Behavioural Finance

Abstract

This analysis examines the theory of behavioural finance related to Prospect theory, and the modern finance theory, which is a theory, based on rational and logical theories such as capital asset pricing model (CAPM) and the efficient market hypothesis (EMH). The two theories, CAPM and EMH suggested that emotions and other extraneous factors do not influence people when it comes to making investment decisions, though as time went by finance academics started to question this point of view as they found that there were anomalies and behaviours that could not be explained by those theories. A relatively new school of thought was Introduced which is the Behavioural finance, this theory seeks to look to cognitive psychology to account for irrational and illogical behaviours that modern finance had failed to explain. this essay aims at understanding of behavioural finance and reveal some insights from this field that apply to the difficulties that investors face when planning to make a decision about investing. According to the evidence obtained from this analysis found, Behavioural finance is the same as incorporating economic, finance, social and psychological judgement of investors in the financial market to question the efficiency of the efficient market hypothesis. In addition, the evidence shows that; most of the disparities in the stock market prices and returns from the efficient market norm as mostly caused by the behaviour of irrational investors thinking and actions in carrying out their investments as explained by Fuller (2000). We will therefore discuss some of the anomalies (irregularities) that conventional theories have failed to address. Also, some key concepts of behavioural finance are to be discussed in this topic such as investment anchoring, mental accounting, gambler's Fallacy, overreaction, Herd theory, overconfidence, mood and optimism, Disposition effect and familiarity. And finally, the study further emphasises on the social effect on the investors as well as ways in which investors can overcome the psychological effects caused by emotions that makes investors make irrational investment decisions.

Keywords: Behavioural Finance, Prospect theory, Psychological biases.

This paper was written in (2013), by Vanessa, Arnaud, Sylvia and Yandisa for our research paper entitled: Behavioural finance. During the time of writing, the students were at the School of Business & Finance at the University of Western Cape.

1. Introduction

In the past decades more specifically in the 1960s the capital asset pricing model (CAPM) had proven to be the most important theory of asset pricing used to determine the required rate of return and the cost of capital of investors. As time went on, the efficient market hypothesis (EMH) was developed by Eugene Fama ( 1970) and became the most renounce model that was used. The model assumed that all market and stock prices reflected the most recent information making it impossible for investors to predict future prices. In addition to that, it assumes that all investors are rational and do not incorporate their emotions in making investment decisions. However as time went by, great abnormities occurred and the variation of the stock prices could not be explained by the two theories. h .Some clear examples were the tulip mania in 1630 and dot-com bubble in the 1990s which could hardly be explained by the traditional theories.The most recent theory which has been brought forth is behavioural finance developed in the 1980s. According to Fuller (2000), Behavioural finance can be linked to the combining of economic, financial, social and psychological judgements by individual investors in the financial market . It is a psychology-based and the brain behind stock market anomalies. According to Nofsinger (2005), it is a modern theory different from what the traditional finance assumes. The investors in this case are all assumed to be irrational and make their decisions based on different human feelings. They focus on emotional factors such as greed, fear, hope, regrets and pride as well as social factors such as internet and the media in deciding to carry out an investment.

The aim of this study is to show how irrational investors make decisions when faced with risky situations where they cannot predict future prices. We found out that most of the disparities in the stock market prices and returns from the efficient market norm are mostly caused by the behaviour of irrational investors. Hsieh and Hodnett (2012) mentioned that anomalies of the asset pricing model arise as a result of investor irrationality due to psychological biases which causes investors to make irrational forecast. This is because they act based on how they think and act at a particular point in time. In order to have a clear understanding of this phenomen ,The following essay will firstly present the prospect theory developed by Kanehman and Tversky in 1979 in order to explain how investors actually behave in times of uncertainty. Secondly some sources of psychological biases will be discussed to explain the reason why irrational investors behave this way. This would be followed by a brief explanation on how their mental account ideology misleads then and cause them to make huge mistakes as their turn to have a huge impact on their portfolio wealth . Finally ways of avoiding the biases would be discussed.

2) The prospect theory:

According to Nofsinger (2005, 6) many of the investors behaviour result from the prospect theory which was developed by kahneman and tversky in 1979 and describes how people make and value decisions in time of uncertainty and risk. In 2002 the authors won a memorial Nobel prize in economics sciences for developing the theory, but Tversky did not benefit its share of the prize because he died before 2002. according to them, people value gains and losses differently and as such base their decisions on perceived gains rather than perceive losses, for example if an investors is given the same mutual fund by two different advisors and the 1st advisor tells him that he has seen the fund performing high returns for the past 7 years. and the second financial advisor tells him that he has seen the fund performing over the average returns for the past 10 years but he has recently observed some losses. the investors will choose the one from the mutual fund from the 1st financial advisor rather than a combination of a gain and a loss. This means that if a person were given two equal choices, one express in terms of possible gains and the other in possible losses, people will choose the former even when they achieve the same economic result according to the prospect theory