Behavioral finance and its role in the stock market

2024 Author: Howard Calhoun | [email protected]. Last modified: 2023-12-17 10:16

This topic is pretty fresh. It is an area that has not yet been fully explored. Therefore, it is still impossible to say that an end has been put here and one can be sure of the information received. Why? What is this direction? What books can you read on the topic?

Introduction

The difference between behavioral and traditional finance is:

1. Objective perception of information.
2. Adequate approach to forecasts.

To put it simply, some economists use specific indicators, while others believe that forecasting cannot be without errors. The second opinion belongs to supporters of behavioral economics. They believe that this is due to the possibility of making mistakes when it is people who make predictions. After all, in this case, you have to use your memory and, reproducing the adoption of certain decisions, rely on its data.

At the same time, people do not really like to apply a logical analysis of the information that is available. This situation leads tooccurrence of errors. To minimize them by accounting, the theory of behavioral finance was invented. People are more likely to be guided by emotions rather than logic. Thus, the psychology of investors has a greater influence on the price of shares than fundamental indicators.

The research of Amos Tversky and Daniel Kahneman should be taken as a basis for considering this topic. Their insights and arguments have appealed to a large number of behavioral economists. These colleagues have repeatedly proved that a person processes data inefficiently. People tend to make ridiculous and quick decisions. This is much more common than unhurried and logical conclusions based on adequacy and objectivity. So, among traders, understanding the market through faith in the best is more common. Together with the memory of the past and drawing parallels, taking into account the signals, which are not a guarantee of the implementation of the forecast expected by the trader.

About models used in forecasting

Unsurprisingly, trying to foresee the future is not without its challenges. After all, there is an extremely close relationship between behavior and movements. Predicting crowd psychology is not easy. This issue has been studied since the 1940s. No one has been able to achieve significant results in predicting the behavior of financial markets. But the attempts don't stop. Enthusiasts are still trying to achieve success in creating complex mathematical models that allow them to accurately predict situations. Many people believe in the reality of this approach. At the same time, psychology is pushed backto the background.

So how does our brain make decisions? Behavioral finance, although met with a certain skepticism, still deserves attention. As one interesting point, there is a desire to bring a little fact: the previously mentioned cognitive psychologist and physiologist Daniel Kahneman received the Nobel Prize in economics in 2002. At the same time, he seriously stands out among all those who had the honor of being awarded it by his specialization alone. Of course, the presence of a prize cannot prove that a theory is genuine. But it was the first step towards world recognition. But in general, this topic dates back to 1985, when behavioral finance emerged as a science.

It is assumed that the use of its information makes it possible to take into account the irrational nature of the activities of investors in market conditions, explaining the behavior of objects in situations where classical dogmas cannot provide a clear explanation. And as a result, it will be possible to cope with the negative results of erroneous judgments, as well as illusions of perception. It is also possible with some success to anticipate the actions of other market participants, develop an effective investment strategy and achieve the maximum effect from the channeled and invested capital.

Follow-up development

No need to think that if the first article was published, then immediately behavioral finance on the stock exchange began to quickly pick up activity. Many experts have met with the impossibility of explaining many of the phenomena thattake place in the financial markets. Classical theories simply did not allow them to fit within the existing framework. At the same time, the idea about the behavioral aspect, expressed at the same time, attracted many people. Therefore, a more detailed study of the relationship between the effectiveness of financial and economic activities and the personal characteristics of people began.

At the moment, more than one theory of behavioral finance has been created. They are aimed at explaining numerous facts when classical approaches diverge from practice. Among all the diversity, it should be noted that the following theories are considered the most promising:

1. Perspective.
2. Investor behavior in the stock market.
3. Noise trading.
4. The influence of the psychological qualities of a trader on the efficiency of transactions.

These are worth considering theories and authors. Behavioral finance is not limited to them. But, nevertheless, they are the most interesting and complete formations. Although some thinkers also deserve mention - for example, G. Simon. Behavioral finance and investors were of considerable interest to him, although during the years of his work this was not very much suspected, because they had not yet taken shape as a separate science. But, nevertheless, he was awarded the Nobel Prize for his research.

