Behavioral Finance. The Influence of Psychological Effects on Investor Behavior

Table of contents

Abstract

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

Bibliography

List of figures

List of tables

Gender Note:

For reasons of easier readability, all parts of the Bachelor's thesis are based on a gender-specific differentiation such as.B market players, investors, investors and the like. renounced. Corresponding terms apply in the sense of gender-appropriate language in principle to both sexes.

Abstract

Abstract in English

(min. 700 - max. 1000 characters)

The behaviour of actors in the financial market cannot be explained only by the assumptions of the traditional capital market theory, which implies rationality to the investors. In this paper it was examined which anomalies of the human behaviour influence investors in their decision behaviour. Taking into account the findings of the "Behavioral Finance" theory could be found out that a huge number of psychological effects influence the investors work beside fundamental and technical and analysis. This leads to a distorted perception of information, information processing and at last influences the actor ́s decision. Particularly in the boom and crash phases it often comes to over-reactions of the market participants themselves which can be explained by behavioral-economic approaches. The findings provide valuable knowledge to optimise investor ́s behavior.

keywords

(min. 8 – max. 15 words)

Behavioral Finance, financial market, stock exchange, investor, investor behaviour, psychological effects, anomalies, boom, crash, profit, loss

1 Introduction

In times of financial market debt crises & Co., enormous volatility of stock market prices, indices, commodity values, etc. and associated risk of loss but also profit opportunities on the financial markets, the question arises as to what triggers can be for such extreme price movements. Do we see prices as a reflection of fundamental economic data of the global economy? Are they rational reactions to the results of technical analyses or does the psychology of the individual actor and the mass of investors in the financial market also play a role? Again and again in the history of the stock market, there have been dramatic price losses, subsequent counter-movements, up to boom phases with sharply rising prices.

1.1 Problem definition and question

Changes in the financial markets of this kind have both economic, social and psychological effects. Economic developments are anticipated by the courses in advance. Real economic changes are having an effect on the supply and demand for goods and services in the affected economies. These effects are particularly strong in phases of boom and recession, with an impact on the intensity of demand on the labour market and all the associated consequences for society.

Economists around the world are therefore concerned with developments in the financial markets. The aim is to track down the decision-making behaviour that induces people to buy or sell. For the explanation of phenomena, the traditional capital market theory, which is based on rationality, is still used today. On the other, there is the "behavioral finance" theory that emerged in the USA in the 90s. The theory makes use of psychological findings and tries to transfer them to economic questions.

Stock exchange trading has become even more important due to the globalization of the economy. Online trading platforms on the Internet have also given the "small investor" easy access to transactions in the financial market. However, trading is increasingly characterized by unmanageability and uncertainty, which is reflected in volatile prices and causes uncertainty among investors.

It turns out that investors do not act rationally in their decision-making behavior, as the traditional capital market theory postulates, but rather rationally, sometimes even irrationally and contrary to the basic economic assumptions. The present work will deal with the findings of the "behavioral finance" theory, its models and psychological effects in order to explain investor behavior. For this purpose, the current state of research in this field will be used.

In the introduction, the anomalies of human behavior are discussed in order to describe those processes that lie in the nature of man and to prevent rational behavior in connection with decisions in the financial market.

Research question:

Specifically, the work is intended to answer the question of which psychological effects lead to irrational investor behavior and have a strong influence, especially in the boom and crash phases.

To answer the question, the findings of the "Behavioral Finance" theory are used.

If forecasts about decision-making behaviour become possible, then it will also be economically viable. Market participants on the financial markets who are aware of their own and other behaviors can discover and avoid mistakes with their actions in knowledge of these relationships. The "Behavioral Finance" theory makes an important contribution to this. Making the findings of behavioral economics usable for one's own actions and understanding them as a supplement to the traditional view is the goal of this work.

1.2 Structure of the paper

First of all, in the context of dealing with these questions, the basic features of traditional capital market theory will be discussed. The focus of this work is on the theory of "behavioral finance".

The theory draws on the findings of psychology and transfers them to economic questions. On the one hand, it deals with individual patterns of behavior, which can often be observed in investment behavior, but also with market phenomena that are difficult to explain, such as those of a stock market boom or bear market (Götte, 2006, p. 63).

