This week deals with efficient market and behavioral issues in corporate finance. To understand the theory, evidence of proble

Volume 12 Issue 14 Version 1.0 Year 2012 Type: Double Blind Peer Reviewed International Research Journal Publisher: Global Journals Inc. (USA) Online ISSN: & Print ISSN:

Abstract – According to the prior studies individual investors do not act according to the

traditional finance assumption. Rather they take investment decision under the influence of

several psychological and other factors. In this paper individual investors of Dhaka Stock

Exchange (DSE) were taken under survey on sample basis who are on the market since 2008 till

now. The study was made to identify the most influential factors which affect investment decision

of individual investors. For this purpose demographic and social economic variables were asked

under different questions. The paper discussed and used relevant theories to select those

questions. Investors’ response was used apply under PCA. After factors analysis it was found

that Psychological factor is the most dominating influence upon investor’s decision making

process. Micro economic factor and social factor also have influence on selecting investment

securities. Though not very much but, little influence also has been observed by macroeconomic

factor and. Index and knowledge of financial analysis of stock market is not very significant to the

investors in fact most of the investors do not understand the process and exact meaning of

index. It is suggest that, the amateur investors should gather more knowledge about the market

and take every declaration under consideration. In order to avoid herd behavior, investors can

gather past data and control their representative bias if they want to seek target profit.

Keywords :

JEL Classificaiton : G 02, G 10, G14,G11, C38.

Strictly as per the compliance and regulations of:

Behavioral Finance, General financial economic, Market efficiency, Investment

decision, Factor model.

© 2012. Sohani Islam. This is a research/review paper, distributed under the terms of the Creative Commons Attribution- Noncommercial 3.0 Unported License http://creativecommons.org/licenses/by-nc/3.0/), permitting all non-commercial use, distribution, and reproduction in any medium, provided the original work is properly cited.

Behavioral Finance of an Inefficient Market

Behavioral Finance of an Inefficient Market Sohani Islam

Abstract – According to the prior studies individual investors do not act according to the traditional finance assumption. Rather they take investment decision under the influence of several psychological and other factors. In this paper individual investors of Dhaka Stock Exchange (DSE) were taken under survey on sample basis who are on the market since 2008 till now. The study was made to identify the most influential factors which affect investment decision of individual investors. For this purpose demographic and social economic variables were asked under different questions. The paper discussed and used relevant theories to select those questions. Investors’ response was used apply under PCA. After factors analysis it was found that Psychological factor is the most dominating influence upon investor’s decision making process. Micro economic factor and social factor also have influence on selecting investment securities. Though not very much but, little influence also has been observed by macroeconomic factor and. Index and knowledge of financial analysis of stock market is not very significant to the investors in fact most of the investors do not understand the process and exact meaning of index. It is suggest that, the amateur investors should gather more knowledge about the market and take every declaration under consideration. In order to avoid herd behavior, investors can gather past data and control their representative bias if they want to seek target profit. Keywords : Behavioral Finance, General financial economic, Market efficiency, Investment decision, Factor model.

I. Introduction

nvestment is a rational income generating decision which normally leads by investor’s necessity of periodic income. Individual amateur investors want to

invest their extra savings on the basis of their demand for income. Jeff Madura (Financial market and Institution, 8th Edition, Ch 8) mentioned it as “Matching principle” which is even responsible to affect price of securities. When fixed income earning people invest in the capital market, they will expect to earn something extra on a regular basis, to get compensation for the risk. The acceptance of compensation depends on that person’s risk tolerance, financial back up the nearby social factors. Not all the investment is profitable, and not all the investment is loss-bearing. The key to a successful financial plan is to keep apart a larger amount of savings and invest it intelligently (Kabra et at, 2010). There are several parameters to determine which has influence upon investment decision such as return,

Author : Assistant Professor (Finance), Department of Business

Administration, Stamford University Bangladesh, 51 Siddeswari Road, Dhaka Bangladesh. E-mail : [email protected]

flexibility, perception towards risk, etc. Investors’

ideology regarding the parameter also depends upon that person’s socio- economic and demographic condition, like, age, fender, profession, saving, rick adjustment etc. study of investor’s such character will help to portrait investment attitude of any investors. This will be helpful to the stock brokers and portfolio managers so that they can offer better portfolios to their investment. This analysis will show the mentality of an investor and his preferences of investment concisely. On that light this study is taken place to identify the major influential factors which leads the investors to pick their desired stocks.

