Gambler's Fallacy and Behavioral Finance in The Financial Markets: A Case Study of Bombay Stock Exchange
Gambler's Fallacy and Behavioral Finance in The Financial Markets: A Case Study of Bombay Stock Exchange
Gamblers Fallacy and Behavioral Finance In The Financial Markets: A Case Study of Bombay Stock Exchange
Rakesh H M
Assistant Professor, Dept. of Business Administration
ABSTRACT : This research paper is relating to behavioral finance and its theories which are in stark
disparity with that of conventional financial theories that have been experienced for decades. Since 1970s behavioral finance has tried to explain and justify the existence of a number of market anomalies by incorporating behavioral characteristics of financial decision making which appear significant to the trader/ dealer. It highlights one aspect of behavioral finance that can be seen in the financial marke t Gamblers Fallacy. The study primarily focuses on the stock and shares market price but also throws light on the way how trading of these devices/ gadgets/ instruments is affected by gamblers fallacy. T he sample population for this research has been selected from Bombay Stock Exchange, India. The required data have been collected through questionnaire and the sample from people with no specialized financial knowledge. This research paper also intends to bridge gap of knowledge by finding out the degree to which misleading notions of gambler which is also called gamblers fallacy exists and has a vital impact on the decisions of investors in India.
Financial decisions are ideally assumed to be free of all emotional and psychological interference and all investors are assumed to be wealth maximizers. However,market trends paint a different picture; especially in a country like India, where stock market crashes are not unheard of and where markets are way too volatile as compared to most of the international markets. On one hand it is true that investors have some level of financial knowledge that they apply before making an investment decision and on the other hand the fact that they dont always make rational decisions in their own interest cannot be overlooked.Behavioral Finance is described as that field of finance that proposes psychology and human emotion-based theories to explain certain investment anomalies that is seen in real life. It assumes the characteristics of market participants and their emotions influence the investors financial decisions and thus the market outcomes. Gamblers fallacy is referred to Monte- Carlo fallacy or the Maturity of Chances fallacy and is studied under behavioral finance. It is the conviction that if divergences/deviations from probable behavior are experiential in recurring independent tests of some unsystematic procedure then these divergences/deviations are likely to be evened out by contrary deviations in the future. Gamblers Fallacy mainly revolves around the illogical concept of any investor that believes that some event(X) is real inherently independent of any other event may be affected by the other event(Y)i.e. even though in reality; logically and rationally X does not affect the outcome or occurrence of Y. Gamblers fallacy states that people illogical amuse that they do. Thisillogical approach often comes into play because asimilarity between random processes is wrongly interpreted by an investor as a predictive relationship between them.Gamblers Fallacy can be in any of the following forms; Run of good Luck, Law of Averages, Law of Averages or Exhausted Its Luck, Run of Bad Luck. No matter what type of gamblers fallacy is taken into account, all versions of gamblers fallacy are based on the same fundamental mistake of the failure to understand statistical independence.
II.
This research attempts to focus on whether or not the gamblers fallacy overshadows Indian investors financial decisions while they make them, or their financial decisions are completely separated from the behavioral aspects due to their sound knowledge and understanding of the financial markets and the way they work.
III.
HYPOTHESIS
Ho: Gamblers fallacy doesnt affect investors expectations while investing in stock market. H1: Gamblers fallacy affects investors expectations while investing in stock market.
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V.
India is a country with an unstable political environment that reflects to some level in the unstable economy and thus inevitably a relatively unstable stock market, however, the level of instability in the stock markets surpasses by all standards the level of instability in the economy of the country. While the economy is no doubt growing and flourishing with every passing year and generally different sectors of the economy seem to be doing well; the stock market is still unstable. This instability cannot be attributed alone to the economy as a whole or the political crisis; it is for these reasons decided to carry out a research in order to gain an insight into the average non-specialized investorsdecision making process in India. In special, due to several hindrances and limitations, scope of the study is confined to gamblers fallacy in Bombay Stock Exchange and therefore, hypothesis is also tested on the sample of 60 investors taken from Bombay Stock Exchange.
VI.
