WHAT MAKES AN INVESTOR TICK?

-By Shruti Dhumal & Ryan Rego (SIES College of Management Studies, Mumbai)

INTRODUCTION

Conventionally under traditional finance, it is assumed that people are rational and make logical decisions while investing and that they are unbiased when it comes to determining the price of a security.  However, that is not usually the case. There are certain psychological and emotional factors that influence investors. Many times, investors derive their own set of rules that supposedly govern the movement of a particular stock which is also known as heuristics.

Behavioural finance is a field that combines psychology with economics and finance to try to provide explanations as to why a person takes an irrational decision

ROLE OF BEHAVIOURAL FINANCE IN STOCK MARKET

It can always be seen in the stock market that emotions and not the fundamental or technical changes are the reasons for the sudden short-term changes. It might be observed in such cases that whenever an analyst is questioned as to why the market was up/down, he/she doesn’t have a specific reason. It’s actually the euphoria or fear amongst the people that drive the market. Investors think irrationally and tend to make cognitive errors. Due to this tendency, it can be concluded that markets cannot be efficient when it comes to information.

Investor’s emotions and their behaviour play an important role in every step of their investment portfolios. At the time of portfolio building, it is important that investors discard their traditional heuristics of their wealth building processes. For long-term investments, it is necessary that the investors have long term perspective rather than short term emotion driven decisions. Sometimes people tend to react collectively because the others are behaving in a particular manner. It could be due to the occurrence of sudden events such as the Brexit. All such reactions are short term and people should not be carried away by the collective emotional decisions of the crowd.

Hence, wisdom is accepting the reality rather than thinking how it should have been.

Shruti

Figure 1: Sensex growth May-June 2017

The above graph shows the Sensex graph for the month of May 2017. One can clearly see a drastic rise in the Sensex since 25th May 2017 and 2nd June 2017. The stock market has been attaining new heights every day. And every moment we tend to see more euphoria driven results.

One can notice a similar phenomenon in the Bitcoin market; one of the main reasons for the Bitcoin boom is that it has been hyped up to a great extent.

An increasing number of investors are also hopping on the Bitcoin wagon and investing due to the fear of missing out on opportunities. This drive creates more momentum thus creating a snowball effect. Bitcoin prices shot up by more than 120 percent in 2017, after gaining 125 percent growth in 2016. Recently Bitcoin has been increasing in the 4000 and 5000 level which is a whopping growth rate.

Shruti dhumal

Figure 2: Bitcoin prices’ variations

On 29th August, 2017 Mumbai faced a heavy downpour followed by floods and the citizens were panic-struck. This incident instilled fear in the minds of Mumbaikars, because of which they opted to stay home the next day despite there being no rains. This is a typical behaviour observed even in the case of investors during market cycles-sell when there is panic in the market, but don’t buy when share prices have reached an all-time low because of fear.

Another example would be the recent missile firing by North Korea towards Japan. Japanese markets were down by only 0.45%, India’s Sensex on the other hand, fell down by 1.2%.Behavioural finance also explains the occurrence of asset bubbles, one of the most famous bubbles that occurred was the American housing bubble in 2006.

CONCLUSION

Behavioural finance tries to identify and study the irrational behaviour of the masses with the hope of correcting such irrational behaviour.It also seeks to provide measures to identify and possibly prevent asset bubbles from occurring and curb the unwanted speculations which ultimately lead to losses.

Efficient market hypothesis – A theory that had and is misguiding generations

By Aditya Alamuri & Mounika Duvva

The efficient market hypothesis which states that all the relevant information is factored in by the market and therefore one cannot make abnormal returns can only be practiced on paper and the reality associated with the same is far different from what the so called ‘white paper’ propagates. The flow of information that is entering the markets have actually made the entire financial ecosystem more volatile and this new information which is said to ‘walk randomly’ had, is and will always create arbitrage opportunities. With the emergence of globalization and interdependence upon economies, we observe that the loopholes in the EMH have continued to rise, thus making the theory obsolete.

Strong form market efficiency – A myth

A market is 100% efficient only when all the players in the market have sound knowledge of the principles that guide and run the market. Yes, we are referring to financial literacy of the investors who operate in the market. The financial institutions such as banks etc. enjoy superior confidence, which is placed on them by the investors. Therefore, we find that the market is being run on emotions of the investors.

Chaos is an everyday phenomenon in the markets as people are confused about what they are doing in the market; are they trading or are they investing? This chaos is due to their low understanding of the markets and the way these institutions function. These retail investors lack the skills and the sophisticated models to track the markets, thus failing in the stock selection criteria due to poor research about the same. Also, people invest in IPOs and stocks which are very volatile, thus making their fortune shop to the tunes of the market. The investors are driven by their greed to earn more and therefore follow the market rallies without having full knowledge of why the bull run is happening.  The vice versa takes place when the market is bear gripped and these ill-informed investors sell their financial assets in panic.

Arbitrage Opportunities – The modern Holy Grail of the financial markets

In everyday trade, we observe and find many scenarios where the prices displayed on the NSE and the BSE, being different. Also, when we carefully observe these indices, we find that for some stocks, there have been only buyers or only sellers on a given day and this too fuels my previous statement that the prices are different on the indices. Though these stock prices equate and the arbitrage opportunities close, new opening chances are spotted. Therefore, in the entire trading session, with well-built algorithms and constant monitoring of the markets, one will always find arbitrage opportunities thus disregarding the Efficient market hypothesis.

Conclusion

We state that the markets are not efficient due to poor regulatory features. Also, a market is made up of many parties and when a significant portion of the same is ill-informed, then one cannot call the market, on the whole, to be efficient.