STUDY ON BEHAVIORAL FINANCE:

IS THE INDIVIDUAL INVESTORS RATIONAL?

Nik Maheran Nik Muhammad

Abstract
Behavioral finance models often rely on a concept of individual investors who are prone to
judgment and decision-making errors. This article provide brief introduction of behavioral
finance, which encompasses research that drops the traditional assumptions of expected utility
maximization with rational investors in efficient markets. The article also review prior
research and extensive evidence about how psychological biases affect investor behavior and
prices. The paper found that the most common behavior that most investors do when making
investment decision are (1) Investors often do not participate in all asset and security
categories, (2) Individual investors exhibit loss-averse behavior, (3) Investors use past
performance as an indicator of future performance in stock purchase decisions, (4) Investors
trade too aggressively, (5) Investors behave on status quo, (6) Investors do not always form
efficient portfolios, (7) Investors behave parallel to each other, and (8) Investors are
influenced by historical high or low trading stocks. However, there are relatively low-cost
measures to help investors make better choices and make the market more efficient. These
involve regulations, investment education, and perhaps some efforts to standardize mutual
fund advertising. Moreover, a case can be made for regulations to protect foolish investors by
restricting their freedom of action of those that may prey upon them.
Keywords: Behavioral finance; Efficient Market Hypothesis; Investors psychology; Arbitrage;
Rationality.

1.

INTRODUCTION

According to economic theorists, investors think and behave rationally when buying and selling
stocks. Specifically investors are presumed to use all available information to form rational
expectations about the future in determining the value of companies and the general health of the
economy. Consequently, stock prices should be accurately reflect fundamental values and will
only move up and down when there is unexpected positive or negative news, respectively. Thus,
economists have concluded that financial markets are stable and efficient, stock prices follow a
random walk and the overall economy tends toward general equilibrium.
In reality however, according to Shiller (1999) investors do not think and behave rationally. To
the contrary, driven by greed and fear, investors speculate stocks between unrealistic highs and
lows. In other words, investors mislead by extremes of emotion, subjective thinking and the
whims of the crowd, consistently form irrational expectation for the future performance of
companies and the overall economy such that stock prices swing above and below fundamental
values and follow a some what predictable, wave-like path.
Investors behavior is part of academic discipline known as behavioral finance which explain
how emotions and cognitive errors influence investors and the decision-making process.
Behavior of the individual investors has long been the interest of academics and portfolio
managers but not the investors themselves since the herd mentality sometimes dominates over

reasons. Human herding behavior results from impulsive mental activity in individuals
responding to signals from the behavior of others (Prechter, 1999).
The purpose of this article is to offer a brief survey of prior research and theory on behavioral
finance and look at the behavior of the investors, their psychology and their investing style. Do
they rational in their decision making or emotional and based on sentiment? The balance of the
paper is organized as follows. Section 2 surveys in literature. Section 3, 4 and 5 will includes
implication, recommendations and conclusion..

2.

LITERATURE REVIEW

2.1

TRADITIONAL FINANCE

The proposition that has dominated finance for over 30 years is efficient market hypothesis
(EMH). There are three basic theoretical arguments that form the basis of the EMH. The first
and most significant is that investors are rational and by implication securities are valued
rationally. Second is based on the idea that everyone takes careful account of all available
information before making investment decisions. It is related to internal consistency. Each
decision has to be made in a systematic way such that it is in agreement with one another
whatever is the subject.
The third principle is that the decision maker always pursues self-interest. Most widely applied in
finance is the expected utility model of choice under risk, proposed by Von Neumann and
Morgenstern (1947) in DeBondt (1998). Its rationality is based on axioms underlying expected
utility maximization as the optimal rule. The accumulation and processing of information and the
formation of expectations occur efficiently, yielding possible outcomes (of total wealth) and
corresponding possibilities. In the case of new information, the probability distribution is
adjusted in conformity with Bayes rule.
2.2

BEHAVIORAL FINANCE

Behavioral finance, is a study of the markets that draws on psychology, throwing more light on
why people buy or sell the stocks and even why they do not buy stocks at all. This research on
investor behavior helps to explain the various market anomalies that challenge standard theory.
This is because this anomaly is persistent. Therefore this behavior exists.
Behavioral finance encompasses research that drops the traditional assumptions of expected
utility maximization with rational investors in efficient market. The two building blocks of
behavioral finance are cognitive psychology and the limits to arbitrage (Ritter, 2003). Cognitive
refers to how people think and the limit to arbitrage when markets is inefficient.
There is a huge psychology literature documenting that people make systematic errors in the way
they think: they always making decision easier (heuristics), overconfidence, put too much weight
on recent experience (representativeness), separate decisions that should be combined ( mental
accounting), wrong presenting the individual matters (framing), tend to be slow to pick up the
changes (conservatism), and their preferences may also create distortion when they avoid
realizing paper losses and seek to realize paper gains (disposition effect). Behavioral finance uses
models in which some agents are not fully rational, either because of preferences or because of
mistaken beliefs. An example of an assumption about preferences is that people is loss averse.
Mistaken beliefs arise because people are bad Bayesians.