LIMITATIONS
The study is limited to Bombay Stock Exchange only. Further studies can be carried out by considering other Stock markets in the country. Another very important limitation is investors hesitation because investors were found very much reluctant to provide any sort of information. Literature Review William A. Branch and George W. Evans (2006) study suggest a model of bounded rationality to overcome hindrance of Standard Rational Expectations (RE) to understand different prominent pragmatic regularities and observes long-run excess returns. It explains alternative theoretical foundations for the empirical findings and takes into account things beyond rational expectations and devises behavioral or through which these anomalies might arise (e.g., Barberis, Shleifer, and Vishny (1998), Hong and Stein (1999), Hong, Stein, and Yu (2005), and Lansing (2006). Previous models taking a behavioral perspective that give understanding of empirical puzzles: overreaction, gamblers fallacy, undue probability changes, to news about dividends, excess trading, long-run predictability, and volatile long-run excess returns. Stock returns in many countries are positively correlated in short term and negatively correlated over long run which is interpreted as evidence that there is initially under reaction to news and later overreaction over time. Jeff Dominitz Charles F. Manski (2005) focus on the more primary problem faced by economists working on behavioral finance: the measuring and interpreting of expectations of equity returns. Measuring expectations is a specifically challenging task since there are no formal models through which they can be measured. The paper tests how behavioral aspects unintentionally influence the expectations of traders while they trade and thus result in anomalies in the market as traders start trading based on those irrationally changed expectations. Robert J Shiller (2002) focuses on the same lines, but on a broader perspective. He traces the market trends from the efficient market theory to behavioral finance and the many traits identified in the field such as gamblers fallacy, over confidence and over reactions. He begins by tracing the historical background of the efficient markets theory which reached the height of its dominance in the 1970s but successive identification of unexplainable anomalies in the market coupled with excessively volatile returns reaching all-time highs and lows for no apparently rational reason led financial analysts and economists to study more deeply into the decision making process of investors who seem to be making decisions that dont always work for their own benefit and defy simple investor logic in the 1980s. Kent Daniel, David Hirshleifer, AvanidharSubrahmanyam (1998) analyzed the impact of following two important psychological biases of investors on their investment decisions: (i) Investor overconfidence about the precision of private information Overconfidence implies negative longlag autocorrelations; excess volatility when managerial actions are correlated with stock miss-pricing, public-event based return predictability.
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As can be seen 79 per cent of the investors gave an unbiased answer stating that a fair coin had a 50-50 percent chance of landing on a Head or a Tail. This goes on to show that provided the investors are given no historical trends or data (recent or otherwise) they will be rational in making predictions 79 times and the probability of the event happening will remain what it actually is i.e. 50 percent.
The Normal Curve and Histogram shows the distribution of results clearly showing the mean to stand at 3.91 and the standard deviation at 0.35. Dismissing the possibility of the existence of gamblers fallacy in the investors mind without any relevant past data availability.
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The third question was designed to test for a form of Gamblers Fallacy which results when the investor wrongly assuming that a trend exists because a series of random events happen in such a manner that they seem non random and connected. This form of Gamblers Fallacy usually results when the mind identifies a pattern of some sort that it assumes is correct.
The above chart clearly shows that gamblers fallacy exists in the investors as 55 percent of them said that 73 percent chance of getting another Tail existed. While 27 per cent of them assumed that 16.50 percent chance of there not being another Tail existed. This shows that while majority of the investors are victims of gamblers fallacy that exists because investors assume that a random event will occur just because it has been occurring in the past consistently, over 15 per cent are victims of the type of gamblers fallacy (referred to as run of luck) which exists because investors assume that a certain event will NOT occur simply because it has been occurring too many times in the recent past. In both the cases the investors f ail to see that the actual probability of getting a Tail or a Head remain the same. Another question designed is more relevant to the environment that investors work is presented investors with another hypothetical situation where they were asked to predict what a particular stocks price would be given recent historical data trend. The question asked was: Suppose a stocks price has been growing up by 5 points for the last 3 weeks (10, 15, and 20) what is the probability of the prices to increase by exactly 5 points the next week? 68 per cent of the investors predicted that just because the stocks price has been going up by 5 points each week it will continue to go up by 5 points the next week too. As explained above this is a form of gamblers fallacy where investors mistake a random series of events as a non-random pattern.
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To test the investors confidence level, results show that investors were confident about the information that they had and so they based their decisions on that which resulted in biased decisions. Confidence level thus contributed to gamblers fallacy in investors while they made their investing decisions. Question No. 1 2 3 4 5 6 7 8 Mean 3.81 4.13 3.09 4.61 1.9 3.58 4.71 1.35 Conclusion Gamblers Fallacy exists Gamblers Fallacy exists Gamblers Fallacy exists Gamblers Fallacy exists Gamblers Fallacy exists Gamblers Fallacy exists Gamblers Fallacy exists Gamblers Fallacy exists
VII.
CONCLUSION
Behavioral Finance is an area of study that still requires a lot of input. Whereas a number of studies have been done in India, still has a long way to go before its investors can start looking into behavioral aspects of investing. The aim of this paper is to get a better insight into the workings of the investors in the Bombay Stock Market and to be able to determine to some extent why the local stock markets here are as volatile and unpredictable as they are. There are several types of gamblers fallacy that are seen in the investors stock exchange. This attribute of behavior has forced investors to make biased decisions. Therefore the hypothesis i.e. investors expectations are affected by gamblers fallacy while investing in stocks is proven which adversely affect the outcome of the investing decisions.Investor needs to make a conscious effort to make sure that their investing decisions are not bias and that they make rational decisions based on calculated facts and not loose assumptions. Only then can the stock market be more stable collectively.
REFERENCES
[1] [2] [3] Schlenker, B.R. &Weigold, M.F. (1992). Interpersonal processes involving impression regulation andmanagement. Annual Review of Psychology, 43, 133-168. Toneatto, T. (1999).Cognitive psychopathology ofproblem gambling. Substance Use and Misuse, 34 (11),1593-1604. Toneatto, T., Blitz-Miller, T., Calderwood, K.,Dragonetti, R.&Tsanos, A. (1997).Cognitive distortionsin heavy gambling.Journal of Gambling Studies, 13,253-266.
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