‘herding’ is derived from ‘impulsive mental activity’ and reaction to other people’s actions. In relation to financial markets, herding causes emotional changes. Therefore, the rational brain can have control over them. Herding, being rooted in the limbic system is impulsive, immutable and uncontrollable. Financial professionals, being a close group, share information in virtual and real space thus vulnerable to emotional herding. The investing public can also form beliefs based on information obtained from media, industry publications among others. This type of herding results from lack of knowledge and social tendencies to following the crowd. Financial professionals also follow the herding behavior patterns perhaps due to the need for consensus. Cognitive dissonance occurs when financial professional hold contrary views. This may call for explanations for choosing one over others. This desire to go with crowds results in making of relatively similar buying and selling decisions. Though this behavior is vital for survival, it tends to prolong market trends hence leading to decreased productivity in financial markets.
The modes of contagion include Quantity Parental Mode, Efficiency Parental Mode, Proselytic Mode, Presentational Mode, Adversative Mode, Cognitive Mode and Motivational Mode. These modes support the theory stating that new economic or financial thinking are slow in penetrating the ‘normal’ and that whereas we witness the market anomalies and unable to elucidate them by CAPM, there is no definite financial model encompassing the human behavior.
Risk Taking and Risk Aversion
Risk taking propensity appears in individual or group decision-making as in the case with herding behavior and thought contagion. People who adopt risky behavior in certain situations can take more risks in managing investments. He observes that risk-taking behavior tends to increase in groups and gives the possible explanation that the group provides an individual with a distribution of risk within its members. This results in less responsibility on an individual, as opposed to responsibility in individual decision-making.
Prospect Theory illustrates the preferences for risk behavior in opposition to utility maximization function that suggests that investors need to be indifferent between choices with the same expected utility. The theory also postulates that attitudes toward gains and losses change depending on reference point. Traditional finance perceives analysts as rational thinkers who strictly base their predictions of future performance and earnings on data. Nonetheless, studies show the existence of inefficiencies in forecast due to interference of data by the analysts’ biases. Therefore, the author suggests that analysts who predict loss are likely to go for riskier behavior in the future leading to overestimation of earnings. Security and potential maximization are two main goals people have. The goal of risk takers is to maximize potential while the risk-averse inventors want security.
Risk choice behavior is usually change with circumstance, but Dreman et al. (2001) claimed that investor sentiment was constant in the 1998 bull market and declined in 2001. Several surveys were taken in 1998 when the stock market was on the rise and in 2001 when there was a rapid market decline. The surveys yielded results showed that invested had similar opinions regarding long-term investments, allocation of assets between bonds and stocks, views on risk and buying on down markets. The analysis of survey results was based on age, gender and income. The data showed that men are more likely to take risks than women are while low-income individuals are more risk averse than the high-income ones. Finally, both age groups of over and below 60 years demonstrated similar confidence in future US market performance, with the older group being less likely to accept large portfolio swings in relation to their retirement cash flow needs.
Cash Availability and Optimism
The conduct of investors while making investments decisions is dictated by the correlation between cash availability and overreaction in the financial market. The modern portfolio theory and ‘invisible hand’ are two theories that typically apply to markets. The invisible hand theory applies to well to the consumer market since consumers buy services and products for their need satisfaction while the modern portfolio theory applies to asset markets with the assumption that investors balance reward and risk in the purchase of securities to maximize utility. For decades, prices for consumer goods have been relatively stable in developed economies including US while security prices fluctuate on ‘expectations and motivations of others’.
Affect Pricing Model
There is an element of emotion in the determination of asset pricing models. It implies that people have similar alignment towards the purchase of sale of stock in the same manner as they do for cars, jewelry and cars. The process of arriving at a decision regarding acquisition of stock is emotive and thus, investors go through some levels of stress. This model explains with illustration the importance of incorporating this emotional aspect in the formulation of CAPM. Although the proposed is not superior to earlier ones, it should be used in practice.
Charts and the Effect of Past Performance over Future Uncertainty
This dimension considers the influence of historical performances of a company’s stock. The decision to purchase will be dictated by price comparisons regardless of the fact that past occurrences may not necessarily replicate themselves in the future. The use of charts to depict stocks behavior over time has wide application in such financial decisions. The popularity of charts is occasioned by its ability to summarize stock movements in a succinct output.
Social Responsibility in Investment Decisions
Social responsibility is an emerging trend in the corporate arena. There are sufficient efforts aimed at adoption of socially responsible investing to the extent of influencing stock purchase or sale decisions. Pressure emanating from the customers, investors and regulatory bodies compel companies to act in socially acceptable manner. An occurrence of irresponsible behavior is likely to scare way customer making the stocks of that company less glamorous than before. Although it may be difficult to predict the occurrence of socially unacceptable risks, investors need to stay abreast with company’s strategy and policy as a means of managing risk proactively.
Analysts: Unbiased Experts or Self-Serving Opportunists
Analyst’s advice is another factor in investment decision making. Many investors are swayed in to engaging the services of an analyst in a bid to make the most optimal investment decision. However, the accuracy of this factor is questionable due to the potential conflict of interests in the process. Inventors are at a risk of receiving fallacious advice from these analysts whose intentions are more of satisfying the interests of their employers other than the potential investor.
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The Case for Behavioral Finance
Although there have been claims that price shifts are occasioned by lead indicators in the market, investors are sometimes irrational in their decisions. They are prone to emotional swings, psychological fluctuations leading to occasional irrationality in judgments. These are heuristically determined behaviors whose perceived outcomes are characterized by sharp shift in stock prices. This aspect of behavioral finance is similar to that of mass action where thoughts of one individual tend to gains wide acceptance among the peers.
As the paper ends, there is a resounding existence of parity between scientifically backed decisions and subjective behavior ones. Although either side of this argument is right in its own perspective, it is proving concise that the two elements of investment decision-making are mutually independent. The differences between the two can only be resolved by seeking a common ground, which incorporates the philosophy of scientific rationalism and subjective behavior. This will ensure that the practical aspect of heuristic, emotional and mass-oriented are amalgamated in widely accepted decisions. By doing this, the newly established models and formulae will not only reflect actual trends in the market but will go a long way in delivering reliable and accurate statistics.