Much of the basic theories of behavioral finance concern with a series of new concept under the
general heading of bounded rationality, a term associated with Herbert Simon (1947, 1983). It
relates to cognitive limitations on decision-making. As a result, human behavior is made on the
basis of simplified procedures or heuristics (Tversky and Kahneman, 1974). This is consistent
with the study done by Slovic (1972) on investment risk-taking behavior. He found that, man has
limitations as a processor of information and show some judgmental biases which lead people to
overweight information. People also tend to be overreact to information ( De Bondt and thaler,
1985,1987).
Shiller (1999) surveys some of the key ideas in behavioral finance, including Prospect theory,
Regret theory, Anchoring, and Over-and under-reaction. Prospect theory introduced by
Khaneman and Tvernsky (1979, 1981, 1986) suggests that people respond differently to
equivalent situations depending on whether it is presented in the context of a loss or a gain.
Investors typically become distressed at the prospect of losses and are pleased by possible gains:
even faced with sure gain, most investors are risk-averse but faced with sure loss they become
risk-takers. Thus, according to Khaneman, investors are loss aversion. This loss aversion
means that people are willing to take more risks to avoid losses than to realize gains. Loss
aversion describes the basic concept that, although the average investors carry an optimism bias
toward their forecasts (this stock is sure to go up), they are less willing to lose money than they
are to gain.
Regret theory (Larrick, Boles, 1995) is another theory that deals with peoples emotional
reaction to having made an error of judgment. For example, investors may avoid selling stocks
that have decreased in value to avoid the regret of having made a bad investment or
embarrassment of reporting a loss. The embarrassment may also contribute to the tendency not to
sell losing investments. Some researchers theorize that investors follow the crowd and
conventional wisdom to avoid the possibility of feeling regret in the event that their decisions
prove to be incorrect. Many investors find it easier to buy a popular stock and rationalize it going
down since everyone else owned it and thought so highly of it. Buying a stock with a bad image
is harder to rationalize if it goes down.
Anchoring (Yates, 1990), is a phenomenon in which, in the absence of better information,
investors assume current prices are about right. In a bull market, for example, each new high is
anchored by it closeness to the last record, and more distant history increasingly becomes an
irrelevance. People tend to give too much weight to recent experience, extrapolating recent
trends that are often at odds with long-run averages and probabilities.
Market over-or under-reaction (DeBondt and Thaler, 1985), is the consequence of investors
putting too much weight on recent news at the expense of other data. People show
overconfidence. They tend to become more optimistic when the market goes up and more
pessimistic when the market goes down. Hence, prices fall too much on bad environment. Most
investors think they can beat the market although evidence is overwhelming that they cannot.
Based on the study done by Kahneman and Odeon (1999) on the behavior of buying and selling
stock, found that when an investor sells a stock and immediately buys another, the stock that is
sold does better in the following year, by 3.4% on average. They also pointed out that people are
prone to cognitive illusions, like becoming rich and famous or being able to get out of the
market before a bubble breaks. People exaggerate the element of skill and deny the role of
chance in their decision making process. People are often unaware of the risk they take. Add
loss aversion to the mix and its no wonder the average investor panics in a market downturn, a
time perhaps to buy rather than sell.

