Herding

This is a cardinal sin in investing and this tendency to follow the crowd and depend on the direction of others is exactly how problems in the stock market arise. There are two actions that are caused by herd mentality:

o Panic buying

o Panic selling

Holding Out for a rare treat

Some investors, praying for a reversal for their stocks, hold onto them, other investors, settling for limited profit, sell stock that has great long-term potential. One of the big ironies of the investing world is that most investors are risk averse when chasing gains but become risk lovers when trying to avoid a loss.

If we are shifting our non-risk capital into high-risk investments, we are contradicting every rule of prudence to which the stock market ascribes and asking for further problems.

ISSUES

One of the most important issues in Behavioural Finance is whether the assumptions of investor rationality are realistic or not.

The concept can be explained with the help of an example. Let's assume that Mr. X invests and manages his portfolio in an efficient market. Here only seconds are available for a respon

The volume of research in the field of Behavioural Finance has grown over the recent years. The field merges the concepts of finance, economics and psychology to understand the human behaviour in the financial markets, to form winning investment strategies.

THE CONCEPT OF BEHAVIOURAL FINANCE

Behavioural finance is the study of the influence of psychology on the behaviour of financial practitioners and the subsequent effect on markets. Principal objective of an investment is to make money. We usually assume that investors always act in a manner that maximizes their return rationally. The Efficient Market Hypothesis (EMH), the central proposition of finance for the last thirty five years rests on assumption of rationality. But it has been proved that people are ruled as much by emotion as by cold logic and selfishness. While the emotions such as fear and greed often play an important role in poor decisions, there are other causes like cognitive biases, heuristics (shortcuts) that take investors to incorrectly analyse new information about a stock or currency and thus overreact or under react. Behavioural Finance is the study of how these mental errors and emotions can cause stocks or currency to be overvalued or undervalued, and to create investment strategies that gives a winning edge over the others investors.

I would like to bring out the behaviour pattern of a rational investor. This rational investor is assumed to act rationally in following ways:

o Makes decisions to maximize the expected utility.

o Fully informed with unbiased information.

o Absence of any distortion of judgement based on emotions.

It is to be kept in mind that risk resides not only in the price movements of dollars, gold, oil, commodities, companies and bonds. It also lurks inside us – in the way we misinterpret information, fool ourselves into thinking we know more than we do, and overreact to market swings. Information is useless if we misinterpret it or let emotions sway our judgement. Human beings are irrational about investing. Correct behaviour patterns are absolutely essential to successful investing - so to be financially successful one has to overcome these tendencies. if we can recognise these destructive urges, we can avoid them. Behavioural Finance combines the disciplines of economics and psychology specifically to study this phenomenon.

THE CONCEPT OF BUBBLES IN STOCK MARKET

A speculative bubble occurs when actions by market participants' results in stock prices to deviate from their fundamental valuation over a prolonged period of time. Speculative bubbles are difficult to explain by rational trading behaviour, and theories have been put forward to explain market psychology through behavioural finance1. They propose that when significant proportion of trading activity in the market is characterized by positive feedback behaviour, it may result in asset prices to shift away from their fundamental valuation. This price deviation encourages rational investors to trade in the same direction.

Speculative trades are based upon investors' private information held today, and are designed to provide investors with higher returns in the next period when that private information is fully revealed to the market. This implies a positive correlation in returns as market incorporate the information into prices. Trades due to portfolio rebalancing, or hedging, is not information based, and occurs when a trader may increase (or decrease) his stock holding by buying (or selling) a portion of his stock holding. This will be accomplished by increasing (or decreasing) the stock price to induce the opposite side of the trade.

