Tactful Management Research Journal

Impact Factor : 2.1632(UIF)

ISSN: 2319-7943

BEHAVIORAL FINANCE AN IMPACT OF INVESTORS

UNPREDICTABLE BEHAVIOR ON
STOCK MARKET

Mugdha S. Kulkarni

Department of Tourism StudiesChrist University, Bangalore

Abstract : Behavioral finance is a part of finance that seeks to understand and explain
the systematic financial market implications of psychological decision processes. It
utilizes knowledge of cognitive psychology, social sciences and anthropology to explain
irrational investor behavior that is not being captured by the traditional rational based
models. This article, namely behavioral finance, presents a new approach in the analysis
of capital markets. Behavioral finance is the study of the influence of the psychological
factors on financial markets evolution. Financial investors are people with a very varied
number of deviations from rational behavior, which is the reason why there is a variety of
effects, which explain market anomalies. Human beings are rational agents who attempt
to maximize wealth while minimizing risk. These agents carefully assess the risk and
return of all possible investment options to arrive at an investment portfolio that suits
their level of risk aversion Classical finance assumes that investors are rational and they
are focused to select an efficient portfolio, which means including a combination of asset
classes chosen in such a manner as to achieve the greatest possible returns over the long
term, under the terms of a tolerable level of risk. Behavioral finance paradigm suggests
that investment decision is influenced in a large proportion by psychological and
emotional factors.

Key words: behavioral finance, capital market, classical finance, investment decision,
market efficiency, psychological factors, rational behavior

INTRODUCTION

Behavioral finance is the study of the influence of the psychological factors on financial markets
evolution. Inother words, financial markets inefficiency is analyzed in the light of the psychological
theories and perspectives. Behavioral finance is a relatively recent and high impact paradigm which
provides an interesting alternative to classical finance. The classical finance assumes that capital markets
are efficient, investors are rational and it is not possible to outperform the market over the longterm.
Psychological principles of behavioral finance include among others heuristics and biases,
overconfidence, emotion and social forces. A very important step for an investor is to understand his
financial personality. In other words, in the posture of investor is vitally important to understand why you
make certain financial decisions or how you are likely to react in common conditions of uncertainty. This
form of analysis is useful in an attempt to understand how you can temper the irrational components of
investment decisions while still satisfying your individual preferences and requirements. Behavioral
finance provides a different perspective, very complex and unconventional. Behavioral financeparadigm
suggests that investment decision is influenced in a large proportion by psychological and emotional
factors Humanemotionalcomplexityincludesthefollowing primary feelings: fear, panic, anxiety, desire,
joy, greediness, pleasure, spirit/egotism. Emotion thus play a vital role in financial markets.
Most of the financial market anomalies cannot be explained using traditional models. Behavioral
finance easy explains why the individual has taken a specific decision, but did not find as easily an

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 Behavioral Finance An Impact Of Investors Unpredictable Behavior On Stock Market

explanation about how future decisions will be. Classical finance has as a cornerstone the Efficient
Markets Hypothesis, according to whom, since everyone has access to the same information, It is not
possible to change the market position, because that stock prices are, in fact, efficient, reflecting
everything we know as investors. A market in which prices always fully reflect available information is
called efficient. Synthesizing, Efficient Markets Hypothesis assume that capital market are information
ally efficient. Eugene Fame, the father of efficient market hypothesis reveals, Market efficiency survives
the challenge from the literature on long-term return anomalies. Consistent with the market
efficiencyhypothesis that the anomalies are chance results, apparent overreaction to information is about
as common as under reaction, and post event continuation of pre-event abnormal returns is about as
frequent as post-event reversal. Most important, consistent with the market efficiency prediction that
apparent anomalies can be due to methodology, most on-term return anomalies tend to disappear with
reasonable changes in technique
In contrast, behavioral finance assumes that, in some circumstances, financial markets are
information ally inefficient.
The main purpose of this article is to have an insight into how the influence of psychology on the
behavior of the investors can explain capital markets imperfections.
Human nature is perfectible, but it is not perfect. Investors are people with many deviations from
rational behavior, which often make illogical decisions. In the existing global financial perspective, the
major influence of psychological factors in investment decision-making is undeniable.

Scope of the study:

The intended study is to be taken in the Capital markets in India. The study will be focusing
onbehavioral pattern of individual investorsresiding in Bangalore. The study is Empirical researchbased
on literature.

Objectives:

1.To understand how emotions and cognitive errors can affect financial affairs.
2.To understand the influence of heuristic (rule of thumb) factors in decision making

Literature review:

Factors Influencing Investor Behaviour: An Emperical Study In Mumbai pointedout the most
impacting and the lowest affecting reasons influencing decision of an investor residing in Mumbai.the
demographic factors were considered.The researcher had categorized investors as follows:-goodwill /self-
image of the firm, financial details, unbiasedinfo, legal recommendations and personal fiscal needs. The
author also attempt to identify the sector which was having higher value in the market in comparison to
standard SENSEX for the period of 2005 to 2012. The result of the survey concluded that the behavior male
and female investing in stock market in Mumbai have almost the same set of factor that influence their
behavior.
Love Inness (2003) in this research the author hasacknowledged and categorizedsections of
individual investors based on their shared investing approaches and behavior. The five main category that
has impact on the behavior of the trader is investment prospect, self-confidence, control, attitude towards
risk and possibility of loss. Majority of the respondentshad similar opinion and hence were categorized 1)
risk irresistible traders; 2) confident investors; 3) Youth risk seeker; risk averselong-term investors. Each
subdivision purchasediverse types of stocks, they have different source of information and has different
levels of investing behavior.

