Behavioral finance – psychology-based theories to explain stock market anomalies part-I

One of the funny things about the stock market is that every time one person buys, another sells, and both think they are astute.”

– William Feather

The field of finance has evolved over the past few decades based on the assumption that people make rational decisions and that they are unbiased in their predictions about the future.  A rational investor can be defined as a one that always

  • Updates his beliefs in a timely and appropriate manner on receiving new information;
  • Makes choices that are normatively acceptable.

There have been many studies that showed evidences in securities markets that contradict the efficient market hypothesis and perfect investor rationality. The foundations of the world economy were shaken by the Financial Crisis of 2008 that originated in the USA and global recession that resulted. A vast majority of economists, and economic forecasters occupying influential seats in governments and financial institutions were caught unawares by this and the follow up events like bankruptcies and defaults. Even after the crisis had begun, many of them were not able to analyze the magnitude or depth of it.

Failures of economists, and consequently the theories they swear by, on various occasions has put forward the question: Are people really rational? Or are they likely to be driven by bouts of emotions like fear and greed which could lead to bad decisions?

Theoretical and Experimental works gave rise to a new paradigm in the 1980s called Behavioural Finance, which “studies how people actually behave in a financial setting. Specifically, it is the study of how psychology affects financial decisions, corporations, and the financial markets.”Behavioural finance essentially tries to supplement the traditional finance theories by merging it with cognitive psychology in an attempt to create a more complete model of human behaviour in the process of decision making.

Moving focus to India in 2008, the SENSEX – India’s oldest and among the most popular stock market index of the Bombay Stock Exchange representing the free-float market value of 30 component stocks representing the most well-established companies across key sectors – had touched an all time high of 20,873 points in January 2008 although the sub-prime mortgage crisis had already originated in the USA. A year later, in March 2009, the index had tanked to 8,160 points, after the crisis had spread globally. Even before the impacts of the crisis has smoothed out completely, the SENSEX touched a new all time high in November 2010 and closed at 20,893 points. Then a new crisis in the form of a Sovereign debt crisis originated in Europe making the SENSEX tank again. One word that has dominated the world of financial markets since 2008 has been ‘Volatility’ and the markets in India have been no exception. Extreme movements in stock prices because of fear and anticipation have, as it is supposed to, made life tough for a rational investor. Market sentiments have been observed to sway wildly from positive to negative and back, in the shortest timeframes like weeks, days and hours. In this context, understanding irrational investor behaviour deserves more importance that it has ever had. Various psychological biases can be arguably influencing the investment decisions of investors, and this is where the problem was identified.


Humans are susceptible to various behavioural anomalies, which can become the biggest obstacle in their attempt to maximize wealth. There are nine commonly identified behavioural biases.

Overconfidence Bias

Overconfidence causes people to overestimate their knowledge, underestimate risks, and exaggerate their ability to control events. People think they are smarter and have better information than they actually do. A common trait among investors is a general overconfidence of their own ability when it comes to picking stocks, and to decide when to enter or exit a position.

Representativeness Bias

Representativeness is a heuristic process by which investors base expectations upon past experience, applying stereotypes. For example, investors might interpret good earnings announcements as predictors of good future performance, without determining whether the performance will continue for the individual firm making the announcement.

Herding Bias

This is the most common mistake where investors tend to follow the investment decisions taken by the majority. That is why, in financial markets, when the best time to buy or sell is at hand, even the person who thinks he should take action experiences a strong psychological pressure refraining him to do so. Herd behaviour is the tendency individuals have to mimic the actions of a large group irrespective of whether or not they would make the decision individually.

Anchoring Bias

Anchoring is a psychological heuristic which can be said to occur when investors give unnecessary importance to statistically random and psychologically determined ‘anchors’ which leads them to investment decisions that are not essentially ‘rational’. When required to estimate a good buy price for a share an investor is likely to start by using an initial value – called the “anchor” – without much analysis, say for e.g. the 52-week low of the stock. Then they adjust this anchor up or down to reflect their analysis or new information, but studies have shown that this adjustment is insufficient and ends producing results that are biased.

Cognitive Dissonance Bias

Cognitive Dissonance is the mental conflict that people experience when they are presented with evidence that their beliefs or assumptions are wrong. When an investor faces a situation where he has to choose between two alternatives, it is likely that some conflict will follow after a decision has been reached. The negative aspects of the alternative he chose are likely to be prominently visible while the positives of the discarded alternative will add to the conflict. There are two identified aspects of Cognitive Dissonance that is related to decision making.

  • Selective perception: where investors only register information, which affirms their beliefs thus creating an incomplete view of the real picture.
  • Selective decision-making:  Investors are likely to reinforce commitments previously made even though it might be visible that it is the wrong thing to do. This occurs because of commitment to the original decision forcing the investor to rationalize actions, which would allow him to stick to it, even though these actions are sub-optimal.

We can now understand why the market is not ‘efficient’ and an investor not ‘rational’. Humans are dictated by their emotions involuntarily and it often affects their decisions.

We will discuss the other biases and some more concepts in the next article.

-To be continued…

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