A STUDY OF INFLUENCE OF INVESTMENT BEHAVIOUR IN FINANCIAL

DECISION MAKING

Abstract

In it endeavors to model financial markets and the behavior of firms, modern finance theory
starts from a set of normatively engaging maxims about individual behavior. Particularly people
are said to be risk-averse anticipated value maximizers and unbiased Bayesian forecasters. This
paper presents a selected review of recent work in behavioral finance. First, we converse how
psychology influences in financial decision making. Then, we discuss about succession of key
behavioral concepts, e.g., people’s well-known tendencies to give too much attention to
flamboyant information and to show excessive self-confidence. The body of paper demonstrates
the significance of these concepts to essential topics in investment theory and corporate finance.
In each case, behavioral finance offers new perception on results that are irregular within the
standard approach.

1.0 Introduction

Behavioral finance is the study of the influence of psychology on the behavior of investors and
the study of succeeding effect of markets. According to Mbaluka, Muthama, Kalunda (2012),
behavioral finance is focused on the application of emotional and economic values to explore
what happens in markets in which investors show human boundaries and difficulties for the
improvement of financial decision-making.

It is also describes as the application of psychology in finance. Behavioral finance has two
structures which are cognitive psychology referring to how people think and limits to arbitrage
referring to forecasting in what situations arbitrage forces will be effective, and when they would
not be has a same description stated as the study of how psychology influence financial decision
making and financial markets.

According to Dr. R. Shanmughama, K. Ramyab (2012), the details content of the trade and the
alteration of economic climate systematically affect personal investment decisions as good as
market results. Nevertheless, an investor’s investment decisions in any one specific trade, say
commodity trade, tend to depend highly on their deep derived from psychological tenet of
1|Page
decision making as only this psychological tenet of decision making may clarify why people
purchase or sell particular commodity.

Consequently, a preferable understanding of behavioral processes and results is significant for

financial planners, because an understanding of how investors normally response to trade
gestures will assist investment advisors in devising appropriate asset sharing strategies for their
clients. Consequently, the recent article focuses on investigating the element effect the behavior
of investors towards commodity trade.

In this part we explain the behavior of common stock returns and overview of the financial
theory that underlies the behavior of stock returns. Generally at the end of every quarter, a
company making profit offers a part of the kitty to the shareholders. This is one of the source of
stock market return one investor could expect. The most common form of generating stock
market return is through trading in the secondary market. In the secondary market an investor
could earn stock market return by buying a stock at lower price and selling at a higher price.

2.0 Literature Review

2.1 Theory of Behavioral Finance

The aim of this paper is to critically analyze the behavioral finance theory and identify property
issues for behavioral research. The evidence that assets market is incompetent or at best only
weak-form efficient, suggests that assets investors do not always hold on to rationality and are
influenced by emotions. Hence, it is considered that behavioral finance theories have a lot to
proffer towards analyzing property investments.

First and foremost, the literature on the two major building blocks of behavioral finance, limit to
arbitrage and investor psychology, were analyzed. Next, the psychological theories used in
behavioral finance are discussed. Then, noise trader risk was analyzed.

Tversky and Kanheman (1979) supported that the Prospect Theory demonstrated how people
manage risk and ambiguity. In essence, the theory clarifies the apparent promptness in human
behaviors when assessing risk under uncertainty. That is, human beings are not constantly risk-
averse; rather they are risk-averse in gains but risk-takers in losses.

2|Page
According to Tversky and Kanheman, people set much more credence on the outcomes that are
distinguished more certain than that are considered mere feasible, a feature known as the
“certainty effect”. People’s choices are also influenced by ‘framing effect’. Framing refers to the
way a problem is masqueraded to the decision maker and their ‘mental accounting’ of that
problem.

Shiller (1993) and Baker et al (2002) argued that arbitrage and financial innovation promote the
efficient allocations of risk and help make investment more rational. Arbitrage is an investment
strategy that offers risk-less profit at no cost. Traditional finance theorists consider that, any
mispricing created by irrational traders (noise traders) in the marketplace, will create a striking
opportunity which will be quickly capitalized on by the rational traders (arbitrageurs) and the
mispricing will be accreted. Behavioral theorists illustrate that, strategies required to correct the
mispricing can be costly and risky; thus, interpretation the mispricing unattractive and allowing
them to continue

As Shefrin (2000,p.3) points out, practitioners studying behavioral finance should learn to
recognize their own mistakes and those of others, understand those mistakes, and take steps to
stay away from making them. This analysis of behavioral finance aims to focus on articles with
direct relevance to users of investment management, corporate finance, or personal financial
planning.

Barberis and Thaler (2003) stated that behavioral finance disputes that there is ‘limits to
arbitrage’, which allows investor ludicrousness to be extensive and have long-lived impact on
prices. To explain investor irrationality and their decision-making process, behavioral finance
illustrates on the experimental evidence of the cognitive psychology and the biases that arise
when people form beliefs, fondness and the way in which they make decisions, given their
certainty and preferences. Hence, limit to arbitrage and psychology are seen as the two building
blocks of behavioral finance.

2.1.2 Noise Traders

Behavioral finance researchers have endeavored to segregate this risk in order to explain and
take advantage of upon the sentiment of the majority of investors. Noise trader risk is implicit to
be more willingly found in small-cap stocks, but has also been identified mid- and large-caps.

3|Page
For example, if the noise trader risk for a fastidious stock is high, an issuance of good news
related to a particular company may manipulate more noise traders to buy the stock, falsely
inflating its market value.