Anovel approach to capital markets:-

The field of modern finance has registered remarkable progress in the last decades. Behavioral
finance is a newapproach to capital markets, having an important role in financial decision making process.
Decision making related with behavioral finance, can be defined as the process of choosing a particular
investment alternative from a number of alternatives. It is an activity that follows after proper evaluation
of all the alternatives.
In the 1960s cognitive psychology initiated to throw light on the brain as an information
processing device in contrast to behaviorist models. Psychologists in this field, such as Ward Edwards,
Amos Tversky and DanielKahneman began to compare their cognitive models of decision-making under

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 Behavioral Finance An Impact Of Investors Unpredictable Behavior On Stock Market

risk and uncertainty to economic models of rational behavior. Mathematical psychology has long-lasting
impact on order of preference and what kind of measurement scale utility constitutes.
In 1979, Kahneman and Tversky was talking on the Prospect theory: An Analysis of Decision
under Risk, paper has used cognitive psychology to clarify various differences of economic decision
making from neoclassical theory. Agreeing to Sewell, behavioral finance is the study of the impact of
psychology on the behavior of financial practitioners and the subsequent effect on markets. Barberries and
Thaler consider that behavioral finance has two building blocks: limits to arbitrage, which debateson the
fact that it can be difficult for rational investors to unwrap the disruptions caused by less rational investors
and psychology, which lists the kinds of difference in investing
According to Fromlet, Behavioral finance closely combines individual behavior and market
phenomena It is the combination of both the psychological and finance. However, mainly, behavioral
finance has not fully developed area, but has major repercussions for the manner in which the investment
process is directed. In other words, behavioral finance is a far-reaching visions paradigm which is trying to
understand and to forecast financial markets based on psychological and emotional implications.
According to some researchers, behavioral finance states the features of interpretation and action based on
the data for organized investing decisions by individuals. In Thaler opinion, behavioral finance defines that
some of the economical factors which may not treat rationality based on the assumption. Thus this study is
the psychological decision process in acknowledgmentof prediction of financial markets.
Behavioral finance represents an area of research that attempts to understand and explain how
reasoning or cognitive errors influence investor decisions and stock market prices. Thus, behavioral
finance combines principles from the fields of individual and social psychology with classical financial
theory to understand and highlight the performance of stock markets.In consequence, the behavioral
finance area is summarized in essence to explain financial market anomalies on the basis of the study of
investors behavior and decision making process.Metaphorically speaking, behavioral finance it is an
alternative solution to the difficulties faced by the classical theory in explaining certain financial
phenomena. In deep contradiction to the classical paradigm, behavioral finance assumes that investors may
be irrational in their reactions to new information and investment decisions.
In these conditions, it can be tough for normalinvestor to adjust with the price change caused by
the irrational investors due to present limits of arbitrage. The theory of arbitragevalidates that if irrational
investors cause deviancies from fundamental value, rational traders will often be helpless to react on
it.Emotion are difficult to interprete includes the following primary feelings: anxiety, greed,happiness,
satisfaction, desire or vanity. It is often seen that all the emotions restrict in certain sizes in a financial
investment decision making.According to Tilson, there are Common Psychological Mistakes, such as:
a) Bullish approach of Overconfidence
b) Estimating future with past data
c) going with the crowd
d) Misinterpretation randomness in market position
e) Obligation and uniformity bias
f) Anxiety, fear of change
g) Interpreting irrelevant info
h) Loss aversion
i) Use of mental accounting methods
j) Taking emotional decisions
k) Fear of ambiguity
l) Embracing certainty
m) Overrating the probability of happenings based on previous trend or experiences and taking hasty
decisions
n) not taking action due to an plenty of attractive choices
o) Fear of wrong decision and feeling stupid (regret aversion)
p) Unwillingness to admit mistakes
q) Believing that ones investment success is due to wisdom rather than a rising market, but failures are not
ones fault
r) Failing to accurately assess ones investment time horizon.
s) A tendency to seek only information that confirms ones opinions or decisions
t) Recognition of large and small information which can be impacted
u) Unfamiliarity with the techniques and information.
Behavioral finance realize a connection relating financial theory to practical investment analysis
in order to provide a means of understanding the financial market complex situations. In fact, the main idea
is finding anexplanation for market inefficiencies such as :mispricings, irrational investment decision

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 Behavioral Finance An Impact Of Investors Unpredictable Behavior On Stock Market

making and return anomalies.

