What Contribution Can Behavioural Finance Make to the Explanation of Stock Market Bubbles and Crashes?

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Last updated: April 26, 2019

M11 EFA BEHAVIOURAL FINANCE What contribution can behavioural finance make to the explanation of stock market bubbles and crashes? Name: Yuan Cao SID: 2925215 Email Address: [email protected] coventry. ac. uk TABLE OF CONTENT 1 INTRODUCTION…………………………………………………………..

3 2 BUBBLES AND CRASHES……………………………………. …………. 4 3 SOCIETY AND PSYCHOLOGY………………………………………….

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1 Overconfidence……………………………………………………………7 4. 2 Representativeness and Momentum…………………………………. …. 9 4. 3 Familiarity and Celebrity Stocks……………………………………….. 0 4. 4 Narrow Framing and positive feedback trading……………………….

12 4. 5 Confirmation bias and denial……………………………………………12 4. 6 Mental Accounting………………………………………. ……………….

13 5 CONCLUSIONS……………………………………………………………. 14 6 REFERENCES………………………………………………………………15 1 INTRODUCTION The phenomenon of Stock market bubbles is that the price of stocks has a sharp rise in a continuous process, the rise of initial price make investors believe that the prices will continue to rise, and then their probability-weighted expectations of gain attract more new investors.Moreover, the purpose of their trading is they intend to profit rather than to use it.

Therefore, the generation of bubble is from speculation activities of pursuing profit than investment activities. The occurrence of stock market bubbles against the assumption of the efficient market hypothesis is that investors are rational. (Keith Redhead2008) But in real life, the participants in stock market are not only rational investors who pursue the dividends but also most of participants are the irrational speculators who pursue the high profit of ascending stock price.Therefore the stock market will be inefficient when the irrational investors are more than rational investors in stock market.

Therefore, the investors’ psychology and behaviour have important and considerable influences on the fluctuation of stock price. 2 BUBBLES AND CRASHES Some writers argued that most bubbles and crashes have common characteristics. Stock prices have large and rapid increases, which leads to share prices rising to unrealistically high levels. (Keith Redhead2008:541) For instance, the Nikkei stock index closed at 13,083 at the end of 1985 and closed at 38,919 at the end of 1989.In these four yours, the Nikkei stock index accumulatively increased 197. 45%. At the initial stage of bubbles, the emergence of new theories or products would justify for the high rise of stock prices. For instance internet was used in the late 1990s.

The persistent and large increase in share prices leads to people believe the prices would continue to rise, so investors buy more shares and intend to gain the huge profit, then the most of investors become to speculators.In the investors, most of them do not have the knowledge of finance, and they just imitate the judgments and behaviours of others. Such herd behaviour push price to unrealistically high levels. (Keith Redhead2008) Keynes’s (1936) beauty contest can be used to explain the stock market bubbles, and the view argues that investors imitate the behavior of others and ignore their own judgment because they want to maximize their profits from the rising stock market. (Keith Redhead2008) 3 SOCIETY AND PSYCHOLOGYIn the society, many investors tend to follow others’ behavior and ignore their own judgment. In a certain time, if the most of investors in financial market conform to the other investors’ behavior, and their behaviours represent the consistency and convergence, such behavior leads to form of herding, and the phenomenon of herding has a great impact on efficiency and stability in financial market, though it increases investors’ short-term benefits. However, herding behavior can help explain the bubbles and crashes.

Herding can be distinguished to intentional and unintentional herding. ( Walter&Weber2006) Intentional herding arises from some investors like to conform to others’ behaviors because they without enough and accurate information and knowledge on stock markets. For example, an article on ShangHai Security News reports the individuals’ herding behavior leads to Shanghai composite index rush to 6000 point and plunge below 2700 points. (Liang Yufeng 2006) Unintentional herding arises from investors analyse the same information by using same method, which often happen in fund managers.John R. Nofsinger (2011) found that the trading of institutional investors mainly drive the herding in stock markets. Walter and Weber(2006) found that mutual fund managers bought stocks then price rises and sold then falls.