Shiller (1984; 1990) disputes that noise traders rely on “popular models” that are erroneous and
subject to fads. Shleifer and Summers (1990) widen this further, arguing “Some investors are not
fully rational, and their demand for assets is affected by beliefs or sentiments that are not fully
justified by fundamental news.” DeLong, Shleifer, Summers and Waldman (1990) model noise
traders as those who misrecognize the future value of the security.

Fischer Black [1986] dedicated his AFA presidential address to the favorable effects of “noise”
on markets, finishing that “noise trading is crucial to the continuation of liquid markets.” Shleifer
and Summers [1990] and Shleifer and Vishny [1997] acknowledged noise traders as the root for
the limits of arbitrage, arguing that noise trading introduces risks that restrain arbitrageurs and
foil prices from converging to fundamental asset values.

Despite this consideration given to noise trading, there remains significant debate regarding its
exact role in financial markets, and over whether society is well advised to frontier noise trading
by taxation or other means, or to ignore it altogether due to its insignificant nature in affecting
market outcomes.

As Shleifer and Summers (1990) noted, this prose implemented the term “noise traders” to
capture behavioral causes for trading not captured by these standard explanations, and in fact
labeled itself the “noise trader approach to finance.” Noise trade risk can be distinct as a form of
market risk associated with the investment decisions of noise traders. The higher the volatility in
market prices for a meticulous security, the greater the associated noise trader risk. Noise traders
play an omnipresent role in the finance literature.

Lastly, we observe the effect of the securities transaction (Tobin) tax, both as a lens to scrutinize
noise trader behavior, and to examine the effects of the transaction tax in its own precise. Not
surprisingly, we find that the transaction tax dramatically shrinks trading volume. However, the
tax reduces activity by noise and informed traders approximately evenly (contrary to the
conjecture of Stiglitz (1989)), and perhaps as a result it does not modify bid-ask spreads or other

4|Page
price impact measures of liquidity, and has only a feeble effect (if at all) on the informational
efficiency of prices.

Table 1: Evidence from Prior Studies of Theory of Prospect and Noise Traders

Author and Sample Sample Methodology Verdict

Date Period Data
Tversky and 1978- University Theory of people value gains and losses differently,
Kanheman 1979 of Prospect and, as such, will base decisions on
(1979) Stockholm perceived gains rather than perceived
losses
Shiller 1980- United Statistical arbitrage and financial innovation
(1993) 2002 Kingdom Analysis promote the efficient allocations of risk
Baker et al and United and help make investment more rational
(2002) States
Shefrin 1986 - Series – psychology drives economic booms and
(2000) 2000 correlation busts, and that crises are inevitable in
capitalistic systems.
Barberis and 1997- Series- arbitrage and financial innovation
Thaler 2003 correlation promote the efficient allocations of risk
(2003) and help make investment more rational
Shleifer and 1980- Series- implemented the term “noise traders” to
Summers 1990 correlation capture behavioral causes for trading not
(1990) captured by these standard explanations

2.2 Investor Behavior

M. Grinblatt, M. Keloharju (2000) stated that the assumptions behind these theories of investor
behavior are founded in psychological research or common sense. Intelligibly, nevertheless, this
line of survey could benefit from a lot complete figure of how investors basically behave and
how they differ from one another in the manner they respond to the same knowledge. A amount
of latest contributions have documented attractive regularities in the last-return-based behavior
of investors. Concurrent survey of the investment behavior and performance of every investor
classification has been not possible until recent because of data limitations. Different study

5|Page
methods, different data frequencies, different horizons for past returns, and different institutional
order unavoidably blur the differentiation of the outcome and make it difficult to identify
common patterns behind the behavior and performance of isolated investor categories. In
specific, investor groups who are apt to purchase winning stocks and sell losing stocks seem to
do so for many varieties of past-return horizons that define winners and losers. The behavioral
patterns survey is basically extremely perfect. The style of contrarianism emerges to be inversely
connected to a standing of the sophistication of the investor variety. Sophistication is likewise
connected to achievement, even since managing for the elect of momentum attitudes on later
portfolio returns.

In addition, Phansatan et al (2012) mentioned that trade where some survey have found that
foreign investors follow information-based, momentum trading strategies, with foreign
investment inflows foreshadowing best subsequent repay .The survey inspect the trading
attitudes of four investor aspects in the Thai stock market, that is foreign, individual, and
institutional investors as best as proprietary dealers, using a novelty way that engage commerce
weighted gauges of purchase and sell volumes to rot investors' trading advantage into gains that
are due to trade timing versus security selection.

Empirical researched document varies of trading format of every investor kind. Foreign investors
are found to follow momentum trading strategies, mainly in emerging trades, with foreign
inflows forecasting positive later returns in the trades receiving the cash inflows. Personal
investors, besides that, trend to be contrarians. Mixed outcome are found for the trading format
of institutional investors. The trading formats of investor kind that are documented in the
literature have been shown to lead to distinction in trading achievement. Froot and Ramadorai
(2001) inspect international portfolio flows into sundry states, example, and find those foreign
investors' trades forecasting later equity returns relatively good. Individual traders are basically
found to have relatively poorer trading achievement. Conclude that overconfidence may clarify
lofty trading degree and the out coming poor achievement of individual investors. Institutional
investors are occasionally found to have informational superiority over other investor kind,
thereby augmenting their trade achievement.

In this appraisal we are going to inspect about the investors behavior according to the advance
behavioral finance theory. The advance explanation was survey by this researcher Dr. R.