The influence of informational asymmetry, psychological, sociological and demographic
structures can represent up to a certain level, a relevant answer to financial market anomalies. Investors are
different some of the other in relation to numerous factors, such as: socio-economic background, financial
context, level of education, religion, age, sex, traditions, ethnicity, marital status, and so on. They form
expectations and beliefs that influence their investment decisions in a dramatic proportion. An optimum
investment decision it cannot be achieved if the investor ignore all of these factors influence.Behavioral
finance paradigm focusing on the cognitive psychology suggest that the investment decision making
process may be analysed successfully through the following variables : overconfidence, herding
complex,overreaction, conservatism, preconceived ideas, excessive optimism, representativeness,
irrationality or rational way of thinking and the impact of media channels. Empirical studies show that
investors are overconfident in their judgments and due to this seemingly insignificant appearance they
make mistakes when perceive information and form their beliefs. Also, investors overreact in certain
circumstances or they act under the impulse of some beliefs such as those mentioned above.

FINDING AND OBSERVATIONS

1.Finding to objective 1To understand how emotions and cognitive errors can affect financial affairs.
It is said that feelings and emotions that may be termed as unrelated feelings and emotions can
affect decisions. Lack of emotions in the decision making process destroys the ability to make rational
decisions, and hence such people become socially dysfunctional. Background feelings and moods
influence financial decisions and such a phenomenon is called misattribution bias. If someone is in a good
mood, he/she is more likely to be more optimistic in evaluating an investment. Good (bad) moods will
increase (decrease) the likelihood of investing in risky assets like stocks.
Feelings have been established as a major factor in buying and selling of investments in the market.
However there are a few more factors that play a vital role. THE SUN, is one important factor!
Psychologists have been determining on the fact that the sun affects ones decisions in investment. Without
the sun one feels bad. When the sun is out, one feels good and this good mood gives out an optimistic feel
about the future prospects and affects the decision making process. Yes, even financial decisions may be
affected by sunshine. Investors hence tend to sell stock on sunny days. Researchers use a weather scale with
9 levels to determine the levels between completely sunny to completely miserable.

2.Finding to the objective 2-To understand the influence of heuristic (rule of thumb) factors in
decision making
The crucial observations is listed as follows
1.Investors make judgment based on approximate rule of thumb, not sternly on balanced analysis.
2.Investors are not necessarily are careful to the equivalent choices if the choices are presented in
significantly different contents, which referred to framing-effect.
3.There are explanations for observed market outcomes that are contrary to national expectations and
market efficiency, which include mispricing, non-rational decision making and return anomalies.
From the above observations, it is clear that judgments can be systematically wrong in various
ways. Systematic errors of judgment are called biases. Financial decisions are made in situations of high
complexity and high uncertainty that preclude reliance on fixed rules and compel the decision-maker to rely
on intuition.

CONCLUSIONS:

Behavioral finance represents a revolution in financial theory. The combination of financial

theory with other social sciences resulted in the appearance of behavioral finance. This is a relatively young
and promising field of modern finance which has registered remarkable progress in the last decades.
Behavioral finance highlights the psychological edge of investment decision making process, in strong
contradiction to the Efficient Markets Hypothesis. The most important issue regarding efficient market
theory is that it is not possible to outperform the market over the long-term. Onthe theory of EMH which
suggests thatseveral information is accessibleto all investors or market participants, so stock prices always
incorporate and reflect all relevant information.
Due to this issue, the price of a stock should reflect the knowledge and expectations of all investors
or market participants. It is a certainty that it is not possible to separate an investorspersonality and the
investment decisions that he may make. Thus, it cannot be ignored the importance of understanding the
individual financial behavior of capital market investors. There is no need to make extensive psychological

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 Behavioral Finance An Impact Of Investors Unpredictable Behavior On Stock Market

assumptions to understand that investment decision do not focus strictly on financial theory. Investors, both
amateurs and professionals, make their choices in a way that it cannot be considered absolutely rational.
There are indisputable arguments in favor of both theories, as both present certain limits. Behavioral
finance is not a perfect replacement to classical finance paradigm, but it is an alternative solution to the
difficulties faced by the traditional theory in explaining certain financial phenomena. The study provides
important information to investment professionals, stock market regulators and companies listed on stock
exchanges. The findings of this study can be used to attract investors and increase their participation in
equity market. Probably the only undeniable truth is that financial markets are extremely complex and
unpredictable to believe that we can understand perfectly their mechanism.
The field of modern financial economics assumes that people behave with extreme rationality, but
they do not. The two common mistakes investors make i.e. excessive trading and the tendency to
disproportionately hold on to losing investments while selling winners have their origins in human
psychology. Because the tendency for human beings to be over confident causes the first mistake and the
human desire to avoid regret prompts the second. So, psychological research teaches as about the true form
of preferences, allowing us to make finance more realistic within the rational choice framework. This is the
reason today Behavioral Finance is a rapidly growing area that deals with the influence of psychology on
the behavior of financial practitioners. The above-mentioned arguments are provided for why movements
towards greater psychological realism in finance will improve mainstream finance. Apart from these things
this particular area also collectively predict some outcomes where the traditional models failed along with
reaches, the same current predictions as the traditional models.

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