The behavior of actors in the financial market cannot be explained solely by the assumptions of traditional capital market theory, which assumes rationality on the part of investors.
In this paper, we investigated which anomalies of human behavior influence investors in their decision-making behavior. Using the findings of the "Behavioral Finance" theory, it was found that, in addition to fundamental and technical analyses, a large number of psychological effects act on investors.
This leads to a distorted perception of information, information processing and ultimately influences one's own decision. Especially in boom and crash phases, market participants often overreact, which can be explained by behavioral economic approaches.
The findings provide investors with valuable input to optimize their investment behavior.
Table of Contents
1 Introduction
1.1 Problem definition and question
1.2 Structure of the paper
2 Traditional capital market theory
2.1 Market efficiency hypothesis
2.2 The model of "homo oeconomicus"
3 Behavioral Finance
3.1 Anomalies of human behavior
3.1.1 Information perception anomalies
3.1.2 Information processing anomalies
3.1.3 Decision anomalies
3.2 Findings from brain research
3.3 Influence of moods
3.4 Influence of stress
3.5 Attitude and expectations
3.6 Motivation
4 Psychological effects in stock exchange trading
4.1 Anomalies in decision-making behaviour
4.1.1 Theory of cognitive dissonance
4.1.2 The status quo bias
4.1.3 Avoiding disappointment (regret aversion)
4.1.4 Illusion of control
4.1.5 Learned carelessness and learned helplessness
4.2 Perception of profit and loss
4.2.1 Prospect theory
4.3 Investor risk behaviour
4.3.1 Weighting of probabilities
4.3.2 Risk management
4.3.3 Illusionary Correlations
4.3.4 Risk return paradox
4.3.5 Reflection and framing effects
4.4 Overreactions
4.4.1 Excessive self-confidence (over confidence)
4.4.2 Herd behavior (Herding)
4.4.3 Fear and greed
5 Summary and outlook
Objectives and Research Focus
This paper examines how psychological anomalies and behavioral factors, beyond the traditional rationality assumptions of capital market theory, influence investor decision-making. The primary research question addresses which specific psychological effects lead to irrational investor behavior, particularly during volatile boom and crash phases of the stock market.
- Analysis of the limitations of the traditional "homo oeconomicus" model in financial decision-making.
- Exploration of human behavioral anomalies in information perception and processing.
- Evaluation of psychological drivers such as moods, stress, and overconfidence on trading patterns.
- Investigation of key phenomena including prospect theory, cognitive dissonance, and the fear-greed cycle.
Excerpt from the Book
4.1.1 Theory of cognitive dissonance
Cognitive dissonance describes the human tendency to hold on to decisions once made. The effect on decision-making behaviour is all the more pronounced the sooner a new decision serves to admit a wrong decision. Admitting that you have made a mistake leads to a reduction in one's own self-confidence. Investors tend to avoid self-impairment by continuing to stick to the original decision. In financial market transactions, this usually leads to the fact that securities are sold too late in the event of strong price losses (Bösenberg, 2009, p.36f).
According to the "cognitive dissonance theory", there are three ways to resolve in discrepancies. There is a possibility to reverse decisions that create dissonance. This is especially the case for decisions with low commitment. With increasing commitment, however, an attempt is made to stick to the decision made. The dissonance can be reduced by trying to complete the decision successfully, even if it involves high costs (sunk cost effect). The third variant for resolving the dissonance is to control one's own perception in such a way that the in disagreements are reduced. In this case, the investor tries to enhance the set decision by collecting consonant cognitions, while at the same time ignoring dissonant cognitions (Nitzsch, 2006, p. 45).
According to Brehm and Cohen (1962), commitment exists when one "emotionally depends on the decision made" (quoted from Goldberg & Nitzsch, 2004, p. 120). The commitment to financial markets is consistently to be classified as very high, since the investment decision is made voluntarily, which in turn is considered a prerequisite for the emergence of dissonance (Götte, 2006, p. 40).
Summary of Chapters
1 Introduction: Introduces the research topic by questioning the rationality of financial markets and defining the scope of the study regarding behavioral finance.
2 Traditional capital market theory: Reviews the classical model of the "homo oeconomicus" and the market efficiency hypothesis, highlighting their reliance on rational decision-making.
3 Behavioral Finance: Defines behavioral finance and discusses systematic anomalies in human behavior regarding information perception, processing, and decision-making, including the role of brain research.
4 Psychological effects in stock exchange trading: Details specific psychological triggers—such as cognitive dissonance, prospect theory, and herd behavior—that cause irrational reactions and market volatility.
5 Summary and outlook: Synthesizes the findings, confirming that psychological factors are essential to understanding market behavior and provide a necessary supplement to technical analysis.
Keywords
Behavioral Finance, financial market, stock exchange, investor, investor behaviour, psychological effects, anomalies, boom, crash, profit, loss, decision-making, risk, prospect theory, overconfidence.
Frequently Asked Questions
What is the fundamental focus of this thesis?
The work focuses on how psychological factors and human behavioral anomalies impact investor decision-making, often causing market participants to act irrationally in ways not predicted by traditional capital market theories.
What are the central themes discussed in the paper?
The paper covers the transition from traditional rationality models to behavioral finance, the influence of internal states like mood and stress, and the role of cognitive biases such as herd behavior and overconfidence.
What is the primary research question?
The research aims to identify which specific psychological effects lead to irrational investor behavior and exert the strongest influence on market outcomes, particularly during extreme market phases like booms and crashes.
Which scientific methodology is applied?
The work utilizes a literature-based analysis of the "Behavioral Finance" theory, drawing on psychological research and existing academic studies to explain investor behavior as a supplement to fundamental and technical analysis.
What topics are covered in the main section of the book?
The main section investigates information perception anomalies, brain research findings regarding financial investments, and specific trading effects like the disposition effect, prospect theory, and the fear-greed cycle.
Which keywords best characterize this research?
Key terms include Behavioral Finance, investor behaviour, psychological effects, anomalies, prospect theory, risk management, and the fear-greed cycle.
How does the "status quo bias" specifically affect financial markets?
Investors often stick to existing knowledge and consolidated opinions, paying less attention to new information if they perceive the consequences of an alternative to be more incalculable than the current state, leading to inactivity.
What does the "fear-greed cycle" represent in the context of the stock market?
It represents the cyclical emotional behavior of market participants—ranging from the euphoria and greed that drive prices up to the fear and panic that result in mass sell-offs and downward spirals.
Why is the "Sunk Cost Effect" particularly dangerous for investors?
It leads investors to hold onto losing positions too long or even repurchase losing stocks to "lower the average price," often justifying past mistakes instead of objectively investing in more profitable opportunities.
- Quote paper
- Dietmar Kubik (Author), 2012, Behavioral Finance. The Influence of Psychological Effects on Investor Behavior, Munich, GRIN Verlag, https://www.grin.com/document/1169773