(Keith Redhead2008) Therefore, individuals may follow the strategy of institutional investors and result in unintentional herding. In a bull stock market, blind and over chase rising lead to generate the bubbles; In a bear market, blind and hasty sell out stocks lead to crashes.The herding behavior results in the great volatility of stock prices and decrease the stability and efficiency of the stock markets. Investors predict current risk in stock market base on the past outcome, so they are willing to take more risks after gains and less risk after losses. ( John R. Nofsinger 2011: 35) These effects are called ‘house money’ and snake bite’ effects. Gamblers do not regard the new money as their money after gaining in the stock market, and they would like to use profit to invest and bet when stock prices rise.So house money effect contributes to bubbles.

Conversely, gamblers are willing to decrease the gamble when they experience a loss. The pain of loss makes investors sell out their stock to avoid the risk of more loss. So snake bite effect contributes to crashes. (Keith Redhead2008) 4 BEHAVIOURAL FINANCE FOR UNDERSTANDING BUBBLES AND CRASHES There are many kinds of investors (such as naive individuals, professional investors or senior financial analysts) in stock market, they are trying to determine the market and make reasonable decision in a ration manner.But as the ordinary people, their judgment and decision-making process would be impacted by some factors, such as cognitive process, emotional fluctuation, social mood and willpower. Finally, their behaviours or decisions may fall into cognitive trap, leading to behavioural biases in the stock market. Some of behavioiral biases can explain how bubbles and crashes happened in the stock markets.

4. 1 Overconfidence Psychologists found that people tend to overestimate their ability of judgment and like to attribute success to their ability, and they underestimate the influence of luck and opportunity.This cognitive bias can be called overconfidence. The overconfidence is partially from a psychological bias that is the illusion of knowledge. The illusion of knowledge mentions that people believe their prediction is right increases with more information, but this information may increase investors’ confidence at a faster rate than accuracy of prediction. ( John R. Nofsinger 2011) However, investors may overconfident on their decision when they obtain increasing knowledge, and then they may believe their forecast and ignore some risk factors. Another psychological factor is the illusion of control.

People think they have influence over the incontrollable events. ( John R. Nofsinger 2011) there are many factors foster the illusion of control, such as choice, outcome sequence, task familiarity, information, active involvement and past successes. In addition, online trading enhances the illusion of control. Barber and Odean found that the online trading makes investors more overconfidence and increase excessive trading.

( Barber&Odean2002) Therefore, the most recent bubble happen in technology stocks. The process of investing is difficult. nvestors must collect information, analyze it and make a decision based on that information.

And overconfidence leads to investors distort the accuracy of information and overestimate their ability in analyzing. ( John R. Nofsinger 2011) Moreover, overconfidence is more pronounced when decision-making task is challenging, and overconfidence has direct and indirect influences for investors’ process of the information. The direct impact is that investors over depend on the information they collected and ignore the information from financial statement of companies.And the indirect impact is investors focus on the information that can enhance their self-confidence and ignore the information that hurt their self-confidence in their analysis of information. Hilary and Menzly(2006 ) found that success leads to overconfidence, that reach the highest peak in the bull market and hit the bottom in the bear market.

The following picture shows the cycle of market emotions, bull market lead to more people overconfident, and continuous increased stock price make people think they are intelligent and enhance their overconfidence.Therefore, overconfident investors push stock price to unrealistically high levels and help to generate bubbles and crashes in stock markets. (Source: http://www. mackensen. com/you-should-know/cycle-of-market-emotions-graphic. cfm 4. 2 Representativeness and Momentum Representativeness is that people tend to conclude the probability of an event by some similar characteristics of another thing and do not consider the other related features.

People assume that future event is similar with past event and seek similar event to judge, and do not consider its reasons and probability of repetition.This process of reasoning is called representativeness heuristic by cognitive psychology. Kahneman and Tversky(1974) reveals there are two serious biases when people use representativeness heuristic to analyse and judge.

