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INTRODUCTION

Behavioral finance is a field of finance that proposes psychology-based theories to explain stock
market anomalies. Within behavioral finance, it is assumed that the information structure and the
characteristics of market participants systematically influence individuals' investment decisions
as well as market outcomes. Behavioral finance is a relatively new field that seeks to combine
behavioral and cognitive psychological theory with conventional economics and finance to
provide explanations for why people make irrational financial decisions According to
conventional financial theory, the world and its participants are, for the most part, rational wealth
maximizes who seek to increase their own well-being. According to conventional economics,
emotions and other extraneous factors do not influence people when it comes to making
economic choices. However, there are many instances where emotion and psychology influence
decisions, causing to behave in unpredictable or irrational ways.

IMPORTANT CONTRIBUTORS

Like every other branch of finance, the field of behavioral finance has certain people that have
provided major theoretical and empirical contributions.

Daniel Kahneman and Amos Tversky

Cognitive psychologists Daniel Kahneman and Amos Tversky are considered the fathers of
behavioral economics/finance.

Kahneman and Tversky have focused much of their research on the cognitive biases and
heuristics i.e. approaches to problem solving that cause people to engage in unanticipated
irrational behavior. Their most popular and notable works include writings about prospect theory
and loss aversion

Richard Thaler

While Kahneman and Tversky provided the early psychological theories that would be the
foundation for behavioral finance, this field would not have evolved if it weren't for economist
Richard Thaler. During his studies, Thaler became more and more aware of the shortcomings in
conventional economic theories as they relate to people's behaviors. After reading a draft version
of Kahneman and Tversky's work on prospect theory, Thaler realized that, unlike conventional
economic theory, psychological theory could account for the irrationality in behaviors.
Thaler went on to collaborate with Kahneman and Tversky, blending economics and finance
with psychology to present concepts, such as mental accounting, the endowment effect and other
biases.
BEHAVIORAL FINANCE – ANAMOLIES

For a while, theoretical and empirical evidence suggested that CAPM, EMH and other rational
financial theories did a respectable job of predicting and explaining certain events. However, as
time went on, academics in both finance and economics started to find anomalies and behaviors
that couldn't be explained by theories available at the time. While these theories could explain
certain "idealized" events, the real world proved to be a very messy place in which market
participants often behaved very unpredictably

In most cases, however, this assumption doesn't reflect how people behave in the real world. The
fact is people frequently behave irrationally. These anomalies prompted academics to look to
cognitive psychology to account for the irrational and illogical behaviors that modern finance
had failed to explain. Behavioral finance seeks to explain people actions, whereas modern
finance seeks to explain the actions of the "economic

An investment theory that states it is impossible to "beat the market" because stock market
efficiency causes existing share prices to always incorporate and reflect all relevant information.
According to the EMH, this means that stocks always trade at their fair value on stock
exchanges, making it impossible for investors to either purchase undervalued stocks or sell
stocks for inflated prices. As such, it should be impossible to outperform the overall market
through expert stock selection or market timing, and that the only way an investor can possibly
obtain higher returns is by purchasing riskier investments.

Although it is a cornerstone of modern financial theory, the EMH is highly controversial and
often disputed. Believers argue it is pointless to search for undervalued stocks or to try to predict
trends in the market through either fundamental or technical analysis
Meanwhile, while academics point to a large body of evidence in support of EMH, an equal
amount of dissension also exists. For example, investors, such as Warren Buffett have
consistently beaten the market over long periods of time, which by definition is impossible
according to the EMH. Detractors of the EMH also point to events, such as the 1987 stock
market crash when the Dow Jones Industrial Average (DJIA) fell by over 20% in a single day, as
evidence that stock prices can seriously deviate from their fair values.

An important debate among stock market investors is whether the market is efficient - that is,
whether it reflects all the information made available to market participants at any given time.
The efficient market hypothesis (EMH) maintains that all stocks are perfectly priced according
to their inherent investment properties, the knowledge of which all market participants possess
equally. At first glance, it may be easy to see a number of deficiencies in the efficient market
theory, created in the 1970s by Eugene Fama. At the same time, however, it's important to
explore its relevancy in the modern investing environment.