6|Page
Shanmugham and K. Ramya ( 2012 )mentioned trading behavior of individual investors had
been the main focus of the accruing part of finance familiar as ‘behavioral finance’. Behavioral
finance hub on the personality attributes, psychological or otherwise, that structure usual
financial and investment practices. Social affect and interplay with other individual will lead
investors to behave irrationally. Investors may enact usual mistakes in a flock way because of
social affect and the force of media news. The media have two parts; they set the point for trade
advance and they also instigate the moves themselves. As well the internet has figured the way of
trading by investors. Internet-based trading was discovered to raise the trading frequency of
person investors. Social behavior, personality characteristic and another ideas relating to
behavioral dispositions are most essential to predict and describe human behavior and have been
impressed by speedy scholars in their analysis.

All together theoretical substructure that brief the decision-making operation of investors,
Theory of Reasoned Action (TRA) which depicted ‘attitude’ and ‘subjective norms’ to be two
determinants of behavioral intention and the Theory of Planned Behavior (TPB) As an extension
of TRA, addresses TRA model’s limitation in dealing with behavior over which people had
incomplete volitional control and thus has been found to be more valid to predict behavior, have
been noticed to be the famous behavioral models. Social aspect is the external forces that
interrupt the person decision making. Media, social interactions with friend and relatives and
internet have become crucial vehicles for spreading and sharing details and plans. Individual
investors discuss with, and are affected by their family member’s neighbors and friends, as far as
their investment conclusion is concerned. In mapping the TPB to the circumstances of the recent
survey, individual investors behavior regarding trading may be powerful as they are making
decisions to attain a wish level of financial stability, whereas family and peers suggestions and
behavior in stock trading may form the ‘subjective norm’ changeable. Furthermore, the
‘perceived behavioral control’ conceptualized as a previous to ‘intention’ within the TPB is
defined as an individual’s perception of the easiness of committing specific behavior. Therefore,
it can be gathered that social affect that is social interactions and media affect the trading
behavior (trading frequency) of individual investors.

Camelia Oprean (2014) found that the behavioral finance investigates the fine surface and
interactions in the human brain, countenance with the undetermined of taking economic

7|Page
decisions. The main important human characteristics (fear, anger, greed, selflessness) spot much
significance on our verdict about cash. Brainpower (grasping a situation), cause (long-term
consequences of the action taken) and emotion (considering a course of action) are all
interrelated; they are the springs behind human decision. Human behavior is normally reactive,
not proactive; hence, it is hard to construct predictions on the foundation of narrow rules.
Behavioral finances can easily effortlessly describe why a person has made ad, but have
difficulty in quantifying what effects that verdict will have on the individual.in addition, due to
uncertainty and constant change, there is a powerful interdependence between experiences
(autobiographical memory) and rational predict about the later..

Overall, behavioral mistakes (optimism, pessimism, depression, anxiety, etc.) steadily win the
dispute opposed to reasonable behavior. And when these different psychological make-ups occur
in a very large number of individuals, the impact are same to those of tornadoes. For the smart
investor, this is nothing but a lucky chance. There is other main point to make with reference to
the emotional aspects: humans behave like animals, feeling safe in a crowd (crowd behavior). If
the others do the same, these affirm the tact of their verdict.

Table 2: Evidence from Prior Studies of Investor Behavior

Author and Sample Sample Data Methodology Verdict

Date Period
M. Grinblatt, From year The investment Financial analyzes whether these
M. Keloharju 1999 to behavior and economies differences in
(2000) 2000 performance of analysis past-return-based behavior and
various investor differences in investor
types in Finland sophistication drive the
performance
Of various investor types.
Phansatan et From year Investor type Basin trading behavior and decomposes
al (2012) 2010 to trading behavior finance the
2012 and trade analysis trading performance of foreign,
performance: individual and institutional
Evidence from investors
the Thai stock as well as proprietary traders in a
market dynamic emerging stock market,
the Stock Exchange of Thailand.
Shanmugham From year Individual Theory of apply the theory of reasoned
and K. 2000 to Investor; Trading trading action (TRA) and the
Ramya 2012 Behaviors; TRA; theory of planned behavior (TPB)

8|Page
( 2012) TPB; Social behavior to explain individual investor
factors behavior
Camelia From year Effects of responsibility analyze the impact of both
Oprean 2009 to Behavioral of Scientific investors who ground their
(2014) 2014 Factors on analysis trading behavior on rational
Human Financial expectations and
Decisions Investors who show
psychological and emotional
facets of the human decision.

2.3 Cognitive Bias

In this review we are going to examine about the cognitive bias of the investors according to the
behavioral finance theory. The further explanation was examined by this researcher Asab,
Ricciardi (2008). Cognitive bias is divided into two parts. Parts of cognitive bias are heuristics
and prospect theory. Heuristics explains about availability biases, gambler fallacy, availability
biases, anchoring and overconfidence. Prospect theory explains about loss aversion, regret
aversion, self-control and mental accounting.

Investors often show overconfident behavior in simple consequences. They tend to display
overconfidence in both the value of their information and their skills. Ricciardi (2008) observes
that people tend to overestimate their skills, talent, and assume for success. Research documents
that overconfident behavior is connected to excessive trading and results in poor investment
returns. It can also lead to investors failing to appropriately diversify their portfolios.

Investor behavior often differs from logic and reason, and investors display many behavior
biases that influence their investment decision-making processes. Two main biases that will be
discussed in this review is overconfidence from heuristic and loss aversion from prospect theory.
Hirshleifer and Teoh (2009) describe the both behavioral biases and suggest how to mitigate
them.

