Behavioural Finance

Simply speaking, behavioural finance deals with psychology and finance to explain the causes of people’s investment and other financial acts. Here Behavioural finance is not a direct branch of standard finance. It is a replacement and it offers better model of humanity. Each individual causes different principles which ultimately leads its behaviour and these principles come from some psychological, sociological and anthropological aspects.

According to Financial & Investment Dictionary (2006), “[n]ew area of financial research that recognizes a psychological element in financial decision making, thus challenging traditional models that assume investors will always weigh risk/return factors rationally and act without bias. ” Generally, behavioural finance can be better explained as the psychological effect on the financial decision of the financial practitioners as well as market situation.

Order custom essay Behavioural Finance with free plagiarism report

450+ experts on 30 subjects Starting from 3 hours delivery

Get Essay Help

In other words, behavioural finance is the study of human psychology which influence the investors to make financial decision and explain why, how, when and where they will practice financial activation. Shefrin (2007) views that, "[b]ehavioural finance is a rapidly growing area that deals with the influence of psychology on the behaviour of financial practitioners. " In practices investors interpret or process various types of information, they don’t always follow specific models. The investor’s behaviour ultimately depends on the market anomalies and financial market economics.

Who is an Investor? In a word, Investor is the financer. The people or institutions that finance in the small and large industries for sake of earning profit are called investors. Investor is one kind of entrepreneur who may take the initiatives for enhancing the organization. “Traditional finance theory recommends that individual investors simply buy and hold the market portfolio, or at least a well-diversified portfolio of stocks. The typical retail investor doesn't; most of those who hold stocks directly hold just a handful of stocks rather than a diversified portfolio (see, e.

g. , Blume and Friend (1975) and the 1998 U. S. Survey of Consumer Finances. ” (SCF) Investor, however, they are the ultimate risk taker not only in the business environment but also in the society. They can be shown as the most confident people in the perspective in their work. They also as like the organizer as they help to organize the elements of production and manage in organization. They can move the motive of the economy and play important role by influencing in the behavior of the money market. Investor can be defined as three types, those are as follows—

Gambler Gambler is like the investor who makes gambling with a view to have more and more profit within a short time. The gambler is the one kind of investor invests for up to three month. The gambler takes high risk for making high profit. According to the Insurance Dictionary, risk-creating device as compared with Insurance which is a risk-reducing or -eliminating device. This is a form of speculative risk. Britannica Concise Encyclopedia (2006) defines it as “betting or staking of something of value on the outcome of a game or event”.

Gambling gave an air of fairly harmless excitement and the payoff (or loss) was immediate (US History Encyclopedia, 2006). According to Columbia Encyclopedia (2003), gambling or gaming, betting of money or valuables on, and often participation in, games of chance (some involving degrees of skill). Speculator Speculation is one modes of investment. The men who get involve in speculation, he is known as the speculator. The speculator makes investment for a short time too but not as less than by the gambler rather than pretty much more. They invest for up to six months.

They make risk more than gambler of low investment than the actual investor. “A speculator is a man who observes the future, and acts before it occurs" (Baruch, n. d. ). Investor Investor is the long time financer in any organization. Investor is the most prominent businessmen for enlarging the business. They invest as for long time and takes low risk than the gambler and speculator. In this case the investment is concerned with more then one year. Investor has the experience and knowledge of money market. They are the real investor for business.

“Investors can also benefit by studying the behavior of money managers to avoid similar pitfalls. Vulnerability to mistakes is particularly acute during bull markets, says Meir Statman, a professor at the University of Santa Clara in California and an expert on behavioural finance. Individuals have a tendency to get optimistic after the market has gone up and increase their expectations for future returns. ” (Spence, 7 August 2007) What is Overconfidence? The investors make then investment decision or portfolio depending on the information available their hand.

