INVESTORS BEHAVIOUR AND INVESTMENT DECISIONS - A BIRDS EYE VIEW

By Dr(Mrs) Chitra Siva Subramanian, Reader, Department of Management Studies, Pondicherry University & Mrs.A.Pankajam, Associate Professor, Avinashilingam School of Management Technology, Avinashilingam Deemed University for Women, Coimbatore-43

Abstract:
According to economic theorists, investors think and behave rationally when buying and selling stocks. In reality however, investors do not think and behave rationally. In the contrary, driven by greed and fear, investors speculate stocks between unrealistic highs and lows. In other words, investors are misled by extremes of emotion, subjective thinking and the whims of the crowd, consistently form irrational expectation for the future performance of companies and the overall economy such that stock prices swing above and below fundamental values and follows a some what predictable, wave-like path. Personality traits bear on investment behavior are

confident or anxious, deliberate or impetuous, organized or sloppy, rebellious or conventional, an abstract or linear thinker. Investors tend to: extrapolate past trends into the
future, follow others because of their mob mentality, feel overly confident in their ability to foretell the future, take risks that are disproportionately large by comparison with potential return

Key Words: Behavioural Finance, Irrational Behavior, Investors behaviour, INTRODUCTION

According to economic theorists, investors think and behave rationally when buying and selling stocks. Specifically investors are presumed to use all available information to form rational expectations about the future in determining the value of companies and the general health of the economy. Consequently, stock prices should accurately reflect fundamental values and will only move up and down when there is unexpected positive or negative news, respectively. Thus, economists have concluded that financial markets are stable and efficient, stock prices follow a random walk and the overall economy tends toward general equilibrium. In reality however, according to Shiller (1999) investors do not think and behave rationally. In the contrary, driven by greed and fear, investors speculate stocks between unrealistic highs and lows. In other words, investors are misled by extremes of emotion, subjective thinking and the whims of the crowd, consistently form irrational expectation for the future performance of companies and the overall economies such that stock prices swing above and below fundamental values and follow a some what predictable, wave-like path. Investors behavior is part of academic discipline known as behavioral finance which explains how emotions and cognitive errors influence investors and the decision making process. Behavior of the individual investors has long been the interest of academics and portfolio managers but not the investors themselves since the herd mentality sometimes dominates over reasons. Human herding behavior results from impulsive mental activity in individuals responding to signals from the behavior of others (Prechter, 1999). Behavioral finance is a study of the markets that draws on psychology, throwing more light on why people buy or sell the stocks and even why they do not buy stocks at all. Behavioral finance encompasses research that drops the traditional assumptions of expected utility maximization with rational investors in efficient market. The two building blocks of behavioral finance are

cognitive psychology and the limits to arbitrage (Ritter, 2003). Cognitive refers to how people think and the limit to arbitrage when market is inefficient. There is a huge psychology literature documenting that people make systematic errors in the way they think: they always make decision easier (heuristics), overconfidence, put too much weight on recent experience (representativeness),separate decisions that should be combined (mental accounting), wrong presenting the individual matters (framing), tend to be slow to pick up the changes (conservatism), and their preferences may also create distortion when they avoid realizing paper losses and seek to realize paper gains (disposition effect). Behavioral finance uses models in which some agents are not fully rational, either because of preferences or because of mistaken beliefs. An example of an assumption about preferences is that people is loss averse. Mistaken beliefs arise because people are bad Bayesians.

Behavior Patterns of Investors

Behavioral finance investigates the behavior patterns of investors and tries to understand how these patterns guide investment decisions. Some studies have shown that investors can adopt irrational behavior modes. These are summarized below: y Over-confidence: Investors are asked their guess about the yearend value of Nifty and they are told to set such an upper and lower limit so that the values obtained would be between these limits with 90% probability. Normally 90% of them are expected to make a correct guess about these limits based on the assumption that investors are rational and that they have equal access to information. However, it does not turn out to be the case. Almost all of the investor forecasts the lowest value higher than it should be and forecast the highest value lower than it should be. One explanation for it is that, investors have over-confidence in themselves (and thus in their forecasts) and that they have to make their guesses in between limits that are narrower than they are supposed to be. Another example for this is an experiment that was conducted previously. Participants are asked to rate their driving skills and to position themselves in comparison to all other drivers (above average, average and below average). Most of the drivers position themselves above the average. This is seen as another sign of over-confidence. y Anchoring and Sticking (Conservatism): This trait is explained by referring to a problem developed by psychologist Ward Edwards in 1964. According to the problem, there are 100 bags and 1,000 poker coins in each of them. The content of the bags are not visible from outside. 45 of them have 700 black and 300 red and the remaining 55 has 300 black and 700 red. Bags are selected randomly by tossing coins. At this point we have two questions facing us:

a) What is the possibility that the number of black coins is more than the others in the selected bag? b) Lets assume that 12 of the coins (after putting them back to the bags one by one) are drawn from the selected bag and that we have drawn 8 black and 4 red coins. In this case, do you want to revise your answer to the above question with this new information? Then what is the possibility of having more black coins in the selected bag? This question actually shows us the following. Lets think of a business and assume that black coins represent that a successful financial picture and the red ones represent the opposite. In this case, when we bring together the two questions above, we would see that a business that has been getting bad results for many years has stated to get good results recently. This is exactly where the problem is. Are the investors stuck with their past performances? Or are they able to make use of new information?