Hirshleifer and Teoh (2009) explain that overconfidence is a faith that one’s personality is better
than they really are. Overconfident strategy experts tend to assume that a social problem has not
been identified by the market, and repair easily on planned solutions. Hirshleifer and Teoh
(2009) refers this value of overconfidence as intervention bias. The improvement mean for

9|Page
potential remedies is negative; overconfidence leads too often to acceptance. Over time this
results in too many procedures, because there are many potential rules to be considered.

Hirshleifer, Teoh (2009) trying to convey that loss aversion can help explain the appearance of
reaction as an accounting practice. Recognition of the profits is delayed until they are sure, while
losses are predicted. Recognition of profits or assets involves a prediction of the future. Users
who find the prospect of being disappointed vividly unpleasant may perceive (rightly or
wrongly) that conservatism reduces the probability of future frustrations. Hold back from
recognizing a gain is not very painful today, but has the benefit of reducing the risk of a painful
future loss. Early acknowledgement of losses feels bad, but at least is rewarded by reducing the
risk of future losses.

Overconfidence explains the high turnovers and poor performance of the investors. Barber,
Odean (2011) describes that a second variety of overconfidence is a belief that one is better than
the median person. “For example, when asked about their own driving ability relative to the
population of drivers, most people rank themselves above the driver of median ability”. A
reasonable amount of proof shows that the better-than-average and overestimation varieties of
overconfidence are connected with higher levels of trading by investors.

According to Mbaluka, Muthama, Kalunda (2012), prospect theory exist when an individual
investor is risk-averse over gains should sell a stock that is trading at a gain fixed to the purchase
price. If the investor is seeking for risk over losses should hold the stock that is trading at a loss.
The reference point is the purchase price, and the investor wants to avoid selling at a loss
regardless of the tax advantage. Besides that, other noticeable reference prices, and, importantly,
ones that are common across investors, are recent high prices, such as stocks. The trading
volume and return patterns change as recent highs are approached for seasoned issues, and finds
that trading volume behavior changes as IPOs reach new maximum and minimum.

Mbaluka, Muthama, Kalunda (2012), also argues that the extent of loss aversion will influence
the occurrence with which investors estimate their portfolio and that the way investors find gains
and losses is reasonably influenced by the way information is obtained to them. Active investors
those that estimate their portfolio often say on a daily basis are more loss averse. Thus, they will

10 | P a g e
assign less of their capital in equities. They call the combination of loss aversion and frequent
evaluations biased loss aversion.

It’s concluded that cognitive bias influence investor’s decision of investment. Behavioral factors
definitely play a vital role in decision making process of traders. Cognitive behavior of investors
is dangerous that recommends that human behavior cannot be ignored while making investment
decision. Irrationality exists in behavioral finance due to factors of Heuristics and prospect
theory. Moreover, there are many other factors like cost and time waste and the opportunity
elimination risk in case for searching rational information for investment. The investigation of
different studies has been concluded that behavioral finance plays a vital role and has more roles
in investors’ decision making than the rational investment decision and more factors of
behavioral finance involve in investors consideration while they make decision of investment.

Table 3: Evidence from Prior Studies of Cognitive Bias

Author and Sample Sample Data Methodology Verdict

Date Period
Asab, From year Pakistan Biographical Support that behavioral
Manzoor,Naz 1999 to 2014 developing information finance play important role
(2014) country and have more role in
investors decision making
Ricciardi From year Karen Altfest’s Biographical Supports that women
(2008) 1996 to 2007 financial information demonstrate higher level of
planing and SPSS worry than men during
analysis financial decision making
Hirshleifer and From year Japan was Theory of Support when individuals
Teoh (2009) 1963 to 2008 envied and regulation have a stronger incentive to
feared by overcome bias when investing
Americans personal
resources
Mbaluka, From year Nairobi SPSS Support that risk averse over
Muthama, 1979 to 2011 securities analysis gains
Kalunda exchange were less likely to make
(2012), changes in their investment
portfolio in the stock market.
2.4 Stock Returns

In this part we explain the behavior of common stock returns and overview of the financial
theory that underlies the behavior of stock returns. Stock Returns are the returns that the
investors generate out of the stock market. This return could be in the form of profit through

11 | P a g e
trading or in the form of dividends given by the company to its shareholders from time-to-time.
Generally at the end of every quarter, a company making profit offers a part of the kitty to the
shareholders. This is one of the source of stock market return one investor could expect. The
most common form of generating stock market return is through trading in the secondary market.
In the secondary market an investor could earn stock market return by buying a stock at lower
price and selling at a higher price. Stock Returns are not fixed ensured returns and are subject to
market risks. They may be positive or negative. Stock Returns are not homogeneous and may
change from investor-to-investor depending on the amount of risk one is prepared to take and the
quality of his Stock Market Analysis. In opposition to the fixed returns generated by the bonds,
the stock market returns are variable in nature. But risk is part and parcel of this market and an
investor can also see negative returns in case of wrong speculations. An investor speculates on
the basis of fundamental and technical analyses.

2.4.1 AMBIGUITY AVERSION

Fox and Tversky's (1995) examine the comparative ignorance hypothesis, ambiguity aversion
which is driven by the comparison with more familiar events or more knowledgeable individuals,
and diminishes or disappears in the absence of such a comparison. They also emphasize that
“comparative ignorance” refers to the state of mind of the decision maker. They extend the
comparative ignorance hypothesis by documenting four new ways in which decision context can
affect willingness to act under uncertainty that do not rely on the comparative and non-
comparative evaluation paradigm used in previous studies. First, people find uncertain bets more
attractive when preceded by questions about less familiar items than when preceded by questions
about more familiar items. Second, the preference to bet on more familiar domains is less
pronounced for the first domain evaluated on a survey than for later domains. Third, people find
bets less attractive when they are provided with diagnostic information that they do not know
how to use, compared to when they are provided with no such information. Finally, people are
sensitive to the relative competence of their counterpart when playing a simple competitive
game, but not when playing a noncompetitive or coordination game that has the same mixed
strategy Nash equilibrium.