Many works and research s have been made upon what factors may affect investment decision of investors. It is found that, investment choice may vary from country to country, but, in most of the studies individual investors’

choice of investment if taken quite

emotionally rather than rationally. Srivastava (2012) surveyed between two different groups of Indian investors on the basis of theories of behavioral finance. According to his identification, people’s experience leads them to take more rational decision than the inexperienced one. Individual investors are influenced by several biases. So if they can reduce or control the effect, rational decision is possible to make.

Baghdabab et al (2011) studied the behavior of Malaysian investors. They have identified 13 influential factors by surveying on the basis of literature review. According to their study firm’s public information is the most influential factors. Financial ratios, and past information are ignored and not taken

as consideration

prior to investment by the potential and existing armature investors of the market. The study did not follow any particular theory; however, the basic behavioral theories were used to enlighten the selection of variables.

Kenneth A. Kim and John R. Nofsinger (2003) studied investors’ behavior of Japan. It was found that individual investors make comparatively poor choice. They own stocks with high risk, large book-to-market (BM) ratios, high trading volume, and earn low returns.

Different findings are drawn from different case

studies by researchers’ of different countries. Behavioral finance theories were exploited to identify the factors. In this paper, theories were discussed at first assuming the market is inefficient. Then that basis,

variables were

used as option of 17 relevant questions. Factors were identified and justified on the basis of both theories and practical. Then some suggestion has been offered

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which can be applied by the legal enforcement authority o reduce the market information.

a)

Rationality and

Objective

Efficient Market Hypothesis (EMH) is required

by all type of stock market for having a steady growth and avoiding the tendency to become a bear market. However, economic condition and weak market regulation often let the market–planner to manipulate with investors common psychology and tendency. As a result the world economy face scammed crash on the stock market.

Market efficiency is a subject of discussion in

Dhaka Stock Exchange (DSE). The general market index never has a steady upward trend except 2008-09 (See Appendix 2). After 1996, either the market had a sharp rise, or unpredictable fall. The major reason identified by the researchers is the failure of weak form of efficiency on the market.

Mollik and Bepari (2007) studied the daily

trading index and the study found negative normal distribution pattern of return. That is the return has a seasonal rise and pick, however randomness is absent in the pattern. Using autoregressive test, they found that, the DSE return series is influenced heavily by various market anomaly.

Hussain et al (2008) applied technical trading

rule upon DSE considering 22 years (1986-2008). The study purpose was to compare the market efficiency before and after the 1996 “market – crash”. They have identified that, because of close monitoring system, circuit breaker, credit rating etc, improved the operational efficiency of the market after 1996. However the market cannot perform with efficiency because of lack of flow of quality information o all to all market participant. Proper rules and implication of those rules by the law enforcement authority and participation of new firm were suggested there.

Same line of findings observed by Mobarek at

el (2008) which identified market may work inefficiently because of herding behavior of the market participant. Sometimes any firms sudden price rise or any price sensitive information overvalued by them. Over demand make Game planners easily access to the market and get in hand easily accessible money. Chaity and Sharmin (2012) proving the market inefficiency added lack of market supervision and ignorance of the participant increase the inefficiency of the market.

So evidently it can be assumed that DSE does not follow the weak form of efficiency and market participant either increase or crashed the market condition by recklessly and whimsically taking the decision.

The objective of this paper is to identify the factor responsible to mold the investors of stock market in taking investment decision. For this reason, investors’ nature and socio – demographic condition has been discussed here. Theoretical behavioral finance and several relevant theories were discussed to identify the

factors. Market condition of DSE is also discussed to prove inefficient market condition.

II.

Overview Of

Conceptual

Framework Behavioral finance

is that part of academic finance which studies people’s buying and selling behavior of stocks. There are emotion, assistance form people, lack of consciousness and information lacking, expectation of earning and so many anomalies which challenged traditional efficient market hypothesis. Efficient market where assumes investors must be rational, their behavioral finance thrown light on their irrational attitude in selecting stocks. According to the Traditional Expected theory of Economics, rational people always make decision putting weight on their maximum benefit and being rational is a constant assumption. In the over view part, at first, EMH and Behavioral Finance is focused¸ then on that light relevant theories and prior work on this sector has been reviewed. Along with the literature review, basis for the factors for this paper also has been selected.

a)

Efficient Market hypothesis (EMH) Fama (1971) introduced EMH which states that,

stock price must reflect all the available information in an

efficient market. The three state of efficiency is relevant to discuss here:-

•

Weak form of efficiency: past price cannot be used to predict or earn abnormal profit.