Prospect Theory

Started by Morgenstern and Neumann in 1944. Then they formulated the theory of expected utility. It now underlies a large number of financial models. But for tradersShe is not of primary interest. Within the framework of the topic, the theory of rational expectations is of the greatest importance, which is an addition that explains the behavior of economic entities at the macro level.

According to the above hypotheses, the formation of people's expectations is carried out not on their own experience, but on the use of the information provided. For example, the government declares that it will take all necessary measures to combat inflation. People must at the same time transform their own expectations according to the information received. Almost immediately, much criticism arose that questioned the universality of such assumptions.

The most influential in this regard is the prospect theory, which was prepared by Kahneman and Twerki and presented to the public in 1979. It is used to explain and predict investor behavior under risk and uncertainty. Prospect theory holds that market participants do not behave rationally. It is an example of descriptive rather than normative analysis. At the same time, the fact that it is based on results obtained from hundreds of experiments does not allow it to be abandoned.

About research results

What conclusions did Kahneman and Twerky come to after work? They found that the feelings of individuals from the acquisitions and losses of monetary amounts equal in absolute value are not symmetrical. What does it mean? The pleasure of a person from acquiring a thousand dollars is much less than the frustration of losing it. At the same time, the desire to avoid loss is weakly associated withwillingness to avoid risk. This leads to an interesting result.

Thus, avoiding losses in real life, people risk much less than if the activity is carried out within a strictly rational framework and seeks to maximize utility in the implementation of actions. Prospect theory also promotes the view that people tend to misjudge probabilities. As a result, behavioral finance and bonds have non-rational values. For example, the probability of events that are almost guaranteed to occur in the future, or vice versa, is underestimated. It is also possible that something is considered to be something that will never happen. Although there is a possibility of their implementation (albeit small). All this contributed to the formation of the main provisions:

1. The usefulness of each outcome must include an estimate of its corresponding probability. At the same time, it is necessary to make an adjustment for the attitude of people to risk.
2. Introduction of the cost function. It is determined not by the final well-being of the subject, but by values, which in a particular case are “losses” and “gains”, which are separated by “points of indifference.”

Prospect theory is used to explain a large number of anomalies that can be found in the market. The most illustrative examples are:

1. Predisposition effect.
2. Increased risk premium.
3. Asymmetric price elasticity of demand.

Theory of behaviorinvestors in the stock market

Let's start the next development. Its formation began with Shleifer's Inefficient Markets: An Introduction to Behavioral Finance. It analyzes a we alth of evidence of both under-reaction and over-reaction of investors to the new data. When could it be?

Under-reaction is observed in cases of negative data, when quotes go down less than they should. In other words, the company's shares are overvalued. Their acquisition brings the investor a loss. An overreaction occurs when, after a series of positive data flows, the price rises excessively. And the property is overrated. At the same time, it brings losses to its owners. Changes are driven by public information.

Evidence of under- or over-reaction has come from numerous observations since the 1970s by a number of experts. For example, Logran, Cutler, Poterb, Summers, and many others received them to refute or confirm the efficient market hypothesis. Shleifer proposed a model according to which it is possible to describe the process of forming an opinion among investors regarding the shares of certain companies. It is based on two factors:

1. Conservative thinking.
2. Misuse of probability theory models in practice.

How do they manifest themselves? The effect of conservatism lies in the insufficient reaction of investors to the receipt of negative information, whichshould lead to a revaluation of shares. Behavioral supervision in the financial market has shown that bad news that does not correspond to prevailing perceptions is poorly received. Therefore, the reaction is delayed or limited. The misuse of probability theory models in practice is that, having a series of good news about the company, investors think that the positive trend will continue in the future. But if the belief is supported only by this, then the result is only a revaluation of assets and a decrease in the income of their owners.

Noise trading theory

It was first offered to the world in 1968. Its main provisions were formulated in the work of Black "Noise". Further development of the theory was carried out by Summers, Bradford, Shleifer, De Long. What is its essence?