2.2.1

THE BEHAVIOR OF INVESTORS

It has long been recognized that a source of judgment and decision biases, such as time, memory,
and attention are limited, human information processing capacity is finite. Therefore, there is a
need for imperfect decision-making procedures, or heuristics (Simon, 1955, Tversky and
Kahneman, 1974). Hirshleifer (2001) argues that many or most familiar psychological biases can
be viewed as outgrowths of heuristic simplification, self-deception, and emotion-based
judgments. Study done by Kent, Hirshleifer and subrahmanyan (2001) had found the evidence
for systematic cognitive errors made by investors and these biases affect prices.
According to Kent, et al. (2001), The most common behavior that most investors do when
making investment decision are (1)Investors often do not participate in all asset and security
categories, (2)Individual investors exhibit loss-averse behavior, (3) Investors use past
performance as an indicator of future performance in stock purchase decisions, (4)Investors trade
too aggressively, (5) Investors behave on status quo, (6) Investors do not always form efficient
portfolios, (7) Investors behave parallel to each other, and (8) Investors are influenced by
historical high or low trading stocks.
Investors often do not participate in all asset and security categories
According to Kent et al. (2001), investors tend to focus only in stocks that are on their radar
screens. That is related to familiarity or mere exposure effects, e.g, a perception that what is
familiar is more attractive and less risky. According to Kent et al., their findings was consistent
with Blume and Friend, (1975) on the study of participation of U.S stock market, where they
found that many investors entirely neglect major asset classes (such as commodities, stocks,
bonds, real estate), and omit many individuals securities within each classes. The same situation
occurred for Kelantanese investors where they are strongly biased in choosing stocks and
choose only stocks that are highly popular (Nik Maheran et. al., 2003).
Individual investors exhibit loss-averse behavior
Kent et al.(2001) also noted that the stocks that investors choose to sell subsequently outperform
the stocks that investors retain. According to them, home sellers also appear to be loss-averse in
the way that they set prices. They are reluctant to sell at a loss relative to past purchase price.
This helps to explain the strong positive correlation of volume with price movement. This
findings was consistent with the theory of Odean (1998) who showed that the individual investors
tend to be more likely to sell their winners than their losses. Tversky and Kahneman, (1991) also
noted that these psychological effects explain the disposition effect, as confirmed by several
studies of behavior in field and experimental markets, that is investors are more prone to realizing
gains than losses.
Investors use past performance as an indicator of future performance in stock purchase
decisions.
Investors frequently based their decisions on historical performance of stock prices using so call
technical analysis. This relates to a tendency to judge likelihood based upon nave comparison
of characteristics of the event being predicted with characteristics of the observed sample
(Representativeness). This suggests that investors will sometimes extrapolate past price trends
naively.

Investors trade too aggressively

Kent et al. (2001) found that investors are overconfident in their decision making process.
Consistent with overconfidence, traders in experimental markets do not place enough weight on
the information and action of others and they also tends to overreact more to unreliable than to
reliable information. Stronger support for overconfidence is provided by evidence suggesting
that more active investors earn lower returns as a result of incurring higher transaction costs (e.g.,
DeBondt and Thaler, 1995). Odean, (1999) noted that males trade more aggressive than females,
incur higher transaction costs, and consequently earn lower (post-transaction) returns.
According to Kent et al. (2001), Barber and Odean (1999) find that investors who have
experienced the greatest past success in trading will trade the most in the future. This evidence is
consistent with self-attribution bias, meaning that the investors have likely attributed their past
success to skill rather than to luck.
Investors behave on status quo
Kent et al. (2001) found that investors gave limited attention and processing power to their
decision-making. This is due to their status quo since they interpreted that the status quo option is
an implicit recommendation. Therefore according to Kent et al., their findings was consistent
with Madrian and Shea (2000) where they found that investors are subject to status quo bias and
tend to stick to their prior decisions in their investment decisions.
Investors do not always form efficient portfolios
More generally, Kent et al.(2001) found the evidence that investors sometimes fail to form
efficient portfolios. Several experimental studies examined portfolio allocation when there are
two risky assets and a risk-free asset and returns are distributed normally. People often invest in
inefficient portfolios that violate two-fund separation.
Investors behavior is parallel to each other
This phenomenon, called herding, is consistent with rational responses to new information,
agency problems or conformity bias; Herding behavior has been documented in the trading
decisions of institutional investors, in recommendation decisions of stock analysts (Welch, 2000),
and in investment newsletter (Graham, 1999). According to Kent et al. (2002), people tend to
behave parallel with each other, regardless of whether the decisions are smart or not.
Investors are influenced by historical high or low trading stocks.
According to Kent et al. (2001), investors were very much influence by historical performance of
the stock price. This findings were consistent with (Daniel, Hirshleifer, Teoh, 2002) where they
suggest that investors may form theories of how the market works based upon irrelevant historical
values, somewhat analogous to making decisions based upon mental accounting with respect to
arbitrary reference points. This also relates to the idea of anchoring suggest by Tvernsky and
Karneman (1974) where investors set an initial value for future prices.

2.2.2

THE PSYCHOLOGY OF INVESTORS.

