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Procedia - Social and Behavioral Sciences 82 (2013) 870 – 876

World Conference on Psychology and Sociology 2012

Behavioural Finance: The Emergence and Development Trends

Egidijus Bikas a * a
, Petras Dubinskas a a

a
-10225 Vilnius, Lithuania

Abstract

Global financial markets are influenced by many factors: the economic processes which take place in the country and the
world, institutional and political constraints, information dissemination and accessibility, and so on. However, one of the most
important factors is the people's reaction and perception. For each investor, regardless of financial instruments, business is a
constant decision-making process. The article aims to analyse the research of non-professional investors' financial behaviour
in a historical-theoretical perspective. This article reveals the aims of recognition and emotional factors on market movements
focusing on a limited number of investor rationality and explains the psychological effects of investing activities. The
methods of analysis and synthesis, description and comparison were applied in the article. Graphical visualization is used for
demonstration of results.

2013 The Authors. Published by Elsevier Ltd.

© 2013 The Authors. Published by Elsevier Ltd. Open access under CC BY-NC-ND license.
Selection and peer review under the responsibility of Prof. Dr. Kobus Maree, University of Pretoria, South Africa.
Selection and peer review under the responsibility of Prof. Dr. Kobus Maree, University of Pretoria, South Africa.

Keywords: Behavioural Finance, Behavioural Biases, Investment Decission Making Of Individuals.

1. Introduction

Investing in financial markets in recent decades has become popular not only among institutional but also
individual investors. Communications and information have become available worldwide in seconds speed.
Undoubtedly, investment decisions depend on the object and its financial status in the future, but often short-term
price changes are driven by market participants that are not always based on logic, sometimes are inspired by
mood or instantly "received news". Trying to explain the influence of various market participants on financial
markets, behavioural finances (which outset some authors derive from 1994 (Uchitelle, 2001), others try to prove
that the beginning of this theory lies in 1950ies or in early 1960ies or even before WW II yet (Hoseini, 2003)
appears and expand. This theory became popular in Lithuania too. Some authors use it for explaining the

pers & Bikas, 2008; Bikas & ; et

al., 2012).

* Corresponding author: Egidijus Bikas. +3706-85-44-280

E-mail address: egidijusvu@yahoo.com

1877-0428 © 2013 The Authors. Published by Elsevier Ltd. Open access under CC BY-NC-ND license.
Selection and peer review under the responsibility of Prof. Dr. Kobus Maree, University of Pretoria, South Africa.
doi:10.1016/j.sbspro.2013.06.363
 Egidijus Bikas et al. / Procedia - Social and Behavioral Sciences 82 (2013) 870 – 876 871

Behavioural finance is the result of the structure of various sciences (Ricciardi & Simon, 2000):
psychology a science that analyses processes of behaviour and mind, how processes are influenced by
physical, psychical, and external environment of human being;
finances a system of formation, distribution and use of resources;
sociology systematic science about socio- behaviour of human being or a group, emphasising the influence

According to Shefrin (2001), behaviour finance is the study of how psychology affects financial decision
making process and financial markets. Since psychology explores human judgment, behaviour and welfare, it can
also provide important facts about how human actions differ from traditional economic assumptions. Raiffa and
Raiffa (1968), Kahneman and Tversky (1979) noted that the behaviour of the individual in theory differs from
practice, and classic financial models cannot explain or predict all the financial decisions. Therefore, earlier and
now the economic rationality of human being in its behaviour finance is criticized reasonably. Behavioural
finance as a science became especially popular after 2002 when Daniel Kahneman was awarded The Sveriges
Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for having integrated insights from
psychological research into economic science, especially concerning human judgment and decision-making
under uncertainty. The article deals with theoretical aspects of behavioural finance scientific inquiries in
retrospect. The methods of analysis and synthesis, description and comparison were applied in the article.

2. The bottom line of the behavioural finance

Definition of behavioural finance supposes two important aspects individual investors and entire market. In
other words behavioural finance in a broad sense is divided to macro behavioural finance and micro behavioural
finance (Pompian, 2006). Macro behavioural finance discloses and describes anomalies of efficient market
hypothesis that could be explained by models of people behaviour. Micro behavioural finance analyses behaviour

stern mathematical- et al., 2012).