EMH TENETS AND PROBLEMS

First, the efficient market hypothesis assumes that all investors perceive all available information
in precisely the same manner. The numerous methods for analyzing and valuing stocks pose
some problems for the validity of the EMH. If one investor looks for undervalued market
opportunities while another investor evaluates a stock on the basis of its growth potential, these
two investors will already have arrived at a different assessment of the stock's fair market value.
Therefore, one argument against the EMH points out that, since the balance of investors value
stocks differently, it is impossible to ascertain what a stock should be worth under an efficient
market.

Secondly, under the efficient market hypothesis, no single investor is ever able to attain greater
profitability than another with the same amount of invested funds: their equal possession of
information means they can only achieve identical returns. But consider the wide range of
investment returns attained by the entire universe of investors, investment funds and so forth. If
no investor had any clear advantage over another, would there be a range of yearly returns in the
mutual fund industry from significant losses to 50% profits, or more. According to the EMH, if
one investor is profitable, it means the entire universe of investors is profitable. In reality, this is
not necessarily the case. Thirdly and closely related to the second point, under the efficient
market hypothesis, no investor should ever be able to beat the market, or the average annual
returns that all investors and funds are able to achieve using their best efforts.This would
naturally imply, as many market experts often maintain, that the absolute best investment
strategy is simply to place all of one's investment funds into an index fund, which would
increase or decrease according to the overall level of corporate profitability or losses. There are,
however, many examples of investors who have consistently beat the market - you need look no
further than Warren Buffet to find an example of someone who's managed to beat the averages
year after year.

QUALIFYING THE EMH

It is impossible for the market to attain full efficiency all the time, as it takes time for stock
prices to respond to new information released into the investment community. The efficient
hypothesis, however, does not give a strict definition of how much time prices need to revert to
fair value Moreover, under an efficient market, random events are entirely acceptable but will
always be ironed out as prices revert to the norm. It is important to ask, however, whether EMH
undermines itself in its allowance for random occurrences or environmental eventualities. There
is no doubt that such eventualities must be considered under market efficiency but, by definition,
true efficiency accounts for those factors immediately. In other words, prices should respond
nearly instantaneously with the release of new information that can be expected to affect a
stock's investment characteristics. So, if the EMH allows for inefficiencies, it may have to admit
that absolute market efficiency is

INCREASING MARKET EFFICIENCY

Although it is relatively easy to pour cold water on the efficient market hypothesis, its relevance
may actually be growing. With the rise of computerized systems to analyze stock investments,
trades and corporations, investments are becoming increasingly automated on the basis of strict
mathematical or fundamental analytical methods. Given the right power and speed, some
computers can immediately process any and all available information, and even translate such
analysis into an immediate trade execution.

Despite the increasing use of computers, however, most decision-making is still done by human
beings and is therefore subject to human error. Even at an institutional level, the use of analytical
machines is anything but universal. While the success of stock market investing is based mostly
on the skill of individual or institutional investors, people will continually search for the surefire
method of achieving greater returns than the market averages.

It's safe to say the market is not going to achieve perfect efficiency anytime soon. For greater
efficiency to occur, the following criteria must be met: (1) universal access to high-speed and
advanced systems of pricing analysis, (2) a universally accepted analysis system of pricing
stocks, (3) an absolute absence of human emotion in investment decision-making, (4) the
willingness of all investors to accept that their returns or losses will be exactly identical to all
other market participants. It is hard to imagine even one of these criteria of market efficiency
being met.

RANDOM WALK THEORY

The theory that stock price changes have the same distribution and are independent of each
other, so the past movement or trend of a stock price or market cannot be used to predict its
future movement. In short, this is the idea that stocks take a random and unpredictable path. A
follower of the random walk theory believes it's impossible to outperform the market without
assuming additional risk. Critics of the theory, however, contend that stocks do maintain price
trends over time - in other words, that it is possible to outperform the market by carefully
selecting entry and exit points for equity investments.