In chapter 3, the term "behavioral finance" is defined and the anomalies on the financial market are discussed. Anomalies characterize irregularities, deviations from a norm that occur in the perception, processing of information and in decision-making. In the further course, findings of brain research, as well as the influence of moods, stress, attitudes, expectations and motivation on investor behavior are discussed.

Finally, chapter 4 describes significant psychological effects in stock market trading. Effects that affect decision-making behavior, influence the perception of profit and loss, determine the risk behavior of investors, and lead to overreactions are explained in more detail here.

The chapter is intended to answer the question of which psychological effects lead to irrational investor behavior and have a strong influence, especially in the phases of boom and crash.

2 Traditional capital market theory

According to classical financial market theory, rationally thinking and acting market participants are assumed. Rationality is related to maximizing the expected benefit. The image of the human actor seems comparable to that of a computer.

2.1 Market efficiency hypothesis

Eugene F. Fama, first postulated the hypothesis of the efficient market in 1970. According to Fama, on an efficient capital market, all information is processed in an efficient manner. The prices therefore reflect all relevant information at all times.¹

Information efficiency is therefore a prerequisite for efficiency on the capital market. If actors on the financial markets act rationally, then all relevant information is incorporated into the prices without delay. This makes systematic information projections and excess returns above those of the market average impossible. Forecasts of future prices cannot be made due to daily new price-determining information. Fama distinguishes between weak, medium-strong and strong information efficiency according to the dependence of the type of information concerned and its input into the pricing (Kiehling, 2001, p.3).

Criticism of the market efficiency hypothesis

The rationality of the market participants, which is postulated in this hypothesis, may be doubted. The condition for rational behavior would be an unlimited processing capacity of newly arriving information. Even if the resources were available to process the flood of information, it would have to be possible to assess clearly its impact on financial markets.²

2.2 The model of "homo oeconomicus"

According to the model, one assumes a completely rational thinking and self-serving person. Rationality includes maximizing the benefit of expectations. In each decision, the alternative that brings the highest advantage is chosen. The probability with which a benefit occurs plays a major role. A generally accepted principle of taking probabilities into account is the calculation of the expected value. Multiplying all possible consequences of an alternative by its probabilities of occurrence leads to the expected value of an alternative. The "Homo Oeconomicus" chooses the alternative that has the highest expected value (Goldberg & Nitzsch, 2004, pp. 38-41).

In order to meet the conditions of absolute rationality, in addition to maximizing the expected benefit, there are three other conditions: The complete recording and processing of information, rational evaluation and decision-making as well as time-stable preferences in the utility function (Goldberg & Nitzsch, 2004, pp. 43-44).

Criticism of the model of "Homo Oeconomicus"

A complete collection of all relevant information with subsequent information processing would overwhelm every person. In practice, the decision-making process incurs costs in the use of time and resources. As a result, it is usually not possible to include all relevant information and take it into account for the optimal decision (Manzeschke, 2010, pp.33-34).

"The core of all motivation is to find and give interpersonal recognition, appreciation, affection or affection" (Bauer, 2008, p. 36). These needs are contrary to selfishness assumption. Without social contacts to establish and maintain, man would not have survived in the course of evolution (Servant & Servant, 2008, p. 50).

3 Behavioral Finance

The term "behavioral finance" includes a behavioral science-oriented financial market theory. This doctrine is the starting point of a limited rational behavior of man. In contrast to the traditional doctrine, which assumes profit maximization as the only motive, investors can also have other motivations according to this approach. Mistakes can also happen in a selection process, information can be evaluated differently depending on the situation and lead to divergent conclusions. The recording, selection and processing of information is at the center of interest of "Behavioral Finance". Essential is the subsequent decision-making behavior of an investor. The theory also deals with the anomalies of human behavior. The findings of the theory are intended to contribute to the optimization of one's own decision-making behavior and to sharpen the understanding of the actual behavior of actors in the financial market (Goldberg & Nitzsch, 2004, pp. 25-28).

3.1 Anomalies of human behavior

Contrary to the assumption of traditional capital market theory, which assumes rational behavior and efficient information perception of investors, the behavioral economic approach assumes weaknesses in the perception and evaluation of information. Research has concluded that the way in which information is selected, absorbed and processed has a significant impact on investors in connection with the formation of expectations and decision-making. These processes lead to systematic patterns of behavior that can be described as anomalies of human behavior and deviate significantly from the assumptions of traditional capital market theory. These anomalies occur in information perception, information processing and ultimately decision-making (Götte, 2006, pp. 59-61).