As for the definition of behavioural finance in the early XVIII century, Adam Smith in The Theory of Moral
Sentiments determined mental and emotional human interaction and communication basics. The author basing on
such behavioural elements as pride, disgrace, insecurity, egoism tried to explain the actions of a man and the
pursuit of profit (Smith, 1998). However, from the beginning of the XIX century when economics was dominated
by neoclassical theories, psychology was displaced from the factors which have an effect on discourse of
economy until the mid of XX century. Behavioural finance as a science originates in 1985 when two articles that

were published in the "Journal of Finance" (De Bondt & Thaler, 1985).

fluctuations. Goldberg and Von Nitzsch (1999) defined behavioural finance as financial market theory oriented
towards behaviour; subject which is applied to facts that people behave rationally only within specific limits.
Thaler (1999) stated that behavioural finance is an integration of classical economics and financial theories
within studies investigating psychology and decision making. Fuller (2000), Fromlet (2001) and Jordan and

making process and market prices. Ritter (2003) stated that behavioural finance strives to supplement standard
financial theories introducing psychological dimension into decision-making process, while Levy and Post
(2005) explained behavioural finance as theories, able to explain market inefficiency and market anomalies.
Parallel to these opinions are Bodie et al. (2007) who describe behavioural finance as a set of models of financial
Financial
behaviour was widely studied by Sewell (2007), who made an overview of the development of this science and
described the most distinguished scholars.
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Basic behavioural factors affecting investor according to Fischer and Gerhardt (2007) are: Fear; Love; Greed;
Optimism; Herd instinct; the tendency to focus on the recent experience; the tendency to overestimate oneself

Hon-Snir et al. (2012) in their study found out that more proficient investors are less affected by the behaviour
biases. The authors examined five behavioural biases in decision-making process in the stock market and
differences of possible individual solutions due to these behavioural deviations: disposition effect, herd
behaviour, availability heuristic, gambler's fallacy and hot hand fallacy.
This topic is particularly relevant to Lithuania during the period of financial instability, as the financial crisis
presupposes a need to know the types of investors, decision-making, and the possible reasons for their decision-
making. Summarizing we can conclude that behavioural finance covers both - the impact of various changes or

financial decision making.

3.

Behavioural finances are more related to analysis of non-

impossible to separate market influence and personal psychological factors analys
treatment in financial markets. Increased interest in the profits gained via financial transactions in recent decade
stimulates the inquiries in this field.
One of the most significant studies appeared in 1998. De Bondt concludes that most people tend to forget the
general principles of investment theory in the investment process (do not use the beta coefficient of systematic
risk assessment) and are guided by intuition and other criteria that conflict with rational theory. In addition, it is
noted that accumulated investment experience of the investor has no significant effect on the amount of errors.
Research findings showed that small investors tend to form diversified portfolios; for this reason, not diversified
portfolios were generally drawn from a few local companies' shares that contradict to traditional portfolio
management theories but this is related to their tendency to invest only in a very well-known company' shares
(De Bondt, 1998). Meanwhile, Daniel et al. (1998) say that market participants are likely to respond to
information about certain events, but they are too sensitive to irrelevant information and at the same time very
often tend to respond poorly to events of major importance. At the same time, Daniel et al., (2002) analysed the
psychology of investor and proposed the theory underlying the valuation of private information and the lack of
formal domain evaluation, which has a negative impact on long-term investment. Huberman uses the case study
approach and confirms de Bondt claims that there is a higher propensity to invest in the local rather than in
international market, especially for those investors whose goal was to accumulate funds for retirement pension
(Huberman, 2001). It can be concluded that the investment in well-known local firms small market participants
consider a better measure of risk reduction rather than diversification of the portfolio, i.e. more preference is

Barber & Odean (2001) raise the question why people tend to overestimate their skills and knowledge. The
results showed that men traded 45% more often rather than women. However, the study revealed the fact that
active trading reduces investors' net returns. For active trading men typically reduce annual return 2.65% and
1.72% for women (Barber & Odean, 2001). The authors also support previous assertions that the market is not
efficient due to excessive investor confidence (Daniel et al., 1998; Barber & Odean, 2001).
Hirshleifer et al.
others may be rational, but investors are usually blamed for their decisions and beliefs being irrational because
they obey the "herd instinct" or react too emotionally in stressful situations. The proof of that research is radical
market changes taking place in the absence of significant news. Such irrational behaviour of stock market prices
is determined by an incorrect value and at the same time market inefficiencies. But at the same Hirshleifer et al.
state that some of the decisions which at first sight may seem irrational can actually be rational. For example, an
 Egidijus Bikas et al. / Procedia - Social and Behavioral Sciences 82 (2013) 870 – 876 873

investor by his decision corrects previous errors or delays in the decision-making and brings it over time, when
the situation can be changed. As a result, it may seem that there is no rational investor behaviour appeared in
point of popped up information. So Hirshleider et al. take an intermediate position between the rational and the
irrational market (Hirshleifer et al., 2001). One of the main goals of Hirshleifer et al. was to figure out how

behaviour theory and conclude that investors can follow the masses and ignore conflicting signals of the personal
information. This is somewhat contrary to the D
rely on their own internal information and are more sensitive to changes in the personal information comparing to
et al. propose to consider the
actions of investors rather than the stock prices changes (Hirshleifer et al., 2001; De Bondt 1998).
Daniel (2002), along with Hirshleifer et al. made more additional findings and stated that: Excessive self-