The random walk theory is the occurrence of an event determined by a series of random
movements - in other words, events that cannot be predicted. For example, one might consider a
drunken person's path of walking to be a random walk because the person is impaired and his
walk would not follow any predictable path.
Applying the random walk theory to finance and stocks suggests that stock prices change
randomly, making it impossible to predict stock prices. The random walk theory corresponds to
the belief that markets are efficient, and that it is not possible to beat or predict the market
because stock prices reflect all available information and the occurrence of new information is
seemingly random as well.

The random walk theory is in direct opposition to technical analysis, which contends that a
stock's future price can be forecasted based on historical information through observing chart
patterns and technical indicators.

Academics cannot conclusively prove or agree on whether the stock market truly operates via a
random walk or based on predictable trends because there are published studies that support both
sides of the issue.

CRITICS
Although behavioral finance has been gaining support in recent years, it is not without its critics.
Some supporters of the efficient market hypothesis, for example, are vocal critics of behavioral
finance.

The efficient market hypothesis is considered one of the foundations of modern financial theory.
However, the hypothesis does not account for irrationality because it assumes that the market
price of a security reflects the impact of all relevant in formation as it is released.

The most notable critic of behavioral finance is Eugene Fama, the founder of market efficiency
theory. Professor Fama suggests that even though there are some anomalies that cannot be
explained by modern financial theory, market efficiency should not be totally abandoned in
favor of behavioral finance. In fact, he notes that many of the anomalies found in conventional
theories could be considered shorter-term chance events that are eventually corrected over time.
In his 1998 paper, entitled "Market Efficiency, Long-Term Returns And Behavioral Finance",
Fama argues that many of the findings in behavioral finance appear to contradict each other, and
that all in all, behavioral finance itself appears to be a collection of anomalies that can be
explained by market efficiency.
Behavioral finance: insights in to Indian stock market realties:

Behavioral finance is an emerging field that combines the understanding of behavioral and
cognitive psychology with financial decision making processes. the traditional economic theory
we understand talks about efficient markets and people making rational decisions to maximize
profits. However this new emerging school of behavioral economists argues that markets are not
efficient ,especially in the short run, and people do not make rational decisions to maximize
profits. Human beings are susceptible to numerous behavioral anomalies, which become
counter –productive to the wealth –maximization principle leading to irrational behavior. If we
reflect on ones own investment decisions and the mistake made in the past would highlight the
essence of behavioral finance.

According to conventional financial theory, the world and its participants are, for the most part,
rational "wealth maximizers". However, there are many instances where emotion and
psychology influence our decisions, causing us to behave in unpredictable or irrational ways.
Behavioral finance is a relatively new field that seeks to combine behavioral and cognitive
psychological theory with conventional economics and finance to provide explanations for why
people make irrational financial decisions.

Behavioral finance is a relatively new field that seeks to combine behavioral and cognitive
psychological theory with conventional economics and finance to provide explanations for why
people make irrational financial decisions

For a while, theoretical and empirical evidence suggested that CAPM, EMH and other rational
financial theories did a respectable job of predicting and explaining certain events. However, as
time went on, academics in both finance and economics started to find anomalies and behaviors
that couldn't be explained by theories available at the time. While these theories could explain
certain "idealized" events, the real world proved to be a very messy place in which market
participants often behaved very unpredictably

One of the most rudimentary assumptions that conventional economics and finance makes is that
people are rational "wealth maximizers" who seek to increase their own well-being. According
to conventional economics, emotions and other extraneous factors do not influence people when
it comes to making economic choices. In most cases, however, this assumption doesn't reflect
how people behave in the real world. The fact is people frequently behave irrationally

These anomalies prompted academics to look to cognitive psychology to account for the
irrational and illogical behaviors that modern finance had failed to explain. Behavioral finance
seeks to explain our actions, whereas modern finance seeks to explain the actions of the
"economic

