Behavioral Finance: How Investor Reacts in Decision

Involving Risk?

INTRODUCTION

Behavioral finance is the integration of classical economics and finance with Psychology and
the decision-making sciences. This study is related to the fact that how investors give
different weightage to investment under similar situation. Some people systematically make
errors in judgment or mental mistakes. Much of the economic theory available today is
based on the belief that individuals behave in a rational manner and that all existing
information is embedded in the investment process or no attention being given to the
influence of human behavior on the investment process.

In fact, researchers have uncovered evidence that rational behavior is not often the case.
Behavioral finance attempts to understand and explain how human emotions influence
investors in their decision making process. These mental mistakes can cause investors to
form biased expectations regarding the future that, in turn, can cause securities to be
mispriced. Behavioral finance is based on the psychology of investors. Psychology primarily
deals with human fallibility, systematic mistakes and biased judgment.

HOW INVESTOR BEHAVE WHILE INVESTING & WHY?

Behaviour Finance field is so new, most professionals responsible for large portfolios were
not exposed to the principles of behavioral finance in their college curricula and these
principles have significant practical implications for investment management.

Consequently, this article provides an overview of behavioral finance. No matter how much
investor is well informed, have done research, studied deeply about the stock before
investing then also he behave irrational with the fear of loss in the future. For instance the
loss of $1 dollar twice as painful as the pleasure received from a $1 gain.

It consider the Idea that people are Irrational & make investment decision from many
reasons for instance some while investing wants to behave like professional & are over
confident, some follow the past trends followed by others.

Tversky and Kahneman originally described "Prospect Theory" in 1979. They found that
contrary to expected utility theory, people placed different weights on gains and losses and
on different ranges of probability. They found that individuals are much more distressed by
prospective losses than they are happy by equivalent gains.

Following Question was asked to the two groups of investors 'A' & 'B' (Identification is not
disclosed due to secrecy reason)

When you invest in a new stock issue, what effect do you expect?

INVESTOR'S GROUPS (I) (II)

Investment will give sure gain of Probability of .5 to gain 100% &
50% of your investment probability of.5 to lose 100%
A 84% 16%
B 31% 69%
From the above table it is clear in the survey that in Group A 84% of the investors choosed
(I) & in Group B 31% choosed (I) Thus it is found that individuals will respond differently to
equivalent situations depending on whether it is presented in the context of losses or gains
This research found that people are willing to take more risks to avoid losses than to realize
gains. Faced with sure gain, most investors are risk-averse, but faced with sure loss,
investors become risk-takers. Buying a stock with a bad image is harder to rationalize if it
goes down. Investors typically give too much weight to recent experience and extrapolate
recent trends that are at odds with long-run averages and statistical odds. In general
individuals tend to feel sorrow and grief after having made an error in judgment.

Typically, investors deciding whether to sell a security are emotionally affected by whether
the security was bought for more or less than the current price Investors sell winners more
frequently than losers. Odean (2000) studies 163,000 individual accounts at a brokerage
firm. For each trading day during a period of one year, Odean counts the fraction of winning
stocks that were sold, and compares it to the fraction of losing stocks that were sold. He
finds that from January through November, investors sold their winning stock 1.7 times
more frequently than their losing loosing stocks. In other words, winners had a 70 percent
higher chance of being sold. This is an anomaly, especially as for tax reasons it is for most
investors more attractive to sell losers.

PSHYCOLOGY OF INVESTOR & EFFICIENT MARKET THEORY

Intellectual dominance of the efficient-market revolution has more been challenged by

economists who stress psychological and behavioral elements of stock-price determination.

Efficient market theory makes two sharp predictions. First, market prices

Equal to intrinsic value. In other words, financial assets have an objective value based on
economic fundamentals, expected cash flows and their level of risk (measured in various
units). The second prediction is informational efficiency-- that prices adjust rapidly to the
arrival of new information and therefore, because news arrives randomly, past price
changes do not predict future price changes. There are very few people, if any, for whom
the prediction is entirely correct that investors are rationale & reflection of new information
is immediate & accurate on stock prices as per EMH Theory.

Another aspect of behavioral finance concerns how investors form expectations regarding
the future and how these expectations are transformed into security prices. Researchers in
cognitive psychology and the decision sciences have documented that, under certain
conditions, people systematically make errors in judgment or mental mistakes. These
mental mistakes can cause investors to form biased expectations regarding the future that,
in turn, can cause securities to be mispriced.

By considering that investors may not always act in a wealth maximizing manner and that
investors may have biased expectations, behavioral finance may be able to explain some of
the anomalies to the EMH that have been reported in the finance literature. Anomalous
returns such as those associated with "value" stocks, earnings surprises, short-term
momentum and long-term price reversals are fertile ground for researchers in.

There is a growing consensus that security markets are not as efficient as we thought
before. The inefficiency is generally attributed to behavioral biases of investors. Since many
behavioral biases have been documented in the cognitive psychology literature, almost any
patterns in the financial markets can be linked to one or several of these biases. However,
"the potentially boundless set of psychological biases that theorists can use to build
behavioral models and explain observed phenomena creates the potential for 'theory
dredging.'" (Chan, Frankel and Kothari, 2002) Furthermore, many theories, while consistent
with empirical patterns that they are set out to explain, are not consistent with other
empirical results. For example, while Bloomfield and Hales (2002) find evidence supportive
of behavioral model of Barberis, Shleifer, and Vishny (1998) in a laboratory setting,
Durham, Hertzel and Martin (2005) find scant evidence that investors behave in accordance
with the model using market data. The link between behavioral theory and investment
behavior are often vague. For example, empirical works reveal that small investors' trading
activities often hurt their investment return (Hvidkjaer, 2001). This is usually thought that
small investors are more prone to behavioral biases than professionals, who are better
trained (Shanthikumar, 2004). Yet some empirical work suggests that professionals exhibit
some behavioral biases to a greater extent than non professionals (Haigh and List, 2005).

CONCLUSION

This study has empirically examines how investor behave while taking investment decisions
which involve risk, it shows that market participants evaluate financial outcomes in
accordance with prospect theory .It shows that psychology of investor effect the share
movement. Moreover, a greater sensitivity to losses than to gains implies that decisions
differ according to how a choice problem is framed.

One particularly important question to be answered within this context is, of course,
whether irrational behavior of individual market participants may also lead to inefficiency of
the market as a whole. Indeed, it is conceivable that even if the average investor behaves
according to the psychological mechanisms mentioned, the market as a whole will generate
efficient outcomes anyway. However, this is not the case, behavioral finance argues, for
example because the arbitrage required to compensate for price inefficiencies is costly and
risky. We often hear the great news on television, the radio or read it in newspapers. "The
market hits new highs!" With all this wonderful news and quotes from industry experts, it is
easy to extrapolate that the upward trend will continue. Millions of people come to the
conclusion that "It is safe to invest again!" Orders flood in and volume soars as prices rise.
This, in itself, is irrational behavior. You would think that the rational man or woman would
want to buy equities when they are on sale. Yet it is often when prices hit their peak that
many people decide it is time to buy.