often tend to re
systematic errors; The government's role is particularly important in the investment process. The government
needs to raise the degree of market efficiency by strengthening the investment rules to increase market efficiency
and improve the quality of financial reporting. Nevertheless, the authors acknowledge that the emotions and
psychological factors have a significant influence on public discourse and political processes, and the
governments themselves face difficulties to dissociate from the subjective and make rational and right decisions.
In this case, to improve the efficiency of the market is proposed to limit statutory inexperienced investor, thereby
helping to prevent irrational decisions.
why bubbles in stock prices
arise. In accordance with qualitative methods, he analyses
statements on investors' tendency to make systematic errors. Ritter argues that these errors are often caused by

inclined to agree completely with the radical proponents of behavioural finance position that an incorrect share
value is entirely determined due to psychological factors. Sometimes the value is distorted by unbalanced supply
and demand. Sometime later, researchers sharing the irration
criticism. For example, Malkiel (2003) in his publication said that the market is less predictable and more
effective than most efficient market hypothesis critics think, most of whom are behavioural and financial
econometrics supporters, and such events as the stock price bubbles are more the exception rather than the rule,
confirming market irrationality. If the share price is irrational, it is only for a very short period. A similar position
is taken by Shiller (2003), arguing that the market has both efficiency and inefficiency features. However, the
existence of anomalies does not prove that the market is efficient, since they occur when investors underestimate
or overestimate certain events, and that is in
studies have shown that the efficient market theory is dangerous due to errors of certain factors (stock price
bubbles) interpretations. In addition, it is very difficult to determine the value of shares only in accordance with
the principles of fundamental analysis (especially when there is a prolonged market bubble), which is also
contrary to the traditional theory of rationality. Efficient market hypothesis and rational behaviour theory are
criticized as incapable of precise definition of the market and thus affecting the wrong conclusions.
Some other authors report no less interesting findings, particularly with regard to the opposition between the
ehaviour. Tseng (2006) suggested combining the traditional efficient market

on of decision-making under uncertainty)

and neural finance. Thus, Tseng shape adaptive markets hypothesis, which includes evolutionary biology,
information technology, neuro-science, psychology and sociology. The aim is to help investors to better predict
the stock market changes and make better decisions. Tseng believes that Adaptive Market Hypothesis proposed
874 Egidijus Bikas et al. / Procedia - Social and Behavioral Sciences 82 (2013) 870 – 876

by him is more accurate than the efficient market hypothesis, because the decision-making process includes more
significant factor.
Traditional finances fall into the following basic paradigms:
a) portfolio is based on the expected return and risk,
b) is subject to risk based capital asset pricing models, such as CAPM,
c) the pricing of contingent claims,
d) Modigliani-Miller theorem.
All of these ideas came from investor rationality. However, the traditional finance does not respond to the
questions:
a) why does an investor trades?
b) how does an investor trades?
c) how does an investor composes portfolios?
d) and, finally, why do stock returns vary no due to the risk?

Influences on investment strategies Inadequate response to events

Bubble The promotion of
induction irrational decisions

Investment Interpretation of
experience information

Confidence Research Areas of Masses

Behavioural Finance effect

Impact on The approach to

Impact on investment Gender aspects Information on investment
trade volumes decisions and education investment object diversification

Figure 1. Research areas of behavioural finance

Therefore, Subrahmanyam (2007), like Tseng (2006), offers to combine the traditional financial theories that
support the rationality with the behavioural finance theory, which predicts that investors' behaviour is not always
in line with the criteria of rationality. Subrahmanyam concludes that the financial behaviour properly
supplements traditional financial theories. It may help to predict not only the expected returns, but also provide
events that influence the return.
Finally, we returned to the research that attempt to find out why small investors are more likely to rely on their
competence rather than that of the experienced experts. It was observed that majority of small investors feel that
they have sufficient knowledge and experience in investing. Graham, Harvey and Huang tried to assess how this
competence effect determines trade frequency. The researchers constructed an empirical model in order to find
out what factors affect investors' competence. It is noted that investors who feel competent trade more often and
tend to have more diversified portfolio. Male investors or investors with higher education and having larger
portfolios often consider themselves to be more knowledgeable rather than women - investors, or investors with
smaller portfolios, and lower education. So, excessively self-confident investors are likely to consider themselves
as competent and are more frequent in trading (Graham et al., 2009).
 Egidijus Bikas et al. / Procedia - Social and Behavioral Sciences 82 (2013) 870 – 876 875

4. Conclusions

Behavioural finance is based on research of human and social recognition and emotional tolerance studies to
identify and understand incoming economic decisions. Behaviour finance examines recognition and emotional
the limited human rationality, explains the
psychology effect on the financial activities and argues that financial phenomena can be better explained due to
the fact that financial market participants are not rational and their decisions are limited.
Non-professional investors' financial behaviour patterns analysis allows us grasp and justify the relevance and
importance of financial behaviour. The main difference between traditional and behavioural finances is that the

Acknowledgements

This research was funded by a grant (No. MIP-007/2012) from the Research Council of Lithuania.

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