Firstly, it focuses a certain characteristic of the event too much and ignores the other relevant probabilities, which lead to the belief bias. Secondly, it ignores the impact of sample size. Investors often make representativeness errors in stock market. DeBondt and Thaler (1985) indicate that the investors tend to overreact while amending probability.They pay more attentions and analysis on recent information than the overall base rate data, and they overreact on probability of profit lead to push stock prices deviate from real value of stock. Furthermore, the one explanation of representativeness is that investors think recent price increases are representative of continuous successes.

(Keith Redhead 2008) The persistence of representativeness would lead to bubbles or crashes. Extrapolation bias is a subset of the representativeness bias because investors often extrapolate past stock returns into future. ( John R.Nofsinger 2011) And investors prefer to follow winners and buy stocks that have increased in the past. ( John R. Nofsinger 2011) However, losers tend to be better-behaved than winners over the next three years by 30 percent. ( John R. Nofsinger 2011) And investors are following the winners that is so popular, and it is called: momentum investing.

Momentum traders judge that the stock price movement continues in a direction, and they just look for good perform of stock over the past week, month even hours. (Keith Redhead 2008) Especially Momentum is very significant in hi-tech bubbles, and media exacerbate bias.The researchers found that there is a trend that almost all investors prefer following and the most of investors persist for several years. This continuous momentum is the portentous information of bubbles. (Keith Redhead 2008) In a word, investors regard past trend of stock as representativeness of future expectations.

But complicated and mutable stock market does not perform as expected. And extrapolation biases lead to momentum trading. So representativeness bias and momentum accelerate the bubbles or crashes to happen.

4. Familiarity and Celebrity Stocks The familiarity bias is people prefer to invest in stocks they are familiar to them, so they are willing to invest more money in their own country and local companies than foreign countries and foreign companies, this is also called “ home bias”. The International Monetary Fund surveys the equity portfolio in each country every year, and the research finds that investors prefer to invest their money at home countries. Indeed, they like to purchase she stocks of local companies they are familiar to them. ( John R.Nofsinger 2011) Similarly, employees prefer to trust the stock of their own company is safer than various stock portfolios.

For instance, 60 percent Enron stock is Enron employee401(k) assets when the stock peak values, and thousands of Enron employees get 401(k) losses of $1. 3 billion. ( John R. Nofsinger 2011) The familiarity bias makes people too confident in the familiar stock, analyzing and forecasting them too optimistically. So when babbles or crashes are coming, investors’ familiarity bias generates the distortion of information and illusion of price rise.

For instance, probability of internet bubble is increasing in recent years because investors think they are familiar to them, so they prefer to purchase internet stocks. (Keith Redhead 2008) Moreover, Internet stocks seem to a celebrity status. Recent society is going to the network information age, and we touch the media every day, even every hour. Therefore, media promote the development and expansion of internet investing and settle the celebrity status of internet stocks. Nowadays, the most stock market information the people know is form the news of media, and this cause a culture of interment investing.

Keith Redhead 2008) Therefore, media accelerates the internet stock bubble. Traditional portfolio theory advises people should diversify their stock investing. Clifford Asness, Roni Israelov and John M. Liew(2010) found that although international diversification may not protect in a short time, it protect you well over longer horizons. The following table shows real cumulative return from each investors’s perspective since 1950 for some countries, every instance indicates the global equity portfolio outperforms the domestic equity. 4.

4 Narrow Framing and positive feedback tradingNarrow framing makes investors pay more attention on the short-term stock price. (Keith Redhead 2008) Narrow framing leads to the people only analyse and consider recent incomprehensive information and ignore long-term information. Therefore, it enhances the tendency of representativeness to causes investors’ inappropriate long-term expectations depend on short-time price fluctuation. (Keith Redhead 2008) In short, narrow framing is one reason of stock market bubbles or crashes. Short-time stock price increases result in investors has expectations of future increases and continue to buy more shares. Keith Redhead 2008)This behavior push stock price up and impel bubbles or crashes to come, the process of price increase often regard as positive feedback trading. 4. 5 Confirmation bias and denial Investors do not want change their opinion when investors have a confident expectation, even though the stock prices have moved too far.