Very often the thinks or predict much more higher than actually what it should be, i. e. they overestimates the precision on their personal information ignoring the other information and determining factors of the market movements. It’s like to show the high degree of self attribution or the business to one’s own ability. According to Shleifer (2000), "[P]sychological research demonstrates that, in areas such as finance, men are more overconfident than women (p. 33). Over confidence generally leads to high volume of trading. High volume of trading calculates extra cost that ultimately rises up the expense or decrease the profit.

Gervais and Odean (2001) and odean (1998) have developed a model of overconfidence predicting that the more the total market returns the more investors confident about the precession of their information. Another can’t be left unmentioned have that though the returns are market wide. The planner or owner unintentionally or say that the grains in wealth is the result of their ability to pick stocks. It’s is who found that the investors who one more confident or overconfident trades more frequently then others. They also believe that this prediction and forecasting ability is greater than the average.

From this psychological facts they treat themselves as wise is market calculation and acts as the gurus of market. Financial economists have long puzzled over investors’ enthusiasm for active trading in highly competitive securities markets where, as Odean (1999) found, those who trade the most lose the most. Empirical evidence in competitive settings outside of security markets suggests that overconfidence in one’s own talent is a pervasive behavioural norm. Investors’ overconfidence in their security valuation skills has recently become a formalized hypothesis among financial economists.

Specifically, Daniel, Hirshleifer, and Subrahmanyam (1998), hereafter DHS, and Odean (1998a) develop equilibrium results that incorporate the assumption that some investors overestimate the precision of their private information (Statman et al. 2006). The cause of individual investors to become overconfident Hard working When individual investors work hard, they get a higher level of confidence which sometimes treat as over confidence. Desire for high achievement Sometimes desire for high achievement of an investor leads him/her to be overconfident.

Individual investors use to sell or buy stocks for better profit. They become overconfident in decision making for the sake of profit maximization. So, desire for high achievement makes individual investors overconfident. Highly Optimistic Investors, who have highly optimistic view about money returns or some related factors, gradually tend to be overconfident. Highly optimistic individual investors more risky investment for higher rate of return and they some times over look the risks associated with the investment. So highly optimistic is a case of overconfidence of individual investors.

Independence Normally individual investors are independent; this independence gives them the facility to make any kind of decision. So, the independence of an individual investor can be a cause of his/her overconfidence. Foresight Foresight is a necessary tool of investment. An individual investor uses foresight in decision making of investment. When the assumption of an investor’ act success then the confidence level of an investor increases. So, sound foresight and its higher success can be a cause of individual investor’s overconfidence. Effects of Overconfidence of Individual Investors

According to the theoretical model, it can be said that, investors who are overconfident, will tend to trade more than the other investors who invest rationally. Overconfident individual investors use to take the decisions of investment in an optimistic way. They use to trade more. Usually, overconfidence gives and individual the power of which are generally called risky, because risky investment gives higher output overconfident individual investors do risky investment. Actually overconfidence of an individual investor, leads him or her to poor results. It creates an illogical portfolio.

The success or good result of this portfolio, which is made over confidently, mainly depends upon luck. Rational investors tend to follow the conventional way of investment. They use of make investment on the basis of market situation. To do this they use to depend upon data, past history and related information. Overconfident individual investors, do the data as others do, but the decision making of overconfident similar to the average individual investors. Sometimes, an overconfident individual investor can make a great output from an impossible source.

Moreover, sometimes overconfidence can make an investor blind to his/her work. However, individual investors often show overconfidence about their judgments which are taken by their own. It can be defined as an experimental setting in which individual investors tend to make their own judgment over confidently for taking any decision about investment and related matters. Let us discuss something about overconfidence in relation with market overreact and under react. Individual investors don’t tend to overreact or under react to all news. Overconfidence does not imply that.

The fact is, evidence shows that, overreaction under reaction of asset prices to news has been mixed. There many evidence of overreaction. Shiller (1979, 1981, a, b) and LeRoy and Porter (1981) has written literature on excess volatility of speculative asset prices. In this literature statistical evidence of market overreacts can be found. On the other side, there are some evidences of underreaction. In the literature of Cutler, Poterba and Sunamers (1989) it can be found. In case of volume of volume of trade in financial markets, the implications of overconfidence are clearer than for any movement to overreact.