The first question is much easier than the second one. And the answer is 45%. However, when a survey is carried out among the respondents of the second question, it was seen that great majority insisted on 45%. These people do not use the new information and react much less then they are supposed to and display a conservative mindset and anchor on the old information. Another group of respondents gave 67% as the answer. Their answer is not correct either. The correct answer is 96.04% which no respondent gave y Protection against uncertainty: Humans have a tendency to choose the certainties in the face of uncertainties. Lets try to explain it with an example. If a group of people are told that a bag contains 80 black and 20 red coins and are also told that they can receive Rs.1,000 without betting or Rs.2,000 with betting and drawing black, most of them would prefer to bet. However, when the same groups of people are asked if they would bet for a bag where no information as to the number of black and red coins is available, most of them would prefer not to bet and opt for receiving Rs.1,000.. Humans always tend to prefer certainty over uncertainty. Protection against loss: Studies have demonstrated that most individuals place more emphasis on the expected loss than they do on the expected return. For example, from among an investment option which would bring a loss of Rs. 10,000 with 50% probability and return of Rs. 10,000 with a probability of 50% and another investment option which would bring a loss of Rs. 2,000 and a return of Rs. 2,000 with a probability of 50%, the second is preferred. Other than that, if we are to expand this example a little more, from among the following options; Rs. 10,000 loss with a probability of 10%, Rs. 2,000 return with a probability of 50% and neither loss nor return with a probability of 40%; Rs. 2,000 loss with a probability of 50% and Rs. 2,000 return with a probability of 50%, it is seen that people tend to choose the second one. However in both cases, the expected value would be zero. Option 1: -10,000 x 10% + 0 x 40% + 2,000 x 50% = 0 Option 2: -2,000 x 50% + 2,000 x 50% = 0 Preventing Loss: In order to prevent loss investors engage in irrational behavior. For example, after realizing that they have followed a wrong strategy, they apply stop-loss in order not to realize their losses; however this behavior can start a chain of mistakes that might cause them to make one mistake after the other. Regret: Individuals wouldnt want to have regrets in the future and try to make decisions to minimize their regrets. It has been observed that the investors, with a motivation to avoid regret, have not sold the stocks with decreasing prices and incurred greater losses. Monetary Illusion: The fact that most of the time, individuals do not take into account the inflation factor in their estimations even in our country where high inflation levels are considered to be normal, is quite interesting. Investors usually disregard this factor while calculating the return and loss from their investments.

One kind of investor behavior that leads to unexpected decisions is bias. A tendency or preference or belief that interferes with objectivity. a predisposition to a view that inhibits objective thinking. Biases that can affect investment decisions are the following: Availability, Representativeness Overconfidence, Anchoring, Ambiguity aversion In addition to the above behavior patterns that the investors they might tend to act in a different way due various factors. Some of these factors are given below: y Gender: Males are more risk-takers compared to women.

y y y y

Marital Status: Singles are more risk-takers compared to married people. Age: Young people tend to take more risks compared to elderly. Education Level: More educated people tend to take more risks compared to those with less education. Financial information: those with more financial information take more risks compared to those with less financial information

Investor Psychology Cycle As the pendulum swings between greed and fear, investors typically become overenthusiastic during bull markets and over-despondent as the bears growl grows louder. It stands to reason that in order to be a successful investor, it is important to distance you from the herd mentality and to take objective decisions based on fundamental reasons. The typical behavior of investors is linked to the so-called investor psychology cycle, as illustrated below.

Contempt: According to the cycle, a bull market typically starts when a market is at a low and investors scorn stocks. Doubt and suspicion: They try to decide whether what they have left should be invested in a safe haven such as a money market fund. They have burnt their fingers with stocks and vow never to invest again.