•

Semi strong form of efficiency: share price reflect all publicly available information diminishing the scope to earn abnormal return.

•

Strong efficiency: even insider information is available through stock price.

EMH built on the basic assumption that;

Investors will act rationally, the existing irrational investors either will cancel their trade or follow the market and market participant must have a well defined utility functions which will be expected to be maximized. (Fundamental of investment, C. P. Jones, 9th edition). Notion of efficient market depends on information availability of price and message of various events. The information discussed from several angel, like, Accounting information (Ball and Brown, 1968), block trades, new issues of securities, stock splits (FFJR, 1969), portfolio performance, sometimes divestitures and merger.

Price availability if adjusted by the rational investors then they can assess their expected earning with adjusted gain. In order to value the expected and unexpected earning Finance Theorist had provided some model such as:

CAPM model : Markowitz (1959) assumed rational investors mean variance efficient portfolio. “mean variance-efficient” portfolios, hold assumption

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that portfolio will 1) minimize the variance of portfolio return, given expected return, and 2) maximize expected return, given variance. Sharpe (1964), Linter (1965) and Mossin (1966) developed the very useful CAPM model which considers only systematic risk as risk factors, providing premium for all other.

Expected return = Risk free rate + (Market factor in period t-risk free rate) β+ϵ it

Expected return model : Fama suggested the following model unexpected return valuation model due to inefficiency of market.

Zi,t+1= r

i,t+1-E(r i,t+1/*t)+ Systematic risk

In a efficient market Zi,t+1 = 0. fragine.

The abnormal performance index: in order to

check the abnormal return from the market Sharpe, Treynor and Jensen introduced abnormal performance index. Sharpe dived the market premium with Ϭ (Standard deviation form return) and Treynor divided with Systematic risk (β). Ball and Brown (1968) identified the abnormal return as return earn form any event rise per dollar return. 1 will be deducted from there to get par week value.

In presence of the market inefficiently and insider information Fama (1997) found that, long tern anomalies are fragile and influenced heavily by the market investors. The basic assumption of this model is the financial market is predictable.

In this paper, it is assumed that, the capital market is inefficient. Several prior studies and current stock market index were postulate for this purpose. (Appendix B)

b) Behavioral Finance In 1936, Keynse state in the famous “The

general theory” economy was well synchronized until investors “animal spirit” leads them from optimism to pessimism. In practical world, none of the capital market can be efficient so, above normal profit is possible to earn. However the investing decision is dominated by several econometric and psychological variables. The concept of behavioral finance argue with the rationality concept of traditional finance; and investors will not always be able to value their utility of decision alternatives, cannot estimate and update probability of events and do not diversify properly.

Tversky and Kaheman (1979) tried to develop inter dependency between psychological knowledge and economic decision of investors. Later on financial analysists and economists discussed about fundamental, industrial and technical anomalies (CP Jones, 9th edition). Tversky and Kaheman criticized traditional Expected Utility theory and developed the foundation of formal study of behavioral finance “Prospect theory”. The theory focuses upon investors’ basis evaluation of Cost-benefit analysis. In the revised version (1992), the authors introduced loss aversion and

mental accounting biasness which leads to investors’ regression theory. According to the empirical evidence the authors introduced loss aversion theory which asserts, risk aversion for gain and risk seeking for loss, and extremely reluctance to accept mixed prospect.

So, it is necessary to discuss the basis and elaboration of the major theories on several prior works.

i. Cognitive Dissonance theory Most of the studies on investors’ behavior

emphasized on this major theory which related with investor’s psychology. Cognitive dissonance is the state of mind when a person has mental conflict with already taken decision. If the feeling is regret the psychology and rationality conflict and the person claims someone else responsible for the unwanted outcome. However logic does not accept that. The theory (Festinger 1957), states that, in order to eliminate or reduce the impact of cognitive dissonance, people may take contradictory decision and may stand on the losing position just to prove own self right.