Since generation ago, stock market analysts have come to recognize that psychological factors
can play a more crucial role in determining the direction of the share prices. However studies
have found that, psychological factors alone cannot send the share price to the moon and then
push them down to the Precipice. Economic factors, as well as political factors also play a
crucial role in determining the share price.
Kahneman (1974) pointed out that people are prone to cognitive illusions, like becoming rich
and famous or being able to get out of the market before a bubble breaks. People exaggerate the
element of skill and deny the role of chance in their decision making process. People are often
unaware of the risky they take. Add loss aversion to the mix and its no wonder the average
investor panics in a market downturn, a time perhaps to buy rather than sell. According to him,
human beings are born optimists. This is precisely the reason why the casino is crowded twentyfour hours a day with luck-seekers. It is the optimistic human nature that tempts investors to buy
stocks and shares when their market prices have reached historic high. At this euphoric market
condition, investors should be selling their stock and shares.
Kent, Hirshleifer and Siew (2002), in their study found that research on the psychology of
investors was done by looking on the relationship between stock returns and variables on factors
such as the weather (Hirshleifer and Shumway, 2001), biorhythms (Samstra, Kramer and Levi,
2001) and societal happiness (Boyle and Walter, 2001). These diverse investigations are
motivated by emerging theories in psychological economics on visceral factors and the risk-asfeeling perspective. Visceral factors are the wide range of emotions, moods and drive states
that people experience at the time of making decision. The risk-as-feeling perspective argued
that these visceral factors could affect, and even override, rational cogitations on decisions
involving risk and uncertainty. This creates predictable patterns in stock returns because people
in good moods tend to be more optimistic in their estimates and judgments than people in bad
moods (Wright and Bower, 1992, in Kent et al, 2002). In relation to stock pricing, the optimistic
or pessimistic judgment about the future prospects from the business direction are widespread,
stock prices should be predictably higher at times when most investors are in good moods than
times they are in neutral or bad moods.
It was found that weather variables affect an individuals emotional state or mood, which creates
a predisposition to engage in particular behavior. It is also found that people have mood
variations based on the seasonal variations in the hours of sunlight in the day; the so-called
Seasonal Affective Disorder (SAD) (Rosenthal, 1991 in Kamstra, Kramer, and Levi, 2001).
Kent et al. (2002) in the study of investors psychology also found that it is particularly important
to note that the fast movement of prices of the stocks and shares in the stock market is largely due
to the investors perceptions such as (i) investors perceptions of the stochastic process of asset
prices; (ii) investors perceptions of value; (iii) Investors perception on the management of risk
and return; and (iv) investors trading practices.
Perceptions of price movements
In the equity markets, investors have tried to spot trends and turning points in stock prices. It is
the art of technical analysis, a model used to identify trend changes at an early stage and to
maintain an investment posture until the weight of the evidence indicates that the trend has
reversed. Investors sentiment is found to depend on market performance during the last 100
trading days, possibly much longer. The evidence overwhelmingly shows that peoples

subjective probability distributions are too tight, particularly, for difficult tasks like predicting
stock prices. Tversky and Kahneman (1974) suggest that the overconfidence results from
forecasters anchoring too much on their most likely prediction. And according to De Bondt
(1993), past price level is their anchor and representativeness.
Perceptions of Value
Perceptions of value depend on mental frames that are socially shared through stories in the news,
media, conversation, and tips from friends or financial advisors (Shiller, 1990). Many people
cannot distinguish good stocks from good companies. Thus, companies that appear on the cover
of major business magazines are seen as excellent investments while companies that report losses
seem inherently unattractive. On average, highly reputed companies seem overpriced.
According to De Bondt (1998), the underlying problem is that too many people are short-term
orientated and judge a book by its cover. Therefore, their valuation always leads to mispricing.
Managing risk and return
Studies found that small individual investors avoid the danger of risk by keeping hefty portion of
their financial wealth in risk-less assets even though equity shares offer more impressive long-run
return. This usually related to risk averse individuals. However, it is commonly believe that
aggressive investors ought to hold a higher ratio of stocks.
Trading practices
Many investors have a psychological disposition to realize gains on past winner stocks early and
an aversion to realize losses. Traders use a variety of rules and commitment techniques to control
emotion. Many individuals trade shares on impulse or on random tips from acquaintances,
without prior planning. One reason is that people are unjustifiably optimistic about almost
everything that concerns with their personal life (Weinstein, 1990 in Kent et al., 2002). Another
problem, mentioned earlier, is that trader sentiment trails the market. As a result, investors are
inclined to buy shares in bull markets and sell shares in bear markets. Finally, reference points
play a major role in trading behavior. They are performance benchmarks. The original purchase
price can be their salient reference point.
.
2.2.3 INVESTING STYLE
From the observation of the Kelantanese investors, Nik Maheran et al. (2003) found that most of
them usually make their first purchase based on the recommendation of a relative or friend. This
first trade usually is for a small amount of shares. If it is successful, the person typically follows
the friends or relatives next recommendation and buys more share than the first time.
Eventually this cycle comes to an abrupt end when the person losses a substantial portion, if not
all, of the money invested.
This finding is consistent with the previous research showing that a rational, long-term
investment plan is often undermined by the desire for quick profits. Indeed, investing in shares is
usually less exciting than speculative in them. For the average investor, a long-term view will
usually involve less anxiety and less need to follow the investment daily.
Peterson (1999) pointed out that the behavior of the investors when making investment decision
is Buy on the Rumor and sell on the news (BRSN). According to the EMH theory, investors