FOCUS ON INTRINSIC VALUE

What are the implications for corporate managers? It is believed that such market deviations make it even more important for the executives of a company to understand the intrinsic value of its shares. This knowledge allows it to exploit any deviations, if and when they occur, to time the implementation of strategic decisions more successfully. Here are some examples of how corporate managers can take advantage of market deviations:

o Issuing additional share capital when the stock market attaches too high a value to the company's shares relative to their intrinsic value.

o Repurchasing shares when the market under-prices them relative to their intrinsic value.

o Paying for acquisitions with shares instead of cash when the market overprices them relative to their intrinsic value.

Two things must be kept in mind as regards this aspect of market deviations.

Firstly, these decisions must be grounded in a strong business strategy driven by the goal of creating shareholder value.

Secondly, managers should be cautious of analyses claiming to highlight market deviations. Furthermore, the deviations should be significant in both size and duration. Provided that a company's share price eventually returns to its intrinsic value in the long run, managers would benefit from using a discounted-cash-flow approach for strategic decisions.

It can thus be summarized that for strategic business decisions, the evidence strongly suggests that the market reflects intrinsic value.

INVESTING IRRATIONALITIES

Often turbulence in the market isn't linked to any perceivable event but to investor psychology. A fair amount of portfolio losses can be traced back to investor choices and reasons for making them. I would like to point out some of the ways by which investors unthinkingly inflict problems on themselves :

Herding

This is a cardinal sin in investing and this tendency to follow the crowd and depend on the direction of others is exactly how problems in the stock market arise. There are two actions that are caused by herd mentality:

o Panic buying

o Panic selling

Holding Out for a rare treat

Some investors, praying for a reversal for their stocks, hold onto them, other investors, settling for limited profit, sell stock that has great long-term potential. One of the big ironies of the investing world is that most investors are risk averse when chasing gains but become risk lovers when trying to avoid a loss.

If we are shifting our non-risk capital into high-risk investments, we are contradicting every rule of prudence to which the stock market ascribes and asking for further problems.

ISSUES

One of the most important issues in Behavioural Finance is whether the assumptions of investor rationality are realistic or not.

The concept can be explained with the help of an example. Let's assume that Mr. X invests and manages his portfolio in an efficient market. Here only seconds are available for a respons

I would like to bring out the behaviour pattern of a rational investor. This rational investor is assumed to act rationally in following ways:

o Makes decisions to maximize the expected utility.

o Fully informed with unbiased information.

o Absence of any distortion of judgement based on emotions.

It is to be kept in mind that risk resides not only in the price movements of dollars, gold, oil, commodities, companies and bonds. It also lurks inside us – in the way we misinterpret information, fool ourselves into thinking we know more than we do, and overreact to market swings. Information is useless if we misinterpret it or let emotions sway our judgement. Human beings are irrational about investing. Correct behaviour patterns are absolutely essential to successful investing - so to be financially successful one has to overcome these tendencies. if we can recognise these destructive urges, we can avoid them. Behavioural Finance combines the disciplines of economics and psychology specifically to study this phenomenon.

THE CONCEPT OF BUBBLES IN STOCK MARKET

A speculative bubble occurs when actions by market participants' results in stock prices to deviate from their fundamental valuation over a prolonged period of time. Speculative bubbles are difficult to explain by rational trading behaviour, and theories have been put forward to explain market psychology through behavioural finance1. They propose that when significant proportion of trading activity in the market is characterized by positive feedback behaviour, it may result in asset prices to shift away from their fundamental valuation. This price deviation encourages rational investors to trade in the same direction.

Speculative trades are based upon investors' private information held today, and are designed to provide investors with higher returns in the next period when that private information is fully revealed to the market. This implies a positive correlation in returns as market incorporate the information into prices. Trades due to portfolio rebalancing, or hedging, is not information based, and occurs when a trader may increase (or decrease) his stock holding by buying (or selling) a portion of his stock holding. This will be accomplished by increasing (or decreasing) the stock price to induce the opposite side of the trade.