Behavioral anamolies:

It is in the pursuit making quick gains that tend to take short-cuts that lead us in to difficult
situations. There is a law of farms you cannot reap today and sow tomorrow. A seed when sown
has to go through various seasons before it turns in to fully grown tree. This takes time so in the
case of investments .one cannot have short cuts to making money by buying stocks that will go
up fast. However, in the world of investments “growth stocks” offer such opportunities. It is the
promise of a dream to make big and fast money. Who does not like an opportunity like this there
are many takers for it. This leads to a scramble for growth stocks and investors fall in to the
“growth trap When every one is chasing the growth stocks, these stocks become a favorite and
they become expensive. Hence in the process investors ignores the basic parameters of
investing ,like valuations, earnings and dividends. Their focus is only on buying a stock, which
they will be able to subsequently sell at a huge profit to some other investor. There are various
cognitive biases which leads to this type of anomalies which are explained below

Cognitive psychologists have documented many patterns regarding how people behave.

Some of these patterns are as follows:

Heuristics:

Heuristics, or rules of thumb, make decision-making easier. But they can sometimes lead to
biases, especially when things change. These can lead to suboptimal investment decisions.
When faced with N choices for how to invest retirement money, many people allocate using the
1/N rule. If there are three funds, one-third goes into each. If two are stock funds, two-thirds
goes into equities. If one of the three is a stock fund, one-third goes into equities. Recently,
Benartzi and Thaler (2001) have documented that many people follow the 1/N rule.
Overconfidence:

People are overconfident about their abilities. Entrepreneurs are especially likely to be
overconfident. Overconfidence manifests itself in a number of ways. One example is too little
diversification, because of a tendency to invest too much in what one is familiar with. Thus,
people invest in local companies, even though this is bad from a diversification viewpoint
because their real estate (the house they own) is tied to the company’s fortunes. Think of auto
industry employees in Detroit, construction industry employees in Hong Kong or Tokyo, or
computer hardware engineers in Silicon Valley. People invest way too much in the stock of the
company that they work for. Men tend to be more overconfident than women. This manifests
itself in many ways, including trading behavior. Barber and Odean (2001) recently analyzed the
trading activities of people with discount brokerage accounts. They found that the more people
traded, the worse they did, on average. And men traded more, and did worse than, women
investors.

Mental Accounting

People sometimes separate decisions that should, in principle, be combined. For example, many
people have a household budget for food, and a household budget for entertaining. At home,
where the food budget is present, they will not eat lobster or shrimp because they are much more
expensive than a fish casserole. But in a restaurant, they will order lobster and shrimp even
though the cost is much higher than a simple fish dinner. If they instead ate lobster and shrimp
at home, and the simple fish in a restaurant, they could save money. But because they are
thinking separately about restaurant meals and food at home, they choose to limit their food at
home.

Framing

Framing is the notion that how a concept is presented to individuals matters. For example,
restaurants may advertise “early-bird” specials or “after-theatre” discounts, but they never use
peak-period “surcharges.” They get more business if people feel they are getting a discount at
off-peak times rather than paying a surcharge at peak periods, even if the prices are identical.
Cognitive psychologists have documented that doctors make different recommendations if they
see evidence that is presented as “survival probabilities” rather than “mortality rates,” even
though survival probabilities plus mortality rates add up to 100%.

Representativeness

People underweight long-term averages. People tend to put too much weight on recent
experience. This is sometimes known as the “law of small numbers.” As an example, when
equity returns have been high for many years (such as 1982-2000 in the U.S. and western
Europe), many people begin to believe that high equity returns are “normal.”

Conservatism

When things change, people tend to be slow to pick up on the changes. In other words, they
anchor on the ways things have normally been. The conservatism bias is at war with the
representativeness bias. When things change, people might under react because of the
conservatism bias. But if there is a long enough pattern, then they will adjust to it and possibly
overreact, underweighting the long-term average.