Furthermore, the persistent mispricing is consistent with a market that includes ambiguity-averse
investors. In particular, ambiguity-averse investors may prefer to trade based on aggregate

12 | P a g e
signals that reduce ambiguity at the cost of a loss in information. Equilibrium prices may
therefore fail to impound publicly available information. While this creates profit opportunities
for ambiguity-neutral investors, ambiguity-averse investors perceive that the benefit of
ambiguity reduction outweighs the cost of trading against investors who have superior
information. The model can explain both under reaction, such as that evident in post earnings
announcement drifts and momentum, and overreaction to accounting accruals.

Wei and Zhou(2012) examine an ambiguity-based interpretation of variance premium which are
the difference between risk-neutral and objective expectations of market return variance. To the
first order, variance premium is a compounding effect of both belief distortion regarding
unknown regimes and market variance differentials between regimes. The belief distortion
represents the difference between Bayesian posterior belief and its uncertainty-adjusted belief.
Based on our calibration, its mean value is very small under the standard time-additive CRRA
utility. Separating inter temporal substitution from risk aversion as in the Epstein-Zin preference
raises the mean belief distortion by about 30 percent. The mean market variance differentials
between recession and boom regimes in the model with Epstein-Zin utility are more than two
times as large as those in the model with time-additive CRRA utility. Introducing ambiguity
aversion into Epstein Zin utility further raises the mean market variance differentials by about 3
times. Overall, ambiguity aversion contributes about 96 percent of the model implied mean
variance premium. They show that the calibrated model with ambiguity aversion can generate a
mean variance premium of 8:51 which is about 80 percent of the empirical estimate of 10:80.

In contrast, models only featuring ambiguity aversion and inter temporal substitution can only
produce variance premiums of 0:0997 and 0:3150. Our model can simultaneously explain the
equity premium, equity volatility, and risk-free rate puzzles. They also show that in univariate
regressions, either dividend yield or variance premium is a significant predictor for excess stock
returns. However, in joint regressions, these two predictors crowd out each other, reflecting the
fact that only one state variable drives return dynamics. This is the main limitation of this model,
which is left for future research. Model implied variance premium series using the consumption
growth data from 1890 to 2009 reveals that the major spikes in variance premium mainly capture
severe down times like the Great Depression, financial panics, deep recessions, and World War II
engagement. After the war, the highest variance premium is reached in 2009, during the peak of

13 | P a g e
global financial crisis. In sharp contrast with the existing economic models that generate realistic
variance premium by relying on either stochastic volatility-of-volatility in consumption or joint
jumps in volatility and consumption, our model features a constant consumption growth variance
and a regime shift in consumption growth. Almost all the action comes from the agent’s
ambiguous belief about the unknown economic regimes and agentís aversion to such an
ambiguity. Our model endogenously generates time-varying stock market variance and time-
varying variance premium, which is predominantly driven by agent’s fear of uncertain economic
downside shifts.

2.4.2 BEHAVIORAL PATTERN DURING BULLISH AND BEARISH MARKET

In this review we are going to examine the overall investor behavior and investment practices of
Malaysian investors. The observation of several surveys carried out for the past 15 years showed
an improving trend. One of the most important improvements is rationality and established
thinking of investors in investment decision making during both bullish and bearish market
positions. The term bullish market means when the market appears to be in a long-term increase.
Bull markets incline to grow when the economy is strong, the unemployment rate is low, and
inflation is under control. The term bearish market describes a market that seems to be in a long-
term decline. Bear markets tend to develop when the economy enters a recession, unemployment
is high, and inflation is rising.

Obiyathulla Ismath Bacha (2012), illustrate that a investor believes that the remaining four
trading days of the week is likely to see an increase in the stock market index value. Long
position gains from rising prices while the short position gains from falling prices. If the market
is bullish the investors’ appropriate strategy would be to long futures. The emotional and
psychological state of investors also affects the market. For example, if investors have faith that
the upward trend in stock prices will continue, they are likely to buy more stocks. If there are
more buyers interested in buying shares at a given price than there are sellers who are willing to
part with their shares at that price, stock prices will continue to rise.

Suppose an investor expects the stock prices to fall over the next several days. This is a situation
of bearish market, Obiyathulla Ismath Bacha (2012). In order to take advantage of the falling
prices, the investor strategy would be to short the futures. Investors lose faith in the market as a

14 | P a g e
whole, which in turn decreases the demand for stocks. A sustained bear market is something that
you should expect to occur from time to time, and that, in the past, the stock market has raised
more than it has declined. An investor goes long (buy) if he is bullish and short (sell) during
bearish. An inter-market spread involves going long in one market and going short the same asset
in another market.

Cheng, Lee, Lin (2013), investigated investor behavior during bull and bear markets. The five
main investigation behavioral dimensions are price anchoring, overconfidence, control, herd
behavior and liquidity. This investigation carried out in 2013 to examine the behavior and
reactions of investors towards bullish and bearish period. Amongst the five behavioral
dimensions examined, self-control and overconfidence were ranked the top two followed by
liquidity preference, price anchoring, and herding behavior among the institutional investors.
Meanwhile, apart from self-control and liquidity preference, which were the two most significant
behavioral dimensions, the results suggested the arrangement in descending position order for
the retail investors were overconfidence and herding behavior. Even though price anchoring was
exposed during bearish periods, it was not significant during bull periods for the retail investors.