(Keith Redhead 2008) People have a tendency to look for supportive evidence of a hypothesis and ignore the information that may disprove the hypothesis, so this behavior is known as confirmation bias. This is like the psychoanalytic concept of denial.Denial makes investors do not want to touch and learn from unhappy experiences because these kinds of experiences are removed from conscious mind. (Keith Redhead 2008) Unconscious mind has a significant influence on the early investing of stocks. (Keith Redhead 2008) Although people are not aware of their unconscious mind, that often impacts their decision and judgment. Investors’ unconscious mind is a reason of bubbles.

When stock prices are from the peak to fall, people would feel panic, shame and regret, so they sell the stock as soon as possible to avoid the more loss and terrible feeling.This behavior is a part of process of denial, and it accelerates stock crushes. 4. 6 Mental Accounting People put expenditure and income into different mental account. The mental accounting is a cognitive illusion, because people prefer to classify the cost according to the importance and non-importance. for instance, people put salary into ‘hard-working account’, and put year-end bonus into ‘reward account’.

So people use their hard-working account carefully and use ‘reward account’ generously.This cognitive illusion affects the investors in financial market, and makes investors generate irrational investment behaviour. Indeed, mental accounting affects investors’ judgment of risks. Therefore, mental accounting is one reason of bubbles and crushes. 5 CONCLUSIONS In conclusion, no one can avoid the affect of psychological biases. And this essay uses behavioural finance to explain the stock market bubbles and crashes, and this analysis benefit to investors for overcoming the biases. In addition, there are five suggestions for investors.

Firstly, understand psychology biases and inspect the biases in yourself for avoiding them in time. Secondly, know the purpose of investment and do not miss the goal in the complex investment environment. Thirdly, diversify money into different investments. For instance stocks, bonds and firms. Fourthly, use professional quantitative investment criteria to analyse the financial market, instead of rumor, emotion or feeling. However, the behavior finance plays important role in bubbles and crashes, investors must know behavioural biases very well for avoiding the risks when bubbles and crashes are coming.

REFERENCES 1 Keith Redhead(2008) Personal Finance And Investments :A Behavioural Finance Perspective. Abingdon, UK:Routledge 13 Keith Redhead(2008), A Behavioural Model Of The Dot. Com Bubble And Crash, Applied Research Working Paper Series Economic, Finance And Accounting 2 Keynes, J.

M. (1936). The General Theory Of Employment, Interest And Money, Macmillan. 3 Walter, A. And F. M.

Weber (2006). ‘Herding In The German Mutual Fund Industry’, European Financial Management 4 Liang Yufeng, Shang Hai Stock News(2006), The Herding Leads To Crash, [Online] Available From ( Http://Www.Cnstock.

Com/Paper_New/Html/2008-07/01/Content_62440852. Htm) [ 3rd Apr 2011] 5 John R Nofsinger(2011), The Psychology Of Investing, US: Prentice Hall 6 Brad Barber&Terrance Odean(1999), The Courage Of Misguided Convictions, Financial Analysts Journal 7 Brad Barber & Terrance Odean (2002), Online Investors: Do The Slow Die First, Review Of Financial Studies15 8 Gilles Hilary& Lior Menzly(2006), Dose Past Success Lead Analysts To Become Overconfident, Management Science 52 9 Picture: The Cycle Of Market Emotion, [Online] Available From <Http://Www.Mackensen. Com/You-Should-Know/Cycle-Of-Market-Emotions-Graphic. Cfm> [ 3rd Apr 2011] 10 Tversky, A. , Kahneman, D.

(1974). Judgment Under Uncertainty: Heuristics And Biases. Science 11 Werner De Bondt&Richard Thaler (1985),Does The Stock Market Overreact? Journal Of Finance 12 Clifford Asness, Roni Israelov And John M. Liew(2010) International Diversification Works, [Online] Available From Source: <Http://Papers.

Ssrn. Com/Sol3/Papers. Cfm? Abstract_Id=1564186> [ 7th Apr 2011]


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