quickly price security-relevant news. For the BRSN pattern to represent price inefficiency, news
about the positive future event must have a delayed impact on investing behavior. News about
future events is often more rapidly disseminated and widely publicized as the events approach in
time.
Hameed and Ting (2000) found from the evidence of Malaysian Market, that the returns from a
contrarian portfolio strategy are positively related to the level of trading activity in the
Malaysian securities which involves buying and selling stocks when they become relatively under
and over valued.
3.

IMPLICATION

Why does it matter if small individual investors do not behave as we think that they should?
There are two reasons according to De Bondt (1998). The first is that substantial financial
management directly affects peoples well-being and the second reason is that investor behavior
likely affects what happens in markets. With costly arbitrage, psychological factors become
relevant and it would be unsound to model market behavior based on the assumption of common
knowledge of rationality. As stated by Graham and Dodd, in De Bondt (1998), the (stock)
market is not a weighing machine, on which the value of each issue is recorded by an extent and
impersonal mechanism Rather the market is a voting machine, whereon countless individuals
register choices which are the product partly of reason and partly of emotion.
4.

RECOMENDATION

With these financial theories in mind, here are some investment tips and tools that can help the
investors avoid many investors common behavioral mistakes. Many people do not begin
investing by setting goals and do not put enough emphasis on their specific time horizon. Many
people buy stocks or fund because it did well in the past, rather than also studying what it may do
in the future. Investors often dont focus enough on diversifying their portfolios. According to
Charles Heath, President of Roller Coaster Stocks, there are four rules before invest in stock
market. (1) dont invest with the crowd, (2) get emotional out of the way, (3) be patient, and (4)
take profit dont give them back.
Researches have shown that many investors are overconfident. The majority of investors believe
they can beat the market, despite historical evidence to the contrary. One reason that investors
may feel overconfident is that the Internet provides quick access to information and leaves people
feeling empowered to make decisions. However, information doesnt lead to good decisionmaking, unless we know how to interpret it.
Investor credulity and systematic mispricing in general suggest a possible role for regulation to
protect ignorant investors, and to improve risk sharing. The potential benefits of government
policy and regulations can help investors make better decisions, and can improve the efficiency of
the market prices.

Investors education, standardization of mutual fund advertising, disclosure rules and

reporting rules in making financial reports consistent and easy to process, may be helpful
for investors to make decision and also limit their freedom of action.

5.

CONCLUSION

From the prior research, it is found that there is persuasive evidence that investors make major
systematic errors and there is evidence that psychological biases affect market prices
substantially. Furthermore, there are some indications that as a result of mispricing there is
substantial misallocation of resources in the economy. Thus, there is some suggestion to the
economists to study how regulatory and legal policies can limit the damage caused by imperfect
rationality.
Emotions and psychological biases in judgment and decision seem to have important effects on
public discourse and the political process, leading to mass dilutions and excessive focus on
transiently popular issues. If individuals were fully rational in their market and political
judgments, therefore, government can intervene to remedy informational externalities in capital
markets. The case against such intervention comes from the tendency for people in groups to fool
themselves in political sphere, and for pressure groups to exploit the imperfect rationality or
political participants.
However, it was a suggestion to help investors make better choices and make the market more
efficient. These involve regulations, investment education, and perhaps some efforts to
standardize mutual fund advertising. Limits on how securities are marketed and laws against
market manipulation through rumor spreading can also protect foolish investors and restrict the
freedom of action of those that may prey upon them.

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