Behavioral Finance In Investment Decision -Myassignmenthelp.Com

Question: Discuss About The Behavioral Finance In Investment Decision? Answer: Introduction Behavioral Finance and investment management goes hand in hand as both are related to managing the Finances(Ritter, 2003). Investment management is a process where funds are managed. It shows as to how can a investor make decisions about investing his money(Stanlay, 2011). While, Behavior management brings together some economy principles which influences psychology of a human behavior while making investment decision. Intention of both of these is to help us make better choices. It involves already imbibed beliefs that make the person bias and these beliefs then hinder the decisions of a person. The concept of efficient market hypothesis is now a part of new modern finance. It is a sound concept in terms of finances. It can be applicable for the capital markets which are linked with the efficiency of cost and the other markets are also analyzed. It deals in the stock market where prices of market show the information about the companies. In other terms, the efficient market hypothes is is a theory of framework which helps in investing when human is going through behavioral finance(Malkiel, 2003). Behavioral Finance challenging the Efficient Hypothesis The Efficient Market Theory has been the only managing and controlling theory of management from many years. Later when behavioral finance came into picture; it challenged the assumptions of Market hypothesis, particularly related to the investment concept. It has involved psychology and emotions into investment behavior theory. Also there are shortcomings of Efficient Market Hypothesis which were pointed out buy the Behavioral Finance and also at the same time, it should be taken positively with respect to stock market studies(Sharma, 2014). The major challenges are the following: Availability and access to information Efficient Market Hypothesis states that the investment markets are sufficient with the information. Everyone can access the information whenever they need and due to this news of investment cannot be manipulated. Although, this statement faces challenges on the basis of two things: access and availability. From the theory point, everyone has access to only the investing information and not on the practical information. Due to daily lifestyle, everyone has different time to access to information. Availability of the information is also a weakness for EMH. Generally, the investment information is available to only top speculators or to the limited group of people who are investing and then at the later stage, it is shared with the public. Hence, the ones who get the information early take the advantage from this. Also, the major emphasis should be given to the on to the method by which the information is communicated rather than the availability of information. In the same context, beh avioral finance says that stock markets are inefficient in information in terms of availability and access(Akintoye, 2008). Fundamental Analysis The methods that help in making investment decisions usually are of two categories: Technical and fundamental analysis. In investment process, if investors want to establish good and profitable relationship with the company, it should apply fundamental components. Its the tendency of the investor to create a picture of the company in their portfolios when an investor is interested in the financial data of the company. Due to this they encourage relationships very confidently with the company they are interested in. In EMH, fundamental analysis is limited. Followers of the EMH, created issues supporting it and due to this, it was taken as a paradoxical theory and at last, concluded with refuting it. Technical Analysis EMH refutes the technical analysis, when the direction of prices on the study of past data forecasting is done. Due to this, the impact on the investment decision making lies because of the historical development of the company. Past data should not be just the focus for the research when one needs to achieve high returns. Past data should only be treated as a memory. Uniformity of Investment As stated by EMH, the people who are very much into the stock market and investment, they are looked as the colorless groups of people those who share the same attitudes, traits, methods and scope. Family or friends, experience or gender are not the things it is limited to. Rational Behavior People who invest in stocks are characterized as logical by the individuals who are efficient in market information. These regular investors are just focused on the outcomes so that they can maximize the profit by that. People, who stay abided by the same investing procedure on a day to day basis, are compared to as the soldiers marching. In investment, being rational is the key and the destination which creates the advantage of competitiveness. Emotions and Investment Investors always form their beliefs on the basis of their emotions involved in every bid. The types of feelings like optimism, pessimism encourage or discourage them from time to time during the investing process. Hence, emotions