Cheng, Lee, Lin (2013), stated that investor decision examination both internal and external
factors of the nature effect contributes to the behavioral finance to analyze on nature versus
nurture in various areas in psychology. They accomplish that human behavior is seldom
determined only by either nature internal features or nurture external features. The simultaneous
examination of both factors gives a unique opportunity to explore whether behavioral traits are
indeed determined by enduring innate characteristics, whether they are also subject to change
over time, and which factor exerts more influence.

Lai, Tan, Chong (2013), examine closely watched indicators of fundamental analysis in the year
2013 for the both the institutional and retail investors’ behavior during the bullish and bearish
period according to the fundamental analysis result. The price earnings (PE) ratio ranked the
highest for the institutional investors for bullish position. The result is followed by profit margin,
earnings per share, volume and dividend yield. The minimum significant indicators for were size
effect, book-to-market ratio, beta, and return on assets (ROA). While for retail investors bullish
position showed their concerns over dividend yield which was ranked the highest, then followed
by debt equity ratio, profit margin and PE ratio. Retail investors measured size effect, book-to-

15 | P a g e
market ratio, and beta factors as the least important indicators. Mostly, the institutional investors
more concern about the price to earnings ratio (PE). Whereby, the retail investors more concern
about the dividend income that they could earn from the investment. Institutional investors trust
the expected future growth of organization before making investment decision as the growth rate
indicates the possibilities of the organization in the long run. The retail investors only concern
about the expected current income they could earn. For the bearish market position, dividend
yield is the most important factor before the PE ratio and earnings per share for institutional
investors. They wanted to ensure how much current income they could earn before seeing the
organizations’ growth. For the retail investors, the closely watched fundamental indicators were
dividend yield. Moreover, profit margin ranked in the top while size effect, book-to market ratio,
and beta was the least significant. Nevertheless, during the bearish market, both the institutional
and retail investors were doubtful in investment, and they ranked dividend yield the highest.

Table 4: Evidence from Prior Studies of Stock Returns

2.5 Limits of Arbitrage

Author Date Sample Sample Verdict
Period Data
Fox and 1995 1994-1995 ambiguity-averse investors prefer to
Tversky's trade based on aggregate signals that
reduce ambiguity at the cost of a loss in
information
Cheng, Lee, 2013 2013 gives a unique opportunity to explore
Lin whether behavioral traits are indeed
determined by enduring innate
characteristics
Wei and Zhou 2012 2010-2012 endogenously generates time-varying
stock market variance and time-varying
variance premium
Lai, Tan, 2013 2009-2013 both the institutional and retail investors
Chong were doubtful in investment, and they
ranked dividend yield the highest
Obiyathulla 2012 2012 a investor believes that the remaining
Ismath Bacha four trading days of the week is likely to
see an increase in the stock market index
value.
Arbitrage, defined as "the simultaneous purchase and sale of the same, or essentially similar,
security in two different markets for advantageously different prices" Sharpe and Alexander
(1990). Arbitrage requires no capital and entails no risk. When an arbitrageur buys a cheaper

16 | P a g e
security and sells a more expensive one, his net future cash flows are zero for sure, and he gets
his profits up front. Arbitrage plays a critical role in the analysis of securities markets, because its
effect is to bring prices to fundamental values and to keep markets efficient. For this reason, it is
extremely important to understand how well this textbook description of arbitrage approximates
reality. This article argues that the textbook description does not describe realistic arbitrage
trades, and, moreover, the discrepancies become particularly important when arbitrageurs
manage other people's money.

In particular, the implications of the fact that arbitrage-whether it is ultimately risk-free or risky-
generally requires capital become extremely important in the agency context. In models without
agency problems, arbitrageurs are generally more aggressive when prices move further from
fundamental values Grossman and Miller (1988), De Long et al. (1990), Campbell and Kyle
(1993).

Theory of Limits to Arbitrage has provided over the years include: the equity premium puzzle
which refers to the empirical fact that stocks have out-performed bonds over the last century
Benartzi and Thaler (1995), Sewell (2005), Thaler and Barberis (2002), the conservatism
principle of share prices, which states that earning reflect bad news more quickly than good news
Basu (1997), the tendency of investors to sell winning investments too soon and hold
investments for too long Odean (1998), overconfidence of investors Daniel, Hirshleifer and
Subrahmanyam (1998), Camerer and Lovallo (1999) , herding behavior in the financial markets
Wermers (1999) among others, and is nowadays yielding insight into the effects of social
networks (such as the number of Facebook Likes and the number of good/bad tweets) on stock
prices of publicly traded companies.

Shleifer and Vishny (1997) stated that capital constraints impair the arbitrage activity of hedge
funds. Their model demonstrates that, although expected returns to arbitrage are high when there
are shocks to asset prices, investment risks also increase, giving hedge fund managers the
incentive to reduce rather than increase investment exposure. Consistent with subjective
evidence, their model introduced the notion of the limits of arbitrage as a theory, but has
remained untested, primarily due to data limitations and problems with heteroskedasticity and
multicollinearity. Arbitrageurs, hedge funds are believed to play an important role in aligning
market prices with fundamental asset values. According to Shleifer and Vishny (1997) presented

17 | P a g e
different views on arbitrage. According to them arbitrageurs, such as hedge funds, may be
ineffective at aligning market prices with fundamental asset values because arbitrageurs might
actually reduce rather than increase their investment exposure in response to asset price shocks.
The reason is that capital constraints may lead the arbitrageur to protect against future states
where capital is unavailable by not betting fully against potential asset mispricing.