FOCUS ON INTRINSIC VALUE

What are the implications for corporate managers? It is believed that such market deviations make it even more important for the executives of a company to understand the intrinsic value of its shares. This knowledge allows it to exploit any deviations, if and when they occur, to time the implementation of strategic decisions more successfully. Here are some examples of how corporate managers can take advantage of market deviations:

o Issuing additional share capital when the stock market attaches too high a value to the company's shares relative to their intrinsic value.

o Repurchasing shares when the market under-prices them relative to their intrinsic value.

o Paying for acquisitions with shares instead of cash when the market overprices them relative to their intrinsic value.

Two things must be kept in mind as regards this aspect of market deviations.

Firstly, these decisions must be grounded in a strong business strategy driven by the goal of creating shareholder value.

Secondly, managers should be cautious of analyses claiming to highlight market deviations. Furthermore, the deviations should be significant in both size and duration. Provided that a company's share price eventually returns to its intrinsic value in the long run, managers would benefit from using a discounted-cash-flow approach for strategic decisions.

It can thus be summarized that for strategic business decisions, the evidence strongly suggests that the market reflects intrinsic value.

INVESTING IRRATIONALITIES

Often turbulence in the market isn't linked to any perceivable event but to investor psychology. A fair amount of portfolio losses can be traced back to investor choices and reasons for making them. I would like to point out some of the ways by which investors unthinkingly inflict problems on themselves :

Herding

This is a cardinal sin in investing and this tendency to follow the crowd and depend on the direction of others is exactly how problems in the stock market arise. There are two actions that are caused by herd mentality:

o Panic buying

o Panic selling

Holding Out for a rare treat

Some investors, praying for a reversal for their stocks, hold onto them, other investors, settling for limited profit, sell stock that has great long-term potential. One of the big ironies of the investing world is that most investors are risk averse when chasing gains but become risk lovers when trying to avoid a loss.

If we are shifting our non-risk capital into high-risk investments, we are contradicting every rule of prudence to which the stock market ascribes and asking for further problems.

ISSUES

One of the most important issues in Behavioural Finance is whether the assumptions of investor rationality are realistic or not.

The concept can be explained with the help of an example. Let's assume that Mr. X invests and manages his portfolio in an efficient market. Here only seconds are available for a respon

Speculative trades are based upon investors' private information held today, and are designed to provide investors with higher returns in the next period when that private information is fully revealed to the market. This implies a positive correlation in returns as market incorporate the information into prices. Trades due to portfolio rebalancing, or hedging, is not information based, and occurs when a trader may increase (or decrease) his stock holding by buying (or selling) a portion of his stock holding. This will be accomplished by increasing (or decreasing) the stock price to induce the opposite side of the trade.

FOCUS ON INTRINSIC VALUE

What are the implications for corporate managers? It is believed that such market deviations make it even more important for the executives of a company to understand the intrinsic value of its shares. This knowledge allows it to exploit any deviations, if and when they occur, to time the implementation of strategic decisions more successfully. Here are some examples of how corporate managers can take advantage of market deviations:

o Issuing additional share capital when the stock market attaches too high a value to the company's shares relative to their intrinsic value.

o Repurchasing shares when the market under-prices them relative to their intrinsic value.

o Paying for acquisitions with shares instead of cash when the market overprices them relative to their intrinsic value.

Two things must be kept in mind as regards this aspect of market deviations.

Firstly, these decisions must be grounded in a strong business strategy driven by the goal of creating shareholder value.

Secondly, managers should be cautious of analyses claiming to highlight market deviations. Furthermore, the deviations should be significant in both size and duration. Provided that a company's share price eventually returns to its intrinsic value in the long run, managers would benefit from using a discounted-cash-flow approach for strategic decisions.

It can thus be summarized that for strategic business decisions, the evidence strongly suggests that the market reflects intrinsic value.

