TOPIC: BEHAVIOURAL FINANCE INTRODUCTION Behavioural finance is the study of the psychology influence on the behaviour of financial investor

and subsequently the effects of the behaviour on financial markets Graham and Dodd assert that; "The market's evaluation of the same data can vary over a wide range, dependent on bullish enthusiasm, concentrated speculative interest and similar influences, or bullish disillusionment. Knowledge is only one ingredient in arriving at a stock's price. The other ingredient, fully as important as information, is sound judgment." L.C. Gupta on other hand states; "Our findings suggest that the market's evaluation processes work haphazardly, almost like a blind man firing a gun rather than on the basis of informed beliefs about the long-term prospects of individual firms. In essence, the views expressed by Graham and Dodd and Gupta above imply that the market may at times display high irrationality causing substantial discrepancy between intrinsic values and market prices. Behavioural finance began as an attempt to understand why financial markets react inefficiently to public information. One stream of behavioural finance examines how psychological forces induce traders and managers to make suboptimal decisions, and how these decisions affect market behaviour. Another stream examines how economic forces might keep rational traders from exploiting apparent opportunities for profit Behavioural finance remains controversial, but will become more widely accepted if it can predict deviations from traditional financial models without relying on too many ad hoc assumptions, and expand to settings (particularly corporate finance) in which arbitrage forces are weaker. (Durlauf and Blume, 2008) Behavioral finance argues that some financial phenomena can plausibly be understood using models in which some agents are not fully rational. The field has two building blocks: limits to arbitrage, which argues that it can be difficult for rational traders to undo the dislocations caused by less rational traders; and psychology, which catalogues the kinds of deviations from full rationality we might expect to see. (Barberis and Thaler, 2001) Historical Development of Behavioural Finance Finance have for a long time been majorly based on assumptions which made it possible to analyze various situations which in real life could be difficult. From the mid 1950s, the field of finance has been dominated by the traditional finance model (also referred to as the standard finance model) developed primarily by the economists of the university of Chicago. The central assumption of the traditional finance model is that people are rational. However psychologists challenged the assumption. They argued that people often suffer from cognitive and emotional biases and act in seemingly irrational manner. Selden (1912) in his book, Psychology of the Stock based his studies `upon the belief that the movements of prices on the exchanges are dependent to a very considerable degree on the mental attitude of the investing and trading public' In 1956 the US psychologist Leon Festinger introduced a new concept in social psychology: the theory of cognitive dissonance (Festinger, Riecken and Schachter 1956). When two simultaneously held cognitions are inconsistent, this will produce a state of cognitive dissonance. Because the experience of dissonance is unpleasant, the person will strive to reduce it by changing their beliefs. Pratt (1964) considers utility functions, risk aversion and also risks considered as a proportion of total assets of an individual.

Tversky and Kahneman (1973) introduced the availability heuristic: `a judgmental heuristic in which a person evaluates the frequency of classes or the probability of events by availability, i.e. by the ease with which relevant instances come to mind.' The reliance on the availability heuristic leads to systematic biases. In 1974, two brilliant psychologists, Amos Tversky and Daniel Kahneman, described five heuristics driven biases heuristicdriven biases and cognitive errors that impair judgment. (Tversky and Kahneman 1974): as follows; Representativeness:

Representativeness refers to the tendency to form judgments based on stereotypes. While representativeness may be a good rule of thumb, it can also lead people astray. For example; Investors may be too quick to detect patterns in data that are in fact random. Overconfidence

People tend to be overconfident and hence overestimate the accuracy of their forecasts. Overconfidence stems partly from the illusion of knowledge. The human mind is perhaps designed to extract as much information as possible from what is available, but may not be aware that the available information is not adequate to develop an accurate forecast in uncertain situations Overcinfidence is mainly driven by: People having special information. Illusion of control also known as self-attribution bias which means that people tend to ascribe their success to their skill and their failure to bad luck human tendency to focus on future plans rather than on past experience Anchoring

After forming an opinion, people are often unwilling to change it, even though they receive new information that is relevant. Suppose that investors have formed an opinion that company A has above-average long-term earnings prospect. Suddenly, A reports much lower earnings than expected Thanks to anchoring (also referred to as conservatism), investors will persist in the belief that the company is above-average and will not react sufficiently to the bad news. So, on the day of earnings announcement the stock price would move very little. Gradually, however, the stock price would drift downwards over a period of time as investors shed their initial conservatism Aversion to Ambiguity

People are fearful of ambiguous situations where they feel that they have little information about the possible outcomes. In experiments, people are more inclined to bet when they know the probabilities of various outcomes than when they are ignorant of the same. In the world of investments, aversion to ambiguity means that investors are wary of stocks that they feel they don't understand. On the flip side it means that investors have a preference for the familiar. Innumeracy

People have difficulty with numbers. In his book Innumeracy: Mathematical Illiteracy and Its Consequences, John Paulos notes that "some of the blocks to dealing comfortably with numbers and probabilities are due to quite natural psychological responses to uncertainty, to coincidence, or to how a problem is framed

Kahneman and Tversky found empirically that people underweight outcomes that are merely probable in comparison with outcomes that are obtained with certainty also that people generally discard components that are shared by all prospects under consideration. The prospect theory describes how people frame and value a decision involving uncertainty. Under prospect theory, value is assigned to gains and losses rather than to final assets; also probabilities are replaced by decision weights And how do people value gains/losses? They value gains/losses according to a S- shaped utility function as depicted in the diagram 1 below, i.e. People feel more pain from a loss than the pleasure from a similar amount Utility Wealth Diagram 1: Kahneman and Tverskys Value Function Features of this utility function are:

1. The utility function is concave for gains. This means that people feel good when they gain, but twice the gain does not make them feel twice as good. 2. The utility function is convex for losses. This means that people experience pain when they lose, but twice the loss does not mean twice the pain. 3. The utility function is steeper for losses than for gains. This means that people feel more strongly about the pain from a loss than the pleasure from an equal gain:- about two and half times as strongly, according to Kahneman Tversky. This phenomenon is referred to as loss aversion. Mental Accounting Investors have a tendency to ride the losers as they are reluctant to realise losses. Mentally, they treat unrealised "paper loss" and realised "loss" differently although from a rational economic point of view they are the same. Investors often integrate the sale of losers so that the feeling of regret is confined to one time period. Investors tend to stagger the sale of winners over time to prolong the favourable experience. People are more venturesome with money received as bonus but very conservative with money set aside for children's education. Investors often have an irrational preference for stocks paying high dividends because they don't mind spending the dividend income, but are not inclined to sell a few shares and" dip into the capital" . Framing

Tversky and Kahneman (1986) argue that, due to framing and prospect theory, the rational theory of choice does not provide an adequate foundation for a descriptive theory of decision making. THEORY OF LIMITED ARBITRAGE The theory of limited arbitrage shows that if irrational traders cause deviations from fundamental value, rational traders will often be powerless to do anything about it. