Understanding the Behavior of Stock Market Functionality: Need and Role of Behavioral Finance

By Shankar, Devesh; Dhankar, Raj S. | Review of Management, December 2015 | Go to article overview

Understanding the Behavior of Stock Market Functionality: Need and Role of Behavioral Finance


Shankar, Devesh, Dhankar, Raj S., Review of Management


Introduction

Classical theories on finance have assumed and backed the notion of investor rationality to gain a systematic understanding of how markets work. However, several inconsistencies have been reported in the empirical testing of models based on this notion. These inconsistencies are commonly referred to as market anomalies (Annexure-1). Owing to these anomalies, explanations were sought to understand the gap that exists between the depiction of stock markets in classical finance theories and the real world stock markets. One of the most prominent explanations is the difference between the notion of investor rationality assumed in classical finance theories, and the existence of complex psychological phenomena which makes investor rationality a utopian concept in the real world financial markets.

Over the past few decades, Behavioral Finance has emerged as a new approach to understand the behavior of stock market functionality. Behavioral Finance is the intersection between Finance and Psychology. In stock markets, forces of demand and supply determine the market price of assets after taking into consideration the perceived risk and return framework of the market participants. These market prices are often different from the intrinsic value of assets as reflected by the constant booms and busts in financial markets. A focus on psychology of investing is essential to bridge the gap that exists between classical finance theories and the real world financial markets.

The purpose of this study is to review the psychological phenomena that affect the market prices of assets. These phenomena, if measured and incorporated correctly into the asset pricing models, can help in explaining the asset prices that prevail in the financial markets. Further, the study provides an account of phenomena that deviates the preferences of investors from those represented in classical finance theories. Moreover, the biases that thwart an investor from making rational choices have also been examined at length. The study discusses the short-cuts used by investors in decision making that are not consistent with rational decision making criteria. Finally, it explores the tendencies of the human mind to deceive oneself and make an irrational decision.

Preferences

Prospect Theory: Prospect Theory of Kahneman and Tversky (1979) suggests that after an increase in asset prices, the investors become less risk averse while a decrease in asset prices of the same magnitude increases the risk aversion of investors by a much larger magnitude than that mandated by the classical risk-return framework. The two main features of prospect theory are: Weighting function and Value function. The probabilities in the expected utility theory are replaced by weighting function, which measures the desirability of prospects rather than the perceived likelihood of events. Value function is a replacement of utility function in the expected utility theory and is defined for changes in wealth (i.e. gains and losses) rather than absolute value of assets. The value function is concave for gains and convex for losses, with a greater value assigned to losses than to gains, thus making the value function steeper in the domain of losses. This shows that investors are much more sensitive to losses than to gains, and that individuals take more risk to avoid losses resulting in time-varying risk aversion. This notion of avoiding losses is known as "loss aversion".

Myopic Loss Aversion: Benartzi and Thaler (1995) dub the combination of loss aversion and frequent re-evaluation of portfolios as "myopic loss aversion" and propose it to be a possible explanation of the equity premium puzzle of Mehra and Prescott (1985) in which there is a large discrepancy between equity returns and returns of fixed income securities. Benartzi and Thaler (1999) provide further evidence of myopic loss aversion with findings suggesting an increase in attractiveness of gambles when the magnitude of single trial losses was reduced. …

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