Behavioral Economics is the combination of psychology and economics that investigates what
happens in markets in which some of the agents display human limitations and complications.
Saving for retirement requires complex calculations and willpower, behavioral factors are
essential elements of any complete descriptive theory.’ Mullainathan and Thaler (2000). The
behavioral finance literature also provides several possible explanations.

There are two main definitions of efficient markets, one ambitious and the other modest. The
ambitious definition is better called rational markets. Rational markets are markets where the 'the
price is always right.' Specifically, these are markets where securities' prices always equal their
intrinsic values. The modest definition of efficient markets is as unbeatable markets. Unbeatable
markets are markets where investors are unable to generate consistent excess returns. Statman
(2011). Rational markets are unbeatable because excess returns come from exploiting gaps
between prices and intrinsic values, gaps absent in rational markets. But unbeatable markets are
not necessarily rational.

Behavioral Finance is the study of the way in which psychology influences the behavior of
market practitioners, both at the individual and group level, and the subsequent effect on
markets. It is concerned with the analysis of various psychological traits of individuals and how
these traits affect the manner in which they act as investors, analysts, and portfolio managers
Sewell (2010). According toThaler and Barberis (2002), behavioral finance has two building
blocks: limits to arbitrage and psychology. Limits to arbitrage seek to explain the existence of
arbitrage opportunities which do not quickly disappear.

Table 5: Evidence from Prior Studies of Limits of Arbitrage

Author and Sample Sample Data Methodology Verdict

Date Period

Thaler and From year NYSE, Amex, Biographical Behavioral finance has two

18 | P a g e
Barberis 1963 to 1990 andNASDAQ information building blocks: limits to arbitrage
(2002) and psychology

Shleifer & From year S&P 500 Biographical State that capital constraints
Vishny 1990 to 1995 Index (SPX) information impair the arbitrage activity of
(1997) and SPSS hedge funds
analysis

Grossman, From year NASDAQ SPSS Arbitrageurs are generally more

Sanford J. 1970 to 1985 Stock Market aggressive when prices move
and Merton further from fundamental values
H. Miller,
(1988)

From year Stock SPSS Yielding insight into the effects of

1980 to 2002 exchange analysis social networks
Weber(1999)

3.0 Conclusion

Prospect Theory is a theory that public value gains and losses in a different way and, as such,
will base decisions on superficial gains rather than superficial losses. Thus, if a person were
given two equivalent choices, one expressed in terms of possible gains and the other in possible
losses, people would choose the former. It is also acknowledged as "loss-aversion theory."

Noise Traders is the term used to illustrate an investor who makes decisions regarding buy and
sell trades without the use of fundamental data. These investors commonly have poor timing,
follow trends, and over-react to good and bad news. An ardently debated issue in behavioral
finance is many investors feel that they're not noise traders and, therefore, only make well-versed
investment decisions. In reality, most people are considered to be noise traders, as very few
actually make investment decisions exclusively using fundamental analysis. Furthermore,
technical analysis is considered to be a part of noise trading because the data is discrete to the
fundamentals of a company.

Dr. R. Shanmughama, K. Ramyab said Individual investors’ commerce behavior has drawn the
concern of academicians and investment practitioners overall. The appearance of behavioral
finance as a latest domain in the capital trade survey is a case in period. survey indicate that
individual investors are describe by surplus trading and often to their harm (Barber and Odean,

19 | P a g e
2000).In this survey, they prevail the theory of reasoned action (TRA) and the theory of planned
behavior (TPB) to describe individual investor behavior. In addition, an effort has also been
made to survey the effect of social element for instance as social interactions, media and internet.
Besides, investors exhibit can behavior biases that affect their investment decision-making
manner.

The research of Mbaluka, Muthama, Kalunda (2012) showed that investors’ decision making is
not as rational as imagined under standard finance theory. They recognized that investors’
decisions are influenced of financial decision making depends on investors’ cognitive bias
theory. Besides, the study found framing effects as a role of significant part in investment
decision making process by individual investors at the NSE. “The study found out that 26.0% of
respondents who choose the sure gain reversed their choices and gambled with losses whereas
29.6% of respondents, who gambled with gains, reversed their choices and selected the sure
loss” Riciarddi (2008). In addition, the volume of funds invested in assets shows that investors
who were risk averse over gains were less likely to make changes in their investment portfolio in
the stock market. It also describes that investors who would choose for a sure loss were less
probable to change the combination compared to those that would gamble with the loss.
Cognitive behavior of investors is critical that suggests that human behavior cannot be ignored
while making investment decision.

The psychological theory of rule can inform policy as well. It is often assumed that the visions of
the behavioral method support policies and regulation to protect investors from their own
psychological biases. This is indeed a strand of behavioral thinking Hirshleifer, Teoh (2009)

However, the behavioral finance theory in some ways supports the case for laissez-faire, because
it suggests that instruction is driven by psychological bias. Investors have a strong
encouragement to overcome bias when investing personal resources than when making political
choices such as tax regulated. A behavioral finance theory recommends that the political process
regularly works even more poorly than markets.

In this section we discuss about the long term predictability of the stock market. Although the
stock market was long thought to be a random walk and unpredictable, numerous researchers
have found that over long horizons the returns on the stock market is at least something that is

20 | P a g e
predictable. Specifically, when stock prices are very high, as judged by price, dividends ratios,
then subsequent returns tend to be low. John Campbell and Robert Shiller review this evidence.