Milan Lovric et al (2008) introduced a conceptual model of investors’ behavior with a general survey of investors. They have identified several variables through which investors’ thinking process move on. The dual-process system starts thanking about the result and end up with the stage of perception-interaction and action. The interaction between investors’ socio-cultural variables and investment environment found out as responsible to influence investor’s decision.

Traditional finance asserts, investors must act rationally to earn profit. However if they are taking decision out of emotion, that may lead to a regret. Cognitive dissonance thereby is taken as a basis of new paradigm (Lucy F. Ackert et al; 2003).

In order to get out of regret stage investors must try to minimize risk. This elimination can be done by making proper portfolio. Portfolio construction efficiently is managed by professionals. The expected rate of return form a portfolio not only depends upon country’s macro variable but also the international economy. For this reason, international portfolio and condition of strongly efficient foreign countries stock market may be considered as influential variable. Such findings were drawn by Ionescu et al (2009) from the stock market of Romania. The study was taken data from the market from August 2007, which was a starting of financial crisis time for USA stock market.

At this stage professional advice is necessary. Harlow and Brown (1990) identified that, people who are adventures or sensation–seeker, are more tending to take financial risk than the others. Though there are different standard of each investors risk –tolerance level, few variables go common for all category of investors. Improved method to assess individual’s risk tolerance is suggested to be introduced by the market participants.

Behavioral Finance of an Inefficient Market

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Callan and Johnson (2002) suggested some guideline to the professional financial advisors. They have understood that, along with questioning about the investors risk tolerance, some methodical and statistical tools can be used to assess, the psychology and attitude of the investors, which may be a better help to assess investors risk tolerance level.

Sevil et al (2007) asked their case respondents about the expected rate of return what they purchased within a year. 10%-20% were the maximum predicted return. The questioned was addressed to see, whether the investors have regret or whether they are facing any cognitive dissonance or not. The question is associated with a prior question asked whether they sale a s profit yielding or loss yielding stock in a financial slow down. The investors are expecting a negative or low return which is also realization of a past wrong decision.

E. Bennet et al (2011) surveyed upon Indian (Tamil Nadu) investors and self satisfaction of investors to invest in any particular firm, has been identified an influential factors of investment behavior.

Naveed Ahmed et al (2011) studied investors behavior of Lahore stock exchange. Investors’ rationality and self confidence were asked with a set of questionnaire. For rationality, institutions contribution was also being asked. Most of the investors (46%) replied that, institutions contribution on their market order will depend on situation. Surprisingly, to test the cognitive dissonance, institutions’ responsibility has been questioned. Investors own analysis was found to be more influential factor than professional advice.

On the basis of this prior studies approach and expectation towards the stock were questioned. The DSE investors were asked, in a “price-falling” condition which security they will sale. The option was Profit yielding stock and Loss yielding stock. Dummy variable was used as 0 for no and 1 for yes answer.

55% investors agreed to sale the Profit yielding stock. They thought about the current proceed. However the loss yielding stock holding will not be wiser at all and in long run hiding the profit yielding stock. Suppose to generate higher return. But amateur investors decide on the basis of their mental accounting.

The second relevant question of cognitive dissonance was their expected return within the case time-frame (2010-2011). The investors were asked what rate of return they were expecting from their last years transaction and investment. A 5 class of return range were given and the following result came out. The result was quite interesting as most of the investors (42%) are expecting quite higher rate of return (10%-25%). This is quite similar with Sevil (2007) for Turkish investors (56% of total sample) who are expecting up to 20% rate of return.

Two important variables are expected to be responsible for this trend. First, the market is segmented, but information is not sufficiently available,

a clear weak form of market (Dr. Kishore, 2011). The second one is, investors’ psychology to do whatever they think is well suited for him, rather than entirely depending on professional planners. Cost of service may be another reason behind the reasons.

Appendix A

Table 1 : Descriptive Statistics.

Table 2 :

Descriptive

Statistics

Below-10%

-10%-0 0-10%

10%-20%

20% to above

0.28

0.20

0.22

0.42

0.03

Table 3 : Descriptive Statistics

Good

time to Buy

Patience holdings

Neutral

Get Worried about recent

Portfolio Decide

to sell

Mean

.32

.26

.21

.13

.07

Sum

102

82

63

40

22

Among the 312 respondents, few did not answer the question because they are not ready to assess their investment by themselves. On the light of this mental state relevant variable found to ask the investors were, “why they are investing in this particular firm”. Investors were asked to rank their preference among seven options on the basis of likert point. Among the other variables, ‘Getting quick rich’ identified as most influential variables. That is, when investors sensed or got know from the available information that, investment in this stock will return them quite higher capital gain, they invest on that particular stock without assessing so much about the firm’s past performance (V16,17,18,19,20,21).