Working in the stock market, when noise (rumors, unverified information, etc.) is used as the basis for making a decision, is opposed to an approach that is based on reliable and timely information. What does it look like in practice? When market participants are guided in their actions by unverified data and rumors, they use the advice of pseudo-experts, this means that they are noise traders. They make deals. In this case, the noise is taken as accurate data, although it is not. In other words, their behavior is not rational.

Often the activity is carried out because, as Black said, "they like to trade." It is this factor that contributes to the increase in activity. For if market prices were always the result ofadequate and reliable information, then in this case it is difficult to get additional profit. And stock trading as it is would lose all meaning.

But the effects in question do not end there. Behavioral finance within the framework of this theory suggests that there must be rational participants. For their designation, the phrase "information traders" is used. As a rule, the former are at a loss, while the latter make a profit. At the same time, information traders take into account the behavior of their "noisy" colleagues and tend to interact more with them than with their rational competitors. This theory contradicts almost all the most important provisions of classical finance. But stock practice calmly fits into its framework, although the behavior of the market itself is unpredictable.

The theory of the influence of the psychological qualities of a trader on the efficiency of operations carried out

When conducting research in the markets of Canada and the United States, a statistically significant correlation was established between a positive set of psychological qualities of a person and the success of his professional activity.

According to this theory, success accompanies those who have a set of the following qualities:

1. There is no desire to control the market and subdue it.
2. Feels an individual risk barrier - the limit values that it can take on. That is, the maximum numbercapital that can be staked without fatal consequences.
3. Make thoughtful and appropriate decisions, even when things don't go as planned.
4. Takes into account the selectivity (selectivity) of memory and perception.
5. Can recognize a state of stress and develop protective mechanisms against rash actions that may be taken in it.
6. Has adequate self-esteem.
7. May take into account the influence of negative tendencies, predispositions and attitudes.
8. Avoids psychological attachment to the use of specific financial instruments.
9. May give up short-term profits to win in the long run.
10. Has endurance and patience.
11. Can plan the development of several, often opposite scenarios in the stock market.
12. Knows how to focus on a goal and constantly act to achieve it based on the decision made.
13. Has the skills to work with large amounts of information to avoid psychological overload.
14. No psychological addiction to trading.

For reference: selection of literature

Behavioral finance, despite its relative newness, is a fairly broad topic. And to fit absolutely everything within the framework of one article is a difficult matter.

And for those who want to know more, a full textbook will do. Behavioral finance has been well studied. They are well consideredin the following writings:

1. Nikolay Rudyk: "Behavioral Finance, or Between Fear and Greed". This book shows very well how the irrational nature of a person affects the decision-making process. It is considered how illusions affect the process of thinking and lead to systematic errors. Rudyk in Behavioral Finance focuses on excessive self-confidence. As well as the "hot hand" delusion, the disposition effect, and many other factors that only create problems.
2. Sergey Filin: “Behavioral finance. Investors, companies, markets”. This is an extensive work that covers the subject of the evolution of attitudes, the psychology of risk, the problem of inefficiency, asset pricing mechanisms and much more. This will allow you to lay a solid foundation for successful activity if you learn and apply the material available in the book. Behavioral finance and the material in this paper will be of interest to traders. Especially for those who have to work with assets and influence legislative and regulatory support.
3. Semyon Bogatyrev: “Behavioral finance. Tutorial". This book explores the origins of the field, diverging from the traditional direction, describing the tools used and showing how they can be used in practice in valuation, accounting, budgeting and trading.

But behavioral finance doesn't stop there. The book can give a basic theoretical understanding of the situation, but only practice will help to fully learn everything in the smallest details.

Criticismabstracts under consideration

Looking at everything in a purely positive way, one can overlook the negative aspects. What is the critique of behavioral finance theory? First of all, they give the following argument: acting economic agents prefer to act rationally. The behavior observed in experiments has limited application in market situations. After all, competition stimulates the most rational behavior.

A number of researchers also draw attention to the fact that existing developments in behavioral finance can only be used in one-time problems similar to those that participants in experiments or surveys have to solve. In addition, there is a certain skepticism towards the research tools used. After all, the most important is the revealed advantage, and not the named one, as is the case with the theory under consideration. Also, do not forget about the risks of system preemption.