Disposition effect

The disposition effect refers to the pattern that people avoid realizing paper losses and seek to
realize paper gains. For example, if someone buys a stock at $30 that then drops to $22 before
rising to $28, most people do not want to sell until the stock gets to above $30. The disposition
effect manifests itself in lots of small gains being realized, and few small losses. In fact, people
act as if they are trying to maximize their taxes! The disposition effect shows up in aggregate
stock trading volume. During a bull market, trading volume tends to grow. If the market then
turns south, trading volume tends to fall. As an example, trading volume in the Japanese stock
market fell by over 80% from the late 1980s to the mid 1990s. The fact that volume tends to fall
in bear markets results in the commission business of brokerage firms having a high level of
systematic risk One of the major criticisms of behavioral finance is that by choosing which bias
to emphasize, one can predict either under reaction or overreaction. This criticism of behavioral
finance might be called "model dredging." In other words, one can find a story to fit the facts to
ex post explain some puzzling phenomenon. But how does one make ex ante predictions about
which biases will dominate? There are two excellent articles that address this issue: Barberis
and Thaler (2002), and Hirshliefer (2001). Hirshliefer (p. 1547) in particular addresses the issue
of when we would expect one behavioral bias to dominate others. He emphasizes that there is a
tendency for people to excessively rely on the strength of information signals and under-rely on
the weight of information signals. This is sometimes described as the salience effect.

PART 2: BEHAVIORAL FINANCE-INDIAN STOCK MARKET


REALTIES(SEVERAL FIELDS)
GROWTH TRAP:

In pursuit of making quick gains that we tend to take short-cuts that leads\us\into difficult situations. there
is the law of the farm: you cannot reap today and sow tommarow.A seed sown has to go through various
seasons before it turns in to a fully-grown tree. So in the case of investments, you cannot have short cuts
to making money by buying stocks that will go up fast. However in the world of investments “growth
stocks “offer such opportunities. It is the promise of a dream to make big and fast money. who does not
like an opportunity like this? there are many takers for it. this leads to a scramble for such growth stocks
and investors fall in to the “growth trap”

To understand the growth trap better lets look at his example.

In the 1970,s and 1980,s,the textile industry witnessed a spectacular boom in India. textile companies
were mushrooming all over the country. If you were in the stock market in 1979,you would have at least
some of your money invested in textile stocks and you would have been a firm believer that the future of
India lies in textiles. There were three textile companies in the sensex viz,century textiles, Indian rayon
and Bombay dying, century textiles had over 6.50% of the weight age in the sensex

It is 1979.you are given a choice to buy one of the two stocks from the index to plan for your retirement.
One is century textiles. It is the stock market favorite and happens to be in a promising sector,textiles.The
other one is associated with cement company(ACC) an ordinary cement company classified as
commodities. The stock would be governed by the prices of cement in this cyclical industry.

Assume that you would be reinvesting all the dividends and subscribe to all the right issues if any. the
returns of this investment will be calculated a quarter of a century later and will be used for your
retirement. In which company will one make investment.

To help one understand better, let us look at the textiles and the cement industries. the textile industry is a
stead sector and is devoid of any industries cycles. There is a demand for textiles throughout the year and
consumers append on clothes more frequently than on cement. Cement being a pure commodity industry
is highly cyclical in nature. The cement industry is directly dependent on the infrastructure spending will
hit the cement industry. At the same time, it is extremely difficult to predict the boom and bust of a
cyclical industry. if one were to ask a professional one would be advised to go for century rather than
McCall the arguments are in favor of ACC.It had all the characteristics of the growth stock. A high PE
signifying high investor expectations and lower dividend yield. growth stock where one could benefit fro
a higher capital appreciation and which was the market favorite would be the natural choice.

However in reality in 27 years later one would have been better off had one bought ACC.buying Century
would have got one into the growth trap.ACC beat century by a wide margin in returns to the investor.
Chasing a fancy and following the herd is a sure way to pay an excessive price and thus get in to the
growth trap.