On the basis of Shiller (1987b), the stock market crash of October 19, 1987, should be discussed here. It can give something about overconfidence and the market impact. During that crash time, Shiller sent out questionnaires to 2000 individual investors who were wealthy, and he also sent out those questionnaires to 1000 institutional investors. Shiller asked them to fill up the questionnaires with the thoughts and reasons for action of that day. 605 individual investors and 284 institutional investors responded completely. From those questionnaires, it was found that, 29. 2% of individual investors and 28.

0% of institutional investors thought that, yes, they had a good idea about when a rebound was to occur. They also said that ‘intuition’ or ‘get feelings’ made them think that they knew when a rebound was to occur. According to Shiller (27 September 1997), “[i]t would appear that the high volume of the trade on the day of the stock market crash, as well as the occurrence duration and reversal of the crash was in part determined by overconfidence in such intuitive feelings. ” It has been already stated that the overconfident business practioners trade more frequent than others.

As a result the trade volume goes up which leads the market index to reach in the summit position. As consequences of these some investors enjoy huge profit on the other hand money investors face a great loss. As an example are can set the great fall of DSE (Dhaka Stock Exchange) index in 1996 in Bangladesh. At that time, the market index was going up and up. Some investors, who seemed overconfident, did not sale their stocks rather they purchased more with the expectation of higher profit than normal. But often certain period, the price of stocks became to decrease and once upon a time it got down to the lower level.

As a result, many overconfident investors face a huge amount of loss some people even loss their last penny. Conclusion In the light of the above discussion it is crystal clear that overconfidence is a one kind of financial behaviour of financial practitioners. It’s such a psychological term which influence the investment decision when, how, how much, where and why to invest his/her accumulated fund. The investor takes his financial decision depending on some private information. All the time the investors give high priority to his/her personal information and prediction of the market.

They always think that they have the skill to predict the market much more than the average which ultimately termed as overconfident. References Baruch, M. Bernard. (n. d. ). http://www. answers. com/topic/speculation? cat=biz-fin Blume and Friend (1975) and the 1998 U. S. Survey of Consumer Finances (SCF)). ” <http://goliath. ecnext. com/coms2/gi_0198-355368/Talk-and-action-what-individual. html> Britannica Concise Encyclopedia. (2006). Britannica Concise Encyclopedia. Encyclop? dia Britannica, Inc. Columbia Encyclopedia. (2003). The Columbia Electronic Encyclopedia, Sixth ed. , Columbia University Press.

<http://www. cc. columbia. edu/cu/cup> Financial & Investment Dictionary. (2006). Dictionary of Finance and Investment Terms. Barron's Educational Series, Inc. Shefrin, Hersh. (2007). Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing (Financial Management Association Survey and Synthesis Series). http://astore. amazon. com/dividen-20/detail/0195304217 Shiller, J Robert. (27 September 1997). Developments in Macroeconomics" it is presented at the Federal Reserve Bank of New York, February 27-8, 1997. file://localhost/D:/Behavioral%20finance/Behavioral%20finance.

pdf Shleifer. (2000) http://overconfidence. behaviouralfinance. net/ Spence, John. (7 August 2007). Learning from their mistakes Professional money managers get advice to overcome bad investing habits. MarketWatch, EDT http://www. marketwatch. com/news/story/individual-investors-can-learn-fund/story. aspx? guid=%7B51E826C9-1391-4D2B-B7A8-87554EB300E6%7D Statman et al. (2006). Investor Overconfidence and Trading Review of Financial Studies. 2006; Vol. 19 (4). 1531-1565 The Insurance Dictionary. (2000). Dictionary of Insurance Terms. Barron's Educational Series, Inc.

Don't let plagiarism ruin your grade

Run a free check or have your essay done for you

Check my essay Hire Writer