are clearly are vital in influencing the decisions of the investors. EMH suggests that there is no influence of the emotions in the stock market and the process of investing while behavior Finance emphasize on the emotions a lot and that they are the back bone of the framework. Efficient market hypothesis bubble As far as the investors are investing in marketing very rationally, the bubbles that are created in EMH cannot be understood. For example: the dot com bubble where internet based companies enjoyed a very high stock price by just adding a .com to it in the end. These bubbles and t hese arguments are in favor of dominating the Behavioral Finance over EMH. A nave hypothesis EMH is not a very complicated theoretical framework as compared to the Behavioral Finance. EMH is considered to be the nave approach or a simple one. Being simple or nave, it is very popular with in investors from a long time as it gives out the positivity in investing decisions, though the outcomes are serious. Behavioral Finance on the other hand is complicated and due to this it is not accepted by the majority of the community(Kalra et al., 2014). Implications of Behavioral Finance for Investment Managers While traditional theory states that the decisions made by the investors are mostly rational, the modern theory says that this is not the case. Decisions are mostly inconsistent and they play a very important role in influencing human mind by creating an illusion. The implications of behavioral finance are informed by the two cognitive illusions: Heuristic Decision Process and Prospect Theory. Heuristic Decision Process When tools like algorithms, techniques and tricks are used for solving problems, and then heuristic decision process takes place. When investors invest, their decision is not always rational as it is very difficult to remove the emotions from in the process. The factors that are included in Heuristic process are: Representativeness: The tendency to take decisions on the basis of the previous experiences is known as stereotype. Tversky Kahneman in 1982, defined representativeness as: 1) When the parent population is equal to the events characteristics and 2) Examines important features of procedure by which it yields. Overconfidence: It was studied by Guth, Dittrich and Maciejobsky in 2001, that only two third of the participants are overconfident. Also it was observed that those who lose their money in market are prone to becoming more confident. Confidence plays vital role in gaining success. Although it is not the only source for gaining success, it is encouraged by all and is considered to be a positive trait. Now when investors become over confident, they tend to excessive training which is bad(Chaudhary, 2013). Anchoring: When people invest, they tend to think that the final result would depend on the initial values of the trade in different situations but it might only be the partial calculation and not the final one. Although later anchoring process was involved where Kahneman and Tversky stated that different estimates lead to the initial values. Failure of Gamblers: When the probable results are being expected, lack of understanding and incorrect estimation can be done sometimes. This lack of incorrect decision making is known as Gamblers Failure. Bias Availability: It is like a cognitive bias which makes the human being to overestimate the possible probabilities of the events with distinct happenings. Generally, investors give more weight on the mostly available information while they make decisions(Jahanzeb et al., 2012). Herd Behavior: When the decision making is done by looking at other peoples decision, it is known as the herd behavior. Whenever anyone new joins the market, he being new would always look forward to other investors decision who is being dealing with the market from a long time. Mental Accounting: Found by Richard Thaler, it is a concept in which the investors frame the transaction the way they look at the utility they are expecting out of it. The bias decision is when the investors value the money on the basis of the source from where it is generated(Sharma, 2016). Conserve Nature: When any kind of change occurs, people tend to be slow toward adapting those new changes. This is known as conservatism bias. If t he changes are occurring on the larger basis, then people will adjust to it sooner and will react to that sooner. They can also possibly overreact too in some circumstances. Effect of Disposition: An investor after investing the money does not want to sell the share until it goes up on the price he put into it earlier. Even when the prices go down, investor does not want to sell. This effect helps in realizing the small gains and small losses that an investor might go through. It reflects in the average of the stocks trading volume(Weber Camerer, 1998). Loss Aversion: This theory is based on the idea that the loss that an investor carries is greater than the gift of the gain of the same amount. If the investors are reluctant to loss than they might invest even more to not be on the same position anymore. This process explains averaging down tactics where investor is exposed to the stock that