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Table of Contents
The problem Statement
Describing the Problem Statement
Portfolio Theory vs. Behavioral Finance.
Prospect Theory and Investor Behavior
The Critical Analysis.
Similarities or Dissimilarities in the opinions of the interviewees.
Strengths and Weaknesses of Interview Comments.
Emotions highly impact the investment decision process and the investor’s emotions are determining factors in their Investment Decisions
As per concepts of behavioral finance, a large crowd of investor takes their investment decisions in the influence of some psychological factors including mood, cognitive biases and emotions. And emotions play an important role that impacts the investment behavior of the investors. Emotions exist and occur in the path of taking prudent and sensible financial or investment decisions. It is in the nature of humans to react differently and in accordance with a particular state of emotion. However investor’s emotions get matured over a phase of time that occurs in the investment life cycle of every investor.
As per the portfolio theory, investors are always rational. They are sophisticated and have financial literacy and acts only on publicly available information in a disciplined way with their investments decisions. Also, the markets are efficient and the investors always make correct updates in relation to their beliefs when they receive a set of fresh information, (which is possessed by every other likely investor) that can improve the chances of earning wealth by the investors. Now since all markets operate efficiently, therefore, the market prices reflect all the relevant and material information (which is publicly available at all times), so no investor can ever be able to create an undue advantage or arbitrage opportunity or purchase a stock at a negotiable price (Barnes 2016).
The portfolio theory propagates the concept of Efficient Market Hypothesis which says that the investor can never outperform the market by exploiting the market anomalies because if there are any anomalies are present that it gets immediately arbitraged away. But in the practical (real) world, efficient market hypothesis does not holds strong as there are tons of cases and examples where market prices of stocks witnessed huge deviation from the fair values.
For example the legendary investors and fund managers like Warren Buffett of USA and Kerr Neilson of Australia have outperformed the market consistently over long periods of time. Buffett generated returns of 1,826,000 % after he took control of Berkshire Hathaway about 50 years ago. This results in compounded annual gross returns (CAGR) of 21.6 %. During this period the S&P 500 index of USA managed to generate returns at a CAGR of only 9.9 %. Also Kerr Neilson, of Platinum Asset Management was able to deliver approx.13 % on an annual basis while Australian benchmarking index were able to generate just 6.3 % during the same period (Degutis & Novickytė 2014).
The Behavioral Finance theories make disagreement with the portfolio theory and states that Investors are not always rational and their decisions are influenced by their own biases. They might not be well educated financially and not all the material and relevant information is available freely and easily without any costs. Also, Stocks and other securities generally trade at unjustified prices. Therefore, investors make cognitive errors that may result in ineffective or incorrect investment decision making.
The prospect theory basically states that investors are risk averse. In financial and economical theories, risk aversion has been explained as a human behavior that makes efforts and attempts to lower the uncertainties (or risks) that it is going to exposed to. It is based on the assumption that gains and losses are differently valued, and therefore, investors make decisions on the basis of professed gains rather on the basis of professed losses, this concept is known as the "loss-aversion" theory. The theory states that if investors are provided with two options, both quantitatively equal, but one of which represents potential gains and the other represents possible losses, then n such condition the first option of perceived gains will always be opted. The prospect theory mainly focus on predictability and states that repeated errors in investment decision making process are generally caused by habits, intuition, social interactions and emotions (Hamid et al. 2017).
For example: the investors who don’t want to take higher risks or exposed to higher possibilities of incurring losses usually invests in risk free securities like bank deposits, fixed deposits, government bonds, etc. such securities delivers very low returns and sometimes even are not able to beat the inflation factor. The risk loving investors or the investors who wants higher returns can invest in securities like shares and derivatives of stocks and commodities or currencies. Such securities expose the investors to high level of risks and allow them to earn higher rate of returns.
As part of the research, two sets of interviews have been conducted with two different staff members of an investment firm. The first interview was conducted with Mr. Tony Stark who is a financial advisor in the firm and the second interview was held with Mr. Bruce Wayne who works as a client service executive in the firm. The findings from the interviews have been discussed in this section:-
After analyzing the interview responses, it can be stated that both Stark and Wayne observed that their clients were making decisions by influencing from emotional biases and made errors in their investment decision making. Stark handled a rookie investors who made loss out of the emotion of fear as he sold all of his holdings in a panic situation occurred due to corona pandemic. Similarly client of Wayne made investment decisions with the emotion of greed, she made initial small profits and practiced similar tactics every time in future and ended up incurring huge losses (Han & Hirshleifer 2015).
The broader dissimilarity in the opinions of the interviewee can be observed in the operations of the firm. Stark found the firms operational structure to be flawless and stated that client dint discussed its investments issues and doubts with the experts which resulted in his losses. While Wayne said that firm’s client’s engagement policies are very strict and stringent and they are required to be relaxed and made a little flexible.
Also, it has been observed that Stark’s client is new in the equity market has started understanding the concepts, hence his capacity to tolerate risk is low while Wayne’s client is an high net worth investor and have years of market experience, also, she will not get effected by small losses, that means she has higher risk tolerance levels (Hirshleifer 2015).
From the above discussion, it can be stated that markets exhibit a little level of inefficiencies that means that psychology and emotion play a very important role in investor’s decisions making process. It leads the investors to sometimes behave in irrational or unpredictable ways. However portfolio theory cannot be fully neglected as it forms a base to value and predict the market.
The concept of herding is applicable in both the case studies, it states that, individual investors feel the requirement to join groups to share important information, these groups are called herds. Such group of investors utilizes the herd behavior while making decisions about investments. In other words, investors follow others like the herd of sheep follows one another without analyzing or utilization of the information available to them (Barnes 2016).
For example: the retail investors are mostly affected and impacted by the herding bias. Such investors have access to the most limited sources of information and also reach very lately to them. Also such investors do not possess the competence to analyze the financial markets like stock market and make their decisions based on influences or advices. In both the cases, the limited information with them was falling markets due to corona pandemic, both started selling. Stark’s client panic sold and incurred loss and Wayne’s client short sell the same time and generated profits, however he remains incapable to analyze the market post lockdown periods and followed the same strategy that resulted in overall loss to her as well (Pompian 2012).
Barnes, P. 2016. Stock market efficiency, insider dealing and market abuse. Gower.
Degutis, A., & Novickytė, L. 2014. The efficient market hypothesis: A critical review of literature and methodology. Ekonomika, 93(2), 7-23.
Ehrlich, E. and Fanelli, D. 2012. The financial services marketing handbook: Tactics and techniques that produce results (Vol. 150). New Jersey: John Wiley & Sons.
Hamid, K., Suleman, M. T., Ali Shah, S. Z., Akash, I., & Shahid, R. 2017. Testing the weak form of efficient market hypothesis: Empirical evidence from Asia-Pacific markets. Available at SSRN 2912908.
Han, B., & Hirshleifer, D. A. 2015. Self-enhancing transmission bias and active investing. Available at SSRN 2032697.
Hirshleifer, D. 2015. Behavioral finance. Annual Review of Financial Economics, 7, 133-159.
Pompian, M.M., 2012. Behavioral finance and investor types: managing behavior to make better investment decisions. New Jersey: John Wiley & Sons.
Ramiah, V., Xu, X., & Moosa, I. A. 2015. Neoclassical finance, behavioral finance and noise traders: A review and assessment of the literature. International Review of Financial Analysis, 41, 89-100.
Thaler, R. H., & Ganser, L. J. 2015. Misbehaving: The making of behavioral economics. New York: WW Norton.
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