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Behavioral Finance Vs Traditional Finance

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Advance Management Journal……………………………………………….Vol. 2 (6) June 2009

BEHAVIORAL FINANCE vs TRADITIONAL FINANCE

Nik Maheran Nik Muhammad
Faculty of Business Management
Universiti Technology Mara, Kelantan
nmaheran@gmail.com

Abstract

Behavioral finance models often rely on a 1. INTRODUCTION

concept of individual investors who are
prone to judgment and decision-making
errors. This article provides a 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 reviews
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.
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
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. In the contrary, driven by greed
and fear, investors speculate stocks between
unrealistic highs and lows. In other words,
investors are misled 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 explains 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

1
Advance Management Journal……………………………………………….Vol. 2 (6) June 2009
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. Are they rational in their
decision making or emotional and based on
sentiment? The balance of the paper is
organized as follows. Section 2 surveys on
literature while Section 3, 4 and 5 will
include 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 the
subject is.
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
2
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 market is inefficient.
There is a huge psychology literature
documenting that people make systematic
errors in the way they think: they always
make 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
Advance Management Journal……………………………………………….Vol. 2 (6) June 2009
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 shows 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 people’s
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
3
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 its 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, they 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 it is 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,
Advance Management Journal……………………………………………….Vol. 2 (6) June 2009
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) 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 were 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
4
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 finding
was consistent with the theory of Odean
(1998) who showed that individual investors
are 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
naive 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 tend to overreact
more to unreliable than to reliable
information. Stronger support for
overconfidence is provided by evidence
suggesting that more active investors earn
Advance Management Journal……………………………………………….Vol. 2 (6) June 2009
lower returns as a result of incurring higher
transaction costs (e.g., DeBondt and Thaler,
1995). Odean (1999) noted that males trade
more aggressively 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 were 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 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
5
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 influenced by historical
performance of the stock price. These
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 suggested by Tvernsky
and Karneman (1974) where investors set an
initial value for future prices.
2.2.2 THE PSYCHOLOGY OF
INVESTORS
Since a 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
Advance Management Journal……………………………………………….Vol. 2 (6) June 2009
making process. People are often unaware
of the risk they take. Add loss aversion to
the mix and it is 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 twenty-four 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 at 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-as-feeling” 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
individual’s emotional state or mood, which
creates a predisposition to engage in
particular behavior. It is also found that
6
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
people’s 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. Moreover, 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
Advance Management Journal……………………………………………….Vol. 2 (6) June 2009
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 is usually related to risk
aversed individuals. However, it is
commonly believed 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.
. Based on the descriptive analysis of
2.2.3 INVESTING STYLE
From the observation of Kelantanese
investors, Nik Maheran et al. (2003) found
that most of them usually make their first
7
purchase based on the recommendation of a
relative or friend. This first trade is usually
for a small amount of shares. If it is
successful, the person typically follows the
friend’s or relative’s 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
speculating 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. EVIDENCE FROM MALAYSIAN
INVESTORS
investment decision making behavior, it
shows that economic factor is the most
influential factor in determining their
investment buying behavior followed by
financial and frame of references.
Advance Management Journal……………………………………………….Vol. 2 (6) June 2009

However, in terms of relying on emotions help the investors to avoid many investors’
(i.e. gut-feeling, over-reaction), most common behavioral mistakes. Many people
respondents rate that they are unlikely in do not begin investing by setting goals and
doing so. do not put enough emphasis on their specific
time horizon. Many people buy stocks or
Table2: Behavioral profile fund because it did well in the past, rather
N=147 than studying what it may do in the future.
Std. Investors often do not focus enough on
Variables Mean Deviation diversifying their portfolios. According to
Rational Charles Heath, President of Roller Coaster
Behavior Stocks, there are four rules before investing
Environment 3.00 .847 in stock market. (1) do not invest with the
Financial 3.69 .942 crowd, (2) get emotional out of the way, (3)
Economy 3.80 .628 be patient, and (4) take profit – do not give
Irrational them back.
Behavior
Emotion Researches have shown that many investors
2.95 1.057
are overconfident. The majority of investors
Frame of
3.1850 .76143 believe they can beat the market, despite
references
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
4. IMPLICATION
empowered to make decisions. However,
information does not lead to good decision-
Why does it matter if small individual
making, unless we know how to interpret it.
investors do not behave as we think they
should? There are two reasons according to
Investor credulity and systematic mispricing
De Bondt (1998). The first is that
in general suggest a possible role for
substantial financial management directly
regulation to protect ignorant investors, and
affects people’s well-being and the second
to improve risk sharing. The potential
reason is that investor behavior is likely to
benefits of government policy and
affect what happens in markets. With costly
regulations can help investors make better
arbitrage, psychological factors become
decisions, and can improve the efficiency of
relevant and it would be unsound to model
the market prices.
market behavior based on the assumption of
common knowledge of rationality. As
Investors’ education, standardization of
stated by Graham and Dodd, in De Bondt
mutual fund advertising, disclosure rules and
(1998), ‘ – the (stock) market is not a
reporting rules in making financial reports
weighing machine, on which the value of
consistent and easy to process, may be
each issue is recorded by an extent and
helpful for investors to make decision and
impersonal mechanism – rather – the market
also limit their freedom of action.
is a voting machine, where countless
individuals register choices which are the
product partly of reason and partly of 6. CONCLUSION
emotion’.
From prior research, it is found that there is
5. RECOMMENDATION persuasive evidence that investors make
major systematic errors and there is
With these financial theories in mind, here evidence that psychological biases affect
are some investment tips and tools that can market prices substantially. Furthermore,
there are some indications that as a result of

8
Advance Management Journal……………………………………………….Vol. 2 (6) June 2009

mispricing, there is substantial misallocation De Bondth Werner F.M., (1991), What do

of resources in the economy. Thus, there are economists know about the stock
some suggestions to the economists to study market? Journal of Portfolio
how regulatory and legal policies can limit Management 18, 84-91
the damage caused by imperfect rationality.
De Bondth Werner F.M., (1993), Betting on
Emotions and psychological biases in trends: Intuitive forecasts of financial
judgment and decision seem to have risk and return. International Journal
important effects on public discourse and the of Forecasting 9, 355-371
political process, leading to mass dilutions
and excessive focus on transiently popular De Bondth Werner F.M., (1991), Behavioral
issues. If individuals were fully rational in Economics; a portrait of individual
their market and political judgments, investors. European Economic
therefore, government can intervene to Review 42, 831-844.
remedy informational externalities in capital
markets. The case against such intervention Herbert A Simon (2001); Rational Decision
comes from the tendency for people in
Making in Business Organizations
groups to fool themselves in political sphere,
and for pressure groups to exploit the
imperfect rationality or political participants. Hirshleifer, D., (2001). Investor Psychology
and Asset Pricing. Journal of
However, it is a suggestion to help investors Finance, 56, 1533-1597
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investment education, and perhaps some D., (2000). Losing sleep at the market;
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also protect foolish investors and restrict the Kenney, Derrick, (2003). Investor
freedom of action of those that may prey psychology plays key role in market
upon them. plays, forth worth, Business Press,
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