is falling in order to regain what they have lost. This is known to be as escalation bias(KONSTANTINIDIS, 2012). Regret Aversion: It rises when the investor wants to avoid the feeling of regret that he gets from the loss of the amount in stocks when he made the poor investment decision. When they regret the decision, they will be more prone to hold their shares which are on the loss(Singh, 2012). Behavioral Finance, Market Hypothesis and Investment Management and their Impacts on each other When an avid investor invests in the market, he should be able to invest his money in the right way and at the right place. Investment management helps an investor to do that. Very often emotions come in between the investment. It depends on the amount that is being invested and the gains or the losses too(DUPERNEX, 2007). That is where behavioral finance comes into picture. Investment Management is also related to the asset management as it helps in the management of the infrastructures for operating the investments(Reyes, 2015). And efficient market theory is also very important for the finance in the modern world. It can be applicable for the capital markets(Degutis, 2014). Behavioral Finance basically refutes two implications of the EMH. Majority of investors takes logical decisions on the basis of information available. The price of the market is always right(nyssa, 2010). Efficient Hypothesis theory and behavioral finance both are important when it comes to investment management as they both have different but helps in the same i.e. investment. Within the last 50 years, EMH has been a subject of the academic research as it precedes fundamental theory of movement in the assets. The basic definition of this is that the market always operated efficiently and the stock prices are reflected in all the information. Now that everybody is keen to know all that information responds to it immediately. The result of which is that the efficient markets does not allow the investors to gain above average returns without taking any risks. While EM theory prevails in the financial economy, the followers of the behavioral finance believe that irrational and rational behavior or emotions influence the investors decision(Nath, 2015). Both these things does impact on the investment management as they both suggests different theories. Proponents of both the theories think different and that changes the prospect of investment management every now and then. Many behavioral finance concepts tend to refute the efficient market hypothesis. But that does not mean that the efficiency should be discounted on the whole. By understanding the weaknesses and the strengths of these theories can help the investor to catch new information and take more informed and subtle decisions. The market prices are high because millions of people thinking indifferently gets motivated by the emotions they feel while investing, gaining or loosing. When all the members who are investing, think alike, the estimate of the result or the prices is always inaccurate. In this situation, one can see the overflow of the information and motivation. It is the herd like behavior which creates one of the two emotions: fear or greed. While greed can make the investors buy same group of stocks, fear makes the investors pull their money out of the stock as they fear of losing it. Now regardle ss of the one who promotes efficient market theory or not, most people agree to the fact that creating the wisdom of crowds must be on the top priority of the avid investors, government, policymakers and regulators(Lo, 2005). Conclusion This essay shows as to how behavioral finance and efficient market hypothesis helps in investment management. When an investor invests in some stock, he goes through a lot of emotional changes as it is said by behavioral finance. Yet efficient market hypothesis refutes this theory of behavioral finance saying that emotions do not have any role in influencing the decisions of the investors while investing. The difference between both these theories is also discussed in this essay. There are some implications of behavioral finance for investment managers. All are discussed in detail as all of them denote different theories and logic behind investing. Finance recently seems to produce long term anomalies. The market anyway does not suggest that market efficiency should be deserted. On the other hand behavioral finance brings together the influences of human behavior in making investment decisions. It does not matter how sophisticated the data is, the decisions has to be taken by the inv estor only(MITROI, 2014). References Akintoye, I.R., 2008. Efficient Market Hypothesis and Behavioural Finance: A. European Journal of Social Sciences, 7(2). Chaudhary, A.K., 2013. IMPACT OF BEHAVIORAL FINANCE IN INVESTMENT. Int. J. Mgmt Res. Bus. Strat, 2(2). Degutis, A., 2014. THE EFFICIENT MARKET HYPOTHESIS: A CRITICAL. ISSN, 93(2). DUPERNEX, S., 2007. WHY MIGHT SHARE PRICES FOLLOW A RANDOM WALK? Student Economic Review, 21. Jahanzeb, A., Muneer, S. Rehman, S., 2012. Implication of Behavioral Finance in investment decision-making proces. 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