INVESTING IRRATIONALITIES

Often turbulence in the market isn't linked to any perceivable event but to investor psychology. A fair amount of portfolio losses can be traced back to investor choices and reasons for making them. I would like to point out some of the ways by which investors unthinkingly inflict problems on themselves :

Herding

This is a cardinal sin in investing and this tendency to follow the crowd and depend on the direction of others is exactly how problems in the stock market arise. There are two actions that are caused by herd mentality:

o Panic buying

o Panic selling

Holding Out for a rare treat

Some investors, praying for a reversal for their stocks, hold onto them, other investors, settling for limited profit, sell stock that has great long-term potential. One of the big ironies of the investing world is that most investors are risk averse when chasing gains but become risk lovers when trying to avoid a loss.

If we are shifting our non-risk capital into high-risk investments, we are contradicting every rule of prudence to which the stock market ascribes and asking for further problems.

ISSUES

One of the most important issues in Behavioural Finance is whether the assumptions of investor rationality are realistic or not.

The concept can be explained with the help of an example. Let's assume that Mr. X invests and manages his portfolio in an efficient market. Here only seconds are available for a respon

o Issuing additional share capital when the stock market attaches too high a value to the company's shares relative to their intrinsic value.

o Repurchasing shares when the market under-prices them relative to their intrinsic value.

o Paying for acquisitions with shares instead of cash when the market overprices them relative to their intrinsic value.

Two things must be kept in mind as regards this aspect of market deviations.

Firstly, these decisions must be grounded in a strong business strategy driven by the goal of creating shareholder value.

Secondly, managers should be cautious of analyses claiming to highlight market deviations. Furthermore, the deviations should be significant in both size and duration. Provided that a company's share price eventually returns to its intrinsic value in the long run, managers would benefit from using a discounted-cash-flow approach for strategic decisions.

It can thus be summarized that for strategic business decisions, the evidence strongly suggests that the market reflects intrinsic value.

INVESTING IRRATIONALITIES

Often turbulence in the market isn't linked to any perceivable event but to investor psychology. A fair amount of portfolio losses can be traced back to investor choices and reasons for making them. I would like to point out some of the ways by which investors unthinkingly inflict problems on themselves :

Herding

This is a cardinal sin in investing and this tendency to follow the crowd and depend on the direction of others is exactly how problems in the stock market arise. There are two actions that are caused by herd mentality:

o Panic buying

o Panic selling

Holding Out for a rare treat

Some investors, praying for a reversal for their stocks, hold onto them, other investors, settling for limited profit, sell stock that has great long-term potential. One of the big ironies of the investing world is that most investors are risk averse when chasing gains but become risk lovers when trying to avoid a loss.

If we are shifting our non-risk capital into high-risk investments, we are contradicting every rule of prudence to which the stock market ascribes and asking for further problems.

ISSUES

One of the most important issues in Behavioural Finance is whether the assumptions of investor rationality are realistic or not.

The concept can be explained with the help of an example. Let's assume that Mr. X invests and manages his portfolio in an efficient market. Here only seconds are available for a respon

Herding

This is a cardinal sin in investing and this tendency to follow the crowd and depend on the direction of others is exactly how problems in the stock market arise. There are two actions that are caused by herd mentality:

o Panic buying

o Panic selling

Holding Out for a rare treat

Some investors, praying for a reversal for their stocks, hold onto them, other investors, settling for limited profit, sell stock that has great long-term potential. One of the big ironies of the investing world is that most investors are risk averse when chasing gains but become risk lovers when trying to avoid a loss.

If we are shifting our non-risk capital into high-risk investments, we are contradicting every rule of prudence to which the stock market ascribes and asking for further problems.

ISSUES

One of the most important issues in Behavioural Finance is whether the assumptions of investor rationality are realistic or not.

