According to the Efficient Market Hypothesis (EMH), the stock markets are extremely efficient in reflecting all the available information about individual stocks and about the stock market as a whole. As soon as new information come up, it is fully incorporated into the price of the share of the company. However, there are still many market anomalies and behaviors which can’t be explained by the EMH or any other financial theory for that matter. In many situations, investors behave irrationally (depending on their nature) and with a certain degree of unfounded bias which results in these market anomalies.
Behavioral Finance attempts to fill this void.
Behavioral finance is premised on the assumption that conventional financial theory looks only at the financial aspects and completely ignores how investors make decisions on cognitive abilities and ignores how these investors (and their decisions) make a difference.
According to EMH, it is assumed that stock prices reflect all the available information about the company like financial update, product launch, capacity expansion etc, whereas Behavioral Finance assumes that investor’s emotions drive the price of a stock above or below its intrinsic value. Thus, it is assumed that the stock prices reflect human behavior and investor psychology. Investor’s sentiment, rather than rational economic calculation, contributes significantly to price formation. The nature of investor bias is such that the final opinion of the individual investors may largely reflect the opinion of a larger group of investors. Consequently, the excessive volatility in the stock market is often caused by the social trend which may have very little rational or logical explanation.
“(Benjamin) Graham’s conviction rested on certain assumptions. First, he believed that the market frequently mispriced stocks. This mispricing was most often caused by human emotions of fear and greed. At the height of optimism, greed moved stocks beyond their intrinsic value, creating an overpriced market. At other times, fear moved prices below intrinsic value, creating an undervalued market.”
— Robert G. Hagstrom, “The Warren Buffett Way”
The information structure and the characteristics of market participants systematically influence individuals’ investment decisions as well as market outcomes. Behavioral finance seeks to combine behavioral and cognitive psychological theory with conventional economics and finance to provide explanations as to why investors make irrational financial decisions. In other words, Behavioral Finance is the area of research that attempts to understand and explain how ‘reasoning errors’ influence investor decisions and market prices of securities.
For Example: talking about the large amount of investment which Warren Buffet made in ConocoPhillips stock (an oil exploration and production company) just before the dramatic collapse of the entire oil & gas sector which brought down the price of ConocoPhillips, Buffet explained his reasoning error as, “I did not anticipate the dramatic fall in energy prices in 2008, so this decision costs Berkshire’s shareholders several billion dollars”.
Behavioral biases largely affect how investors frame questions of risk versus return, and therefore make risk-return trade-offs. The imperfection in financial markets is due to a combination of cognitive biases such as overconfidence, overreaction, and information bias etc. Listed below are some common biases which can have a materially negative impact on our decision making capabilities, including the way we invest in stocks:
1. Overconfidence: Pertains to the enduring tendency of people to think that they know more than other and overvalue their own abilities. Overconfident investors make careless decisions for themselves and influence other market participants by their decisions. As the price of a stock recently purchased by an investor rises dramatically, it will form an opinion in his mind that his judgement is correct, making him believe in his expertise. As the price moves up further, the same investor detects a pattern of price increases. Overconfidence confirms the trend resulting in more buying of shares.
2. Overreaction Bias: People tend to overreact to both good and bad news. For Example: if the quarterly result of a company doesnot come up to the expection, the typical investor response would be to sell their holdings even before understanding the reason(s) for the bad results. This has a disproportionate negative effect on stock prices.
3. Confirmation Bias: Under the influence of confirmation bias, investors tend to seek out and notice only the information that supports their existing beliefs. Any information to the contrary to their beliefs is discounted or ignored.
4. Mental Accounting: Investors are much more distressed by prospective losses than they are happy by equivalent gains. Investors typically consider the loss of Rs. 100 twice as painful as the pleasure received from a Rs. 100 gain. Individuals will respond differently to equivalent situations depending on whether it is presented in the context of losses or gains. When faced with sure gain, most investors become risk-takers and when faced with sure loss, they become risk-averse.
5. Availability bias: This describes the tendency of people to overweight events or circumstances that are at one’s fingertips, recent, or well-publicized, or traumatic, or vivid. Investors are more likely to act on this readily available information. Blue chips stocks or the growth stock are most preferred as investors are influenced by the vividly publicized information about the stock and choose to buy that stock above those with less media attention.
6. Herding: Investors tend to imitate others. When a market is moving up or down, they are subject to a fear that others know more or have more information. As a consequence, investors feel a strong impulse to do what others are doing.
All these psychological components seem to be influencing individual investors’ trading behavior in the stock market.
Behavioral Finance and Technical Analysis
The science of Behavioral finance helps in understanding market trends, which in many ways is the basis for how a large number of market participants make financial decisions.
One application of the understanding of behavioral finance is through the use of technical analysis which involves market data analysis such as as historical price movements, trading volume or trading systems or chart based techniques to detect short-term or long-term price movements. Technical analysts attempt to search recurring and predictable patterns in stock prices to generate superior investment returns. They search for bullish or bearish signals (i.e. positive or negative indicators) for stock price movements or market direction.
In technical analysis, there is much importance given to the identification of support and resistance levels, which is based on human beliefs and behavior. The idea behind these support and resistence levels is straightforward. As a stock’s price (or the market as a whole) falls, it reaches a point where investors increasingly believe that it can fall no further and investors start buying from that point, thereby “supporting” the price. A resistance level is formed by reverse logic. As a stock’s price (or the market as a whole) rises, it reaches a point where investors increasingly believe that it can go no higher and start selling their shares, thereby “resisting” further advances.
All of this is based on certain assumptions about human behavior (mainly greed and fear).
There is always a possibility that the market prices are influenced by factors like errors in judgment by investors, sentiments, emotions, and irrationality. To take wise decision, it is essential to avoid certain types of behavior(s). Investors can make potential damage to their portfolio from overconfidence and other psychologically induced errors.