Relevance Of Behavioral Finance In Malaysias Financial Scenario Finance Essay - Free Essay Example

Sample details Pages: 5 Words: 1629 Downloads: 5 Date added: 2017/06/26 Category Finance Essay Type Cause and effect essay Did you like this example? Investors think and act rationally when it comes to buying and selling stocks according to economic theorists. The economists have opined that the financial markets are stable and efficient due to the stock prices that seem to follow an expected pattern and the overall economy portrays trends toward general equilibrium. According to Shiller (1999), in real world, the investors do not investigate and act rationally. Don’t waste time! Our writers will create an original "Relevance Of Behavioral Finance In Malaysias Financial Scenario Finance Essay" essay for you Create order Investors speculate stocks between unrealistic highs and lows because of their attitude of greed and fear. This type of investors behavior is known as behavioral finance which explains on how emotions and cognitive errors influence investors and the decision making process. The behavioral finance is a study of the markets which related to a psychology aspect where it concerns more on the reason why people buy or sell the stocks and also in the event where they do not buy stocks at all. This study encompasses research that revised the traditional assumptions of expected utility maximization with rational investors in efficient market. The two pertinent points of behavioral finance are cognitive psychology and the limits to arbitrage (Ritter, 2003). Cognitive refers to a situation where how people think and the limit to arbitrage when market is inefficient. Behavioral finance uses models in the case of some agents in a situation of not fully cautious either because of preferences or because of mistaken beliefs i.e. the loss averse agent. Herbert Simon (1947, 1983) indicated that many of the basic theories of behavioral finance related to a series of new concept of bounded rationality. It is related 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). A study has been done by Slovic (1972) on investment risk-taking behavior and 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). 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. THE BEHAVIOR OF INVESTORS 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 emotionbased judgments. This is due to reason that 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. 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. 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. 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 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. Kent, Hirshleifer and Siew (2002), in their study found that re search 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. 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 an 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 mo st investors are in good moods than times they are in neutral or bad moods. . EVIDENCE FROM MALAYSIAN INVESTORS Based on the descriptive analysis of 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. However, in terms of relying on emotions (i.e. gut-feeling, over-reaction), most respondents rate that they are unlikely in doing so. IMPLICATION Why does it matter if small individual investors do not behave as we think 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 is likely to affect 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, where countless individuals register choices which are the product partly of reason and partly of emotion. RECOMMENDATION With these financial theories in mind, here are some investment tips and tools that can help the investors to 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 studying what it may do in the future. Investors often do not focus enough on diversifying their portfolios. According to Charles Heath, President of Roller Coaster Stocks, there are four rules before investing in stock market. (1) do not invest with the crowd, (2) get emotional out of the way, (3) be patient, and (4) take profit do not 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 does not lead to good decision making, 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. CONCLUSION From 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 are some suggestions 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 pr essure groups to exploit the imperfect rationality or political participants. However, it is 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.