WHY DID ACC BEAT CENTURY TEXTILES:

THE answer in short is valuation. Valuation is nothing but the price that one pays for the future stream of
expected earnings and the dividends. Since century was a growth stock and a market favorite there was
too much of investor expectations built in to the stock price. Hence an investor ended up paying a higher
price for its future stream of earnings. This resulted in a low yield. On the other hand ACC being a
neglected stock, there were no inbuilt investor expectations in the stock price. This made ACC a high
dividend yield stock. This benefited yield of ACC was more than double the dividend yield of
century.ACC,s average PE ratio, an imp parameter of valuation, was 14 points lower than that of century
textiles. This made aACC far cheaper than century. the following table shows the wide difference in the
valuation measures of both the companies.

Valuation measures Century textiles ACC


Average dividend yield 2.41 5.51
(1979-2006)
Average PE (1979-2006) 38.94 24.31

ACC had a lower price and a higher dividend yield. Thus ,more shares could be bought out of its yearly
dividends. This has resulted in a return of 25.67%.As against that century has returned 19.33% only ,a
difference of 6.34%.

SOURCES OF RETURN(1979-2006)

RETURN MEASURES CENTURY TEXTILES ACC


Capital appreciation 16.92% 20.16%
Dividend yield 2.41% 5.51%
Total return 19.33% 25.67%

To help us put the premium of 6.34%,earned over an extended period of 27 years ,let us compare the final
value of RS 1 lakh invested in 1979,at the end of 2006

Name CAGR% Final accumulation


Century textiles 19.33 1.2 crores
ACC 25.67 5.1 crores
In the case of century textiles,rs 1 lakh grew 120 fold to rs 1.2 crores.howerver for ACC THE RS 1
LAKH GREW 510 FOLD TO A WHOPPING RS.5.1crores.At the end of 27 years taking in to
consideration inflation this difference is a phenomenal for the retired person.

2.2 SECTOR INVESTING:

A host of companies is listed on the stock market, and if one were to look for a good investment
opportunity, one would definitely try to narrow the search by first identifying the industry or the sector
that looks promising, and then identifying various companies in that particular industry or sector. Growth
in a particular sector would signify that companies in that sector. Growth in a particular sector would
signify that companies in that sector would also enjoy high growth and would attract investments from
investors.

Stock markets are all about discontinuity and creative destruction. From time to time, different sectors
dominate investor intersest.No sector has a permanent appeal amongst investors. It is the inherent nature
of investors to get enamored by the new, as it signifies growth opportunities, which in turn lead to
abnormal returns.

How do new sectors happen and catch the fancy of investors? It could happen with the change in fortunes
of particular sector, due to factors such as change in price of raw material as we saw in the recent
commodities boom, change in government policies, economic growth and shortage due to natural
disasters.

Alternatively, it could be due to the advent of new technology, as we saw with the internet, the birth of
the technology sector, the telecommunications sector and the hardware industry. this technological
revolution could also spell the death of knell for certain industries. for examples the optic cables replaced
the wire cable industry, mobile wireless phones are replacing the old-fixed phones. Over time such
changes happen, and the stock market is a place where such new idea get funded. Investors are always
looking at getting in to a new sector, as they firmly believe that these future growth sectors would make
them immensely rich. Investors have a penchant for chasing the new, and thus new sectors soon become
the stock market factors.

Major anomalies in the sector specific stocks

1.representativeness

2.avilability

3.herd mentality

4.anchoring

5.winners curse

6.confirmation bias

To illustrate this effect we will take the example of reliance power IPO
This is an interesting case study as it shows how greed can become a graveyard for even a strong brand
like “reliance”. Evidence was shown that power sector was the hottest sector in 2007.It was showing
signs of bubble. However ,everything changed in February 2008.

Management of RPL:

Although the promoter had another listed company, reliance energy, they chose to float RPL as a separate
company. May be the wild sector growth prompted him to get in to the trap. These were certain transfers
from reliance energy, and capital structuring and financing questions with RPL.this action signifies the
promoter greed.