The cognitive dissonance refers towards two basic psychological state–Prospect and Heuristics bias.

ii.

Prospect theory

A well documented prior study supports the concept that, investors can make mistake and they have different perception regarding risk. The concept generally termed as Prospect theory. Tversky and Kaheman (1979) introduced the leading prospect theory which identified a person’s intention to invest. The intention was segment into two major theme; editing them (how the stock will do) and judgment principle (evaluating loss and gain). The theory is introduced and technically explained

by Kahneman and Tversky (1979)

which was revised in 1992. The prospect theory was

Which stock will you sale in a price falling situation?

Mean

Stock that

yields a profit

0.55

Stock that yields a loss

0.45

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focused and discussed from different context among which Loss aversion, Regret aversion and Mental accounting Bias are significant (Milan Lovric, Uzay Kaymak and Jaap Spronk; 2008). Other emotional and psychological biasness under prospect theory also rule as influential factors upon investment behavior. However, most of them ultimately ended up to these three biases. So this paper also focuses upon these three biases.

Guven Sevil et al (2007) studied the small investor’s behavior in Istanbul. The study questioned roll of brokerage house in guiding the investors. 7.8% of the target sample denied the role of financial institutions. 34.8% respondents accepted the effectiveness of financial institutions to choose the stocks. Shareholders’ reaction about share price rise and fall also considered here as they are expected to not to act rationally. The study shows most of the people (72.4%) will sale a profit yielding stock in a price-dropping situation. From this result it can be stated that, may be lack of in depth knowledge lead them to take such decision. These two variables are also tested by Naveed Ahmed et al (2011) for the investors of Lahore Stock Exchange. There were fifty–fifty response for profit yielding and loss yielding securities.

All the prior studies focused upon investors’ emotional behavior. Elster (1998) used six features to explain emotion-which are Cognitive antecedents, intentional objects, psychological arousal, Physiological expression, and valence and action tendencies. His study explains why because of having the feeling of joy and regret, with all the sense of right and wrong, investors sometimes cannot take decision. Because of wrong action investors are very commonly regret (Gilovich and Medvec;1995).

In order to judge the influence of investors’ psychology, on economic decision, investors’ mental assessment about a particular security is another crucial

point. Shefrin and Statman (2002) developed Behavioral portfolio theory in two versions to show that, this type of portfolio differ from typical Markwitz CAPM-portfolio theory. They developed BPT in two versions: a single mental account BPT version (BPT-SA) and a multiple mental account version (BPT-MA). Because of the intension to take risk even at a risky project, BOPT model securities are quite similar with real world securities as demonstrated by the authors.

On the basis of expected utility and investors risk-return analysis capability; several studies were organized were on the basis of theories of behavioral finance.

a. Loss aversion

Gilovich and Medvec (1995) studied the regret of investors and the reason behind their loss. Form the literature review it has been stated that, “it appears that people experience regret over negative outcomes that

stem from actions taken than from equally negative outcomes that result from actions foregone”. Kahneman, Knetsch, and Thaler (1990) stated it as, losing some amount will give double pain than pleasure to gain from double of that amount (Gaining $ 2= losing $1).

Barbeir and Huang (2001) studied stock return of portfolio basis and individual stock returns and their impact upon investors. Their evidence suggests that the loss aversion level depends on prior gains and losses: that is, if investors already gained to overcome a loss then that is less painful, than a prior gain less loss. This is a mental set back of the investors.

Khoshnood and Khoshnood (2011) investigate significance of behavioral biasness among investors of Iran. On the basis of theory they studied the practical capital market investors. They defined loss aversion as investors’ strong desire to avoid loss than to acquiring gains. Because of this loss averting tendency, amateur investors, most of the time forget about the common rule of stock market that,-buy when the price is lowest and vice versa. Loss aversion is investors avoiding tendency from any sort of possible loss project. They are not that much egger to assess the prospectus gain at the same time if that is not much bigger than the loss.

In order to check the condition of Dhaka stock exchange, in the survey question, it was as

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