Their analysis suggests that stock prices were too high being the mid 1990s, and they were
predicting the bear market that eventually arrived. We also discuss about the historical difference
between the return on equities and the risk free rate has been judged too big to be explained
within traditional asset pricing models of expected utility maximization. It also offer a behavioral
explanation for part of this puzzle based on two concepts from the psychology of decision
making that is loss aversion that is the tendency to weight losses much more heavily that gains
and narrow framing that is the tendency to consider returns over brief periods of time rather than
the long run. Equity premium can be understood if people weigh losses twice as much as gains
and evaluate their portfolios roughly once a year.

There is substantial evidence of short-term stock price continuation, which the prior literature
often attributes to investor behavioral biases such as under reaction to new information. If short-
term price continuation is due to investor behavioral biases, we should observe greater price drift
when there is greater information uncertainty. As a result, greater information uncertainty should
produce relatively higher expected returns following good news and relatively lower expected
returns following bad news.

Hereafter, the question that remains to be answered is why arbitrage opportunities do not quickly
disappear even if investors know how to exploit them? The idea is that strategies designed to
correct the mispricing can be both risky and costly. Fundamental risk refers to the risk that new
bad information arrives to the market after you purchased the security. Theoretically this risk
could be perfectly hedged by buying a closely related product. Unfortunately substitute securities
are rarely perfect, making it impossible to remove all the fundamental risk. To sum up,
fundamental risk always persists even though there are ways of hedging the portfolio against it.

4.0 References

21 | P a g e
Alistair Byrne and Mike Brooks (2008). Behavioral Finance: Theories and Evidence. The
Research Foundation of CFA Institute Literature Review
Asab, Manzoor, Naz. (2014). “Impact of Behavioral Finance & Traditional Finance on Financial
Decision Making Process” “Journal of Economics and Sustainable Development”, Vol.5, No.18,
2014.
Barberis, N. and Thaler, R. (2001). A survey of behavioral finance, Retrieved January 5, 2004.
Camelia Oprean (2014). 21st International Economic Conference 2014, IECS 2014, 16-17 May
2014.
Camerer, C., & D. Lovallo. (1999) “Overconfidence and Excessive Entry: An Experimental
Approach.”
Daniel Kahneman; Amos Tversky (1979). Prospect Theory: An Analysis of Decision under Risk.
Econometrica, Vol. 47, No. 2. (Mar., 1979), pp. 263-292.
Dr. R. Shanmughama, K. R. (2012). 2nd Annual International Conference on Accounting and
Finance (AF2012). Impact of Social Factors on Individual Investors’ Trading Behaviour, p. 10.
Grossman, Sanford J. and Merton H. Miller, 1988. Liquidity and market structure, Journal of
Finance 43, 617-633.
Hirshleifer, Teoh. (2009). “Psychological Influences on Financial Regulation and Policy”
“Behavioral Finance: Investors, Corporations, and Markets, H. Kent Baker and John R.
Nofsinger, eds., Wiley, Hoboken, NJ, (2010):151-167”.
Mark Grinblatt!, *. M. (2000). The investment behavior and performance of various investor
types: a study of Finland's unique data set. p. 25.
Markus J. Milne, Christian C.C. Chan(1999). Narrative Corporate Social Disclosures: How
Much Of A Difference Do They Make To Investment Decision-Making?. The British Accounting
Review.Vol 31, Issue 4, December 1999, Pages 439–457.
Mbaluka, Muthama, Kalunda. (2012). “Prospect Theory: Test on Framing and Loss Aversion
Effects on Investors Decision-Making Process at the Nairobi Securities Exchange, Kenya”
“Research Journal of Finance and Accounting”, Vol. 3, No 9, 2012.
Moskowitz. (2002). A Private Equity Premium Puzzle? The Returns to Entrepreneurial
Investment: 34.
Paul Slovic(2012). Psychological Study of Human Judgment: Implications For Investment
Decision Making. The Journal of Finance.Vol 27, Issue 4, pages 779–799.
Prescott, M. a. (1985). Journal of Monetary. “The Equity Premium: A Puzzle, 33.
Robert Bloomfield, Maureen O’Hara, and Gideon Saar (2007). “How Noise Trading Affects
Markets: An Experimental Analysis” Johnson Graduate School of Management, Cornell
University

22 | P a g e
Robert J. Shiller(2003). From Efficient Markets Theory to Behavioral Finance. The Journal of
Economic Perspectives, Vol. 17, No. 1. (Winter, 2003), pp. 83-104.
Robert J. Shiller.(2003).From Efficient Markets Theory to Behavioral Finance.Journal of
Economic Perspectives,Vol. 17, No 1,Pages 83–104.
Shefrin, H. 2000. Beyond Greed and Fear: Understanding Behavioral Finance and the
Psychology of Investing. Boston: Harvard Business School Press. 2001.
Sibiu, Romania. Effects of Behavioural Factors on Human Financial Decisions, p. 6.
Statman, Meir, 2011b. What Investors Really Want, New York: McGraw-Hill.
Suwipa Phansatan a,J.G.(2012). Investor type trading behavior and trade performanceEvidence
from the Thai stock market. p. 23.
Tversky, A. and Kahneman, D. (1974). Judgement Under Uncertainty: Heuristics and Biases.
Science,185, 1124-1131.
Werner F. M. De Bondt, Richard H. Thaler(1994). Financial Decision-Making in Markets and
Firms: A Behavioral Perspective.
Zhou, W. a. (2012). Ambiguity Aversion and Variance Premium, 41.

23 | P a g e