Caution: The market then gradually starts showing signs of recovery. Most investors remain cautious, but prudent investors are already drooling at the possibility of profit. Confidence: As stock prices rise, investors feeling of mistrust changes to confidence and ultimately to enthusiasm. Most investors start buying their stocks at this stage. Enthusiasm: During the enthusiasm stage, prudent investors are already starting to take profits and get out of the stock market, because they realize that the bull market is coming to an end. Greed and conviction: Investors enthusiasm is followed by greed, which is often accompanied by numerous IPOs on the stock market. Indifference: Investors look beyond unsustainably high price-earnings ratios. Dismissal: As the market declines, investors show a lack or interest that quickly turns to dismissal. Denial: Then they reach the denial stage where they regularly affirm their belief that the market definitely cannot fall any further. Fear, panic and contempt: Concern starts to take a hold and fear, panic and despair soon follow. Investors again start scorning the market and once again they vow never to invest in stocks again.
In layman's terms, various studies have concluded that behavioral finance postulates the following: y Individual and institutional investors are susceptible to herd mentality, a tendency at the root of many bubbles and crashes; y The pain of a rupee lost generally is much greater than the pleasure of a rupee gained; y People tend to take a self-centered approach to investing. That is, they put emotional weight in the price they paid for the stock relative to its current position; y Overconfident investors tend to trade too much and under perform the market; y People tend to be more optimistic when the market goes up and more pessimistic when it goes down; y People are afraid to admit an error in judgment and are thus more likely to sell winners in their portfolios than losers; Tendency of irrational behavior Low tendency of irrational behavior Anchoring Confirmation bias Hindsight bias Gamblers fallacy Herd behavior Medium tendency of irrational behavior Strong tendency of irrational behavior

Overconfidence Cognitive reflection task Prospect theory

Decision-making style categories. The main difference from EMH is that the behavioural decision- making process follows an intuitive rather than rational way of thinking. To deal with bounded rationality, decision-makers use heuristics. Heuristics are highly useful mental tricks or rules of thumb that people use to simplify decision making in complex situations. Three of the most important heuristics are availability, representativeness, also anchoring and adjustment. From the studies of judgment under uncertainty it is known that complexity, use of heuristics, and cognitive limitations may lead to biased results. Biases are common errors that result from the use of heuristics HEURISTICS Availability Representativeness BIASES Overestimating the frequency of vivid, extreme, or recent events and causes Failure to take into account base rates and overestimating the likelihood of rare events Inappropriate decisions when initial amounts are too high or too low

May lead to

May lead to

Anchoring and adjustment

May lead to

Contrarian strategies (as value investing) produce higher returns, because they exploit the tendency of some investors to overreact to good or bad news. Overreaction means that prices adjust by more than is justified by fundamentals. Unpopular value stocks that have done badly are oversold, become under-priced, and are corrected at some point in the future when a switch in investor sentiment raises the prices of these stocks. In addition, there are also some findings that most investors tend to behave according to the realm of human psychology the assumption that the crowd is always right and the comfort of being part of the herd. Using a contrarian strategy to the common behaviour could also be one source from which value investors can gain. Momentum trading and herding are two trading patterns, which are often argued to destabilise stock markets. In momentum strategies, investors buy past winners and sell past losers, possibly ignoring information on fundamentals. Winners and losers can be defined on the basis of either past returns or accounting variables, such as book-to-market ratio. Herding, in the context of financial markets, refers to investors tendency to mimic one anothers trading decisions. Over Confidence ---- leads to ------over estimation ---leads to ---- over reaction

Financial Advice:
Financial advising is a prescriptive activity whose main objective should be to guide investors to make decisions that best serve their interests. To advise effectively, advisors must be guided by an accurate picture of the cognitive and emotional weaknesses of investors that affect investment decision making: their occasional faulty assessment of their own interests and true wishes, the relevant facts that they tend to ignore, and the limits of their ability to accept advice and to live with the decisions they make. In the long run behavioral finance would certainly help in building better models. By focusing rigorously on root causes, behavioral finance can help fiduciaries recognize conditions that are conducive to irrational behavior, avoid falling into "sub optimality traps," and exploit profitably the irrational actions of others. An investor cant be assumed to be a machine, always making logical calculations and uninfluenced by psychological factors. People trade not only for profit but for emotional and cognitive reasons as well. These aspects if factored could make the analysis more accurate and reliable. Knowledge of this area may also help an investor at a personal level as it makes them aware of the common mistakes they make.

Conclusion:
Individuals do not always act rationally in their financial decisions and that their behaviors cause them to make different choices about their financial decisions. Behavior is the action taken by an individual as a response to the complex influence of the external stimulants. Individual, who, at this point analyses the situation and reaches a rational outcome; can easily move away from these rational decision due to reasons such as past experiences, life standards and anxiety related to future and can make a mathematically incorrect decision. Financial literature has brought out the following aspects in the behaviour of investors, i.e. investors tend to: extrapolate past trends into the future, follow others because of their mob mentality, feel overly confident in their ability to foretell the future, take risks that are disproportionately large by comparison with potential return. Many personality traits bear on investment behavior are confident or anxious, deliberate or impetuous, organized or sloppy, rebellious or conventional, an abstract or linear thinker.

Reference: y y y y y
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