RPL, a new company with a profit of merely Rs.16 lakhs,planned to enter the markets at around Rs.450
per share for the face value of RS.10.This is again greed and the over confidence in the reliance
brand.Overconfidance bias was so strong that one hardly saw any banners or advertisements were linked
to the India growth story and powering India. No doubt, the issue was heavily over subscribed and made
a record to be called the mother of all issues. The brand name had worked.

Investment bankers appointed by RPL:

The job of the investment bankers is to advise the company on pricing the issue and to create a win-win
situation for both the company and the investors.However,when brand reliance is scouting for investment
bankers there is mad rush to be in the list. the advisory role takes a back seat and they all become selling
agents. Their goal is to please the company and to sell the company’s shares at a price the company
wants. Professional wisdom takes a back seat and greed dominates. Greed to earn huge fees and greed to
be associated with brand Reliance. The issue was oversubscribed and they all celebrated. Each one took
pride in their collection to the isuue.But no one knows how much of his or her own money he or she
invested in the issue.

What made the issue a success:

1.strong sector growth and fancy attached the investors

2.Brand reliance under the leadership of the late Dhirubai Ambani,the father of equity investing in
INDIA, had never let down those who invested in his company.RPL was an “Anil Ambani group
“company>representative heuristic was at work

3.bullish market conditions prevailing at the time

4.greed of the investors

5.Aggressive selling of investment bankers and grey market premium.

Behavioral traits that worked in marketing:

AVAILABILITY BIAS:

There was this theme of “powering India”.RPL was the answer.this was linked to the India growth
story.Every one believed in the India growth story and ,thus started believing in the RPL story of
powering India.Moreover,it was the strong brand of reliance that was viewed in every ones mind
Representative thinking:

Since the power sector was hot, all the power companies stocks were quoting at high PE multiples.
Investors had seen the prices of these companies going up. There were also visible listing giants in
companies like power grid and NTPC.This made investors see RPL as representative of a good power
sector stock.

Gray premium manipulation:

Let us go back a decade when there was a grey market premium for the close ended mutual fund
launched by Morgan Stanley. It was the classic case of investor insanity and brute manipulation.
Investors got trapped and lost money. the reputation of Morganstanley was tarnished and, to date ,they
have not ventured to bring another mutual fund to the markets. there was a gray market premium of
around Rs.400 to 500 in RPL.Investors got trapped with two heuristics: availability heuristic, where
available information of a market price on listing assure profits: and representative heuristic, where RPL
stock was representative of a price equal to the issue price plus the gray market premium. In short, a stock
available at 50% discount to the expected market price. Over –Zealous investment bankers capitalized.

Greater fool theory:

The investors also understood that the stock offering price of around Rs.430 to 450 was expensive, but all
were confident that they would sell their stock on listing and make a clean profit. There were broker
reports recommending subscription to the issue with an exit on listing. The greater fool theory was at
work.Surprisingly,even the qualified institutional investors were also thinking on the same lines.

Herd mentality: Every body wanted to sell on the listing and the stock tumbled. It was the herd at work.
the same herd had made the issue a mother of all issues a fortnight back. this is how crowd behavior
works.

Lesson to be leant:

Only 10% of shares were issued to the public. the main promoters Anil Ambani and Reliance energyltd
held 45% each. They had offered themselves each share at Rs.10,while the public was offered the same
shares at Rs.430-Rs 45o per share. This was a blatant display of overconfidence and greed.

Wisdom ignored:

An issue price of Rs.250-300 would have changed the situation drastically. The decrees in resource
mobilization would have been more than offset by the goodwill of the investors gained. Brand reliance
would have become much stronger. This is what Mr.Dhirubai Ambani had done. he understood the
psychology of the markets and investors.That,how he created brand reliance and became known as the
father of equity investing in India. Here GREED together with Biased advisors ,evaded wisdom.