Figure 1: Categorization of the anomalies

Abbildung in dieser Leseprobe nicht enthalten

Source: Bies (2011, p. 35)

In accordance with Roßbach (2001), p.13-14 and Heidorn/Siragusano (2004), p. 4-9

3.1.1 Information perception anomalies

The human brain has limited capacities. All sensory perceptions arrive in ultrafast memory and are evaluated according to their relevance before they are passed on to working memory. Making oneself aware of something is much slower and consumes more energy than unconscious thinking, apart from the fact that only a fraction of information we perceive through our senses reaches consciousness at all. Everyday functions are therefore often delegated to the unconscious. One consequence of this is that decisions are often made according to simple rules. These are then energy-efficient, but sometimes also unfortunately wrong (Schwarz, 2010, pp. 22-23, p. 61).

In addition to the limited absorption capacity, people tend to neglect information if it does not meet their expectations (Goldberg & Nitzsch, 2004, p.59).

The availability heuristics (availability heuristic), the selective perception (selective perception) and the type of presentation (framing) are to be assigned, among other things, to the information perception (Bies, 2011, p. 35).

According to Kahneman & Twersky, the availability heuristic characterizes the degree of ease with which information can be accessed from memory. Investors are more likely to see an event occur, the more examples you can think of and the easier it is to remember them. It is therefore a question of the retrievability of information if no objective sources are available or if there is not sufficient time for their processing (Raab, Unger, Unger, 2010, p.121).

"If you ask a group of unemployed people how high they estimate the unemployment rate in their place of residence, you will get a much higher average estimate than if you ask a group of employees in that place" (Raab, Unger, Unger, 2010, p.121). Due to their situation, the unemployed will more easily recall fates that are similar to their personal ones (Raab, Unger, Unger, 2010, p. 121).

Selective perception leads investors to neglect information that does not meet their own beliefs and expectations. New information is often given too little weight, but in other situations too much importance is attached. If players in the financial market expect falling prices, then they absorb negative news much more strongly than those market participants who are optimistic and perceive positive news, but attach less importance to negative news (Eller, Heinrich, Perrot, 2010, p. 177).

3.1.2 Information processing anomalies

In the phase of information processing, the investor is required to draw the right conclusions for a profitable commitment. For an efficient management of a large amount of incoming information, rules of thumb, so-called heuristics, consciously or unconsciously, are used. Heuristics thus help to simplify complex issues. In financial market events, judgments are often passed under high time pressure. Once the situation has been reduced to a tolerable level, it is a question of applying rules that make it possible to act quickly. Here, too, heuristics are used, which on the one hand facilitate further processing, but can also lead to erroneous conclusions (Goldberg & Nitzsch, 2004, pp. 49-50, p. 66).

Individuals tend in many cases to orient themselves to an initial or guideline value when processing information (Anchoring). This anchor value is then subsequently adjusted in the direction of a true value, taking into account additional information (Adjustment). Study results show that the anchor value is overestimated, and the adjustment is influenced by it (Nitzsch, 2006, p. 22-23).

The Mental Continging (mental accounting), the reference point effect (Reference point effect) and the loss aversion (Loss aversion) are attributable to information processing (Götte, 2006, p. 61).

3.1.3 Decision anomalies

Decision anomalies explain irrational patterns of behavior that occur in the course of decision-making, according to the phases of perception and processing of information (Bies, 2011, p. 37).

The representativeness heuristic, overconfidence, cognitive dissonance and regret aversion can be counted among the decision anomalies. (Götte, 2006, p. 61)

[...]

¹ Stifterverband. Magazin Stiftungen (04/2005). Der Kurs irrt nie. Online:http://stiftung.stifterverband.info/t012/pdf/deutsche_bank_prize_wuw_4_2005.pdf [Accessed on 14.10.2011]

² Dr. Thomas Ankenbrand (2000).Blick in die Kristallkugel. Online: http://www.privatebankingmagazine.ch/de/artikelanzeige/artikelanzeige.asp?pkBerichtNr=25030 [Accessed on 14.10.2011]