The concept can be explained with the help of an example. Let's assume that Mr. X invests and manages his portfolio in an efficient market. Here only seconds are available for a response to the news. There are a great number of factors that affect the decision of Mr. X. Further, these factors can affect each other. How can Mr. X draw the right judgements when the information is updated very frequently? Probably Mr. X works on a computer, through out the day, on which a utility function program is installed for his work. Every decision Mr. X is based on the calculation given by his computer. As soon as the portfolio is rebalanced, the computers utility function program analyses new alternatives. This process goes on and on over the course of the day. Obviously, Mr X does not show any joy, when he wins and no panic when he looses. Can a human brain behave like this? We know that a human brain can master only seven pieces of information at any one time.

So, how could one possibly absorb all the relevant information and process it correctly? People use simplifying heuristics (shortcuts) in order to control the complexity of information received. Psychological research has shown that the human brain often uses shortcuts to solve complex problems. These heuristics are rules or strategies for information processing, which help to find a quick, but not necessary optimal, solution. Once the information is simplified to manageable level, people use judgement heuristics. These shortcuts are needed to resolve the decision making as quickly as possible. Heuristics are also used to arrive at a quick judgement, they can, however, also systematically distort judgement in certain situations.

SIMPLIFICATION BIAS

The first step in reducing complexity is to simplify the decision. However it also adds the risk of arriving at a non-rational conclusion, unless one is careful.

MENTAL ACCOUNTING

People focus on one account (say purchase of share x) in particular when weighing things, relationship with other commitments or accounts (say purchase of share y) are usually ignored. I would like to explain this with the help of an illustration. For instance, Company A produces bathing costumes, and company B produces raincoats. Both companies are new, extremely efficient and innovating, so that purchasing shares in these companies would be a profitable proposition. A financial gain, however depends to a large extent on the whether in both cases, Company A will produce huge profits if the weather is fine, while Company B will make a loss, even though this is kept to a minimum, thanks to its efficient management. The situation is reversed in the case of bad weather. With mental accounting, either investment is risky when seen in isolation. But if we take into account the mutual effect of the uncertainty factor, i.e. the weather, then a combination of both shares become a lucrative, and at the same time secure investment.

AVAILABILITY CONSTRAINT

Not everybody has same degree of information. Some people prefer to see business news on CNBC TV 18, NDTV PROFIT. But others may like to see the serials on STAR PLUS. Obviously the first one may have more information, as compared to second.

REPRESENTATIVENESS

This is one of the mental shortcuts that make it hard for investors to correctly analyse new information. It helps the brain organise and quickly process large stock of data, but can cause investors to overreact to old information. For example, if a company is repeatedly giving losses, investors will become disillusioned with this past data, and thus may overreact to past information by ignoring valid signs of recovery. Thus, the stock of the company is undervalued because of this bias.

CHLALLENGES

Under the paradigm of traditional financial economics, decision makers are considered to be rational and utility maximizing. The assumption of rational expectations is simply an assumption - an assumption that could turn out not to be true.

Behavioural Finance has the potential to be a valuable supplement to the traditional financial theories in making investment decisions. The following fundamentals of behavioural finance give us a glimpse of the pitfalls to be avoided. These are the challenges which need to be overcome and addressed.

1. Hubris hypothesis: it is the tendency to be over optimistic. It results from psychological biases. The investor gets swayed by the momentum generated in the markets in recent past.

2. Sheep theory: it is a phenomenon where all the investors are running in the same direction. They follow the herd – not voluntarily, but to avoid being trampled.

3. Loss aversion: it says that investors take more risk when threatened with a loss. Thus mental penalty associated with a given loss is greater than the mental reward from a gain of the same size.

4. Anchoring: this causes investors to under react to new information. This can lead to investors to expect a company's earning to be in line with historical trends, leading to possible under reaction to trend changes.

5. Framing: this states that the way people behave depends on their way decision problems are framed. Even the same problem framed in different ways can cause people to make different choices.

6. Overconfidence: this is what leads people to think that they know more than they do. It leads investors to overestimate their predictive skills and believe they can time the market.

RELEVANCE TO INDIAN STOCK MARKETS

Behavioural finance holds definite clues and appears apt in the curre