2.3.Bubble trap:
About the century and a half ago, the philosopher ,Santayana observed that those who donot learn from
their history are condemned to repeat it. Speculative excesses, referred to concisely as bubble or mania,
and contraction from such excesses in the form of crash, crisis or panic, can be shown as ,if not
inevitable, at least historically common. It appears that the financial community as a whole does not seem
to learn from the previous mistakes and continuous to repeat these mistakes, in different forms, leading to
the same painful and financial crisis.

A bubble can only be formed when there are many greedy investors who are willing to allow someone to
exploit their greeed.this crowd goes on increasing in size, as other greedy investors join the bandwagon
out of envy. This has a snow balling effect, leading to creation of an illusion in the form of a bubble. The
recent recession and the bubble burst is also the result of the same kind of behavior.

Human behavioral ANAMOLIES:

Bubbles are formed due to the irrational human behavior. History ahs shown that, when there is euphoria,
people become irrational, and their decisions are more emotional than rational and practical. Let us
examine the few anomalies that cause the bubble trap

Availability heuristic:

People tend to make decisions based on recent events, which are vivid in their minds. when certain types
of information hit you on a regular basis, you tend o be swayed by such information. your decision
making process gets guided by this recently and regularly available information. In the time of optimism
in the markets ,there is a lot of investor interest regarding company news, new offerings, new investment
tips,etc.the people kindly follow the information on the markets and they make the decisional based on
the information they get from the media. Bullish conditions provide positive news on economy, the stock
markets and stock investments. The media are the vehicles to promote this news.

Excessive optimism:

In times of excessive optimism ,companies become very aggressive and come out with huge ambitious
plans requiring huge capital outlays. They borrow excessively and approach the capital markets for
funding. Excessive optimistic investors are always ready to take part in the action. THE initial public
offering of “RPL”is a classic example of what excessively optimistic promoters and investors can do. It is
important to understand nothing is permanent in life. being equanimous is the key to success

Over confidence;

Over confidence in one’s ability arises from one’s success in investing. As there are a few successes in
stocks, due to the general improvement in the stock market sentiment and a bit of luck, makes people
overconfident of their ability. From 2003 onwards we have seen such a bull run that everyone who
entered the stock markets has made money.However.this success is not related to one’s ability alone.
when the sentiment changes and the tide turns, stock prices just collapse even if the fundamentals of the
company have not changed. being overconfident of one’s knowledge and ability could lead one to make
financial blunders, especially in bubble phase.

There are few other anomalies during the time of recession include, greed of investors, representative
heuristic, envy and the endowment effect.
CONCLUSION AND ANALYSIS

Investors would do better not only in investing, but also in all walks of life, if they keep in mind the
behavioral biases that effect clarity in thinking .Money is good as long it is in the pocket. It becomes
dangerous when it goes in the head. That is when we become irrational and start making blunders.

“house money effect” is used to denote the tendency common amongst gamblers playing in casinos,
where they are ready to take more risk with money earned easily or unexpectedly, which is eventually
what success in gambling means This tendency is not limited to gambles in the casinos: it is prevalent in
the stock market as well, particularly during bull runs. financial markets are growing all over the world.
Every country needs to attract capital for its growth and what better route can there be than the stock
markets? Borders are opening up and with the use of new technologies such as internet, information is
available to all.thus,financial markets have become very fluid. With the click of a button, transactions
take place. this has led to growth of an investing class hungry for investing opportunities to make fast
buck. The chaos in the market along with the emotions of greed and fear have created investors who are
very short-sighted and unpredictable.

It is important to understand the behavior of these investors so that we can manage their perceptions
and,thereby,control the volatility in the stock prices due to their actios.they are the stakeholders of a
corporation and understanding their behavior will help the corporation to manage its stock volatility.

REFERENCES

1.WWW.INVESTOPEDIA.COM

2.AGAINST THE GODS:THE REMARKABLE STORY OF RISK by Bernstein,Peter

3.VALUE INVESTING AND BEHAVIORAL FINANCE by Parag Parikh

4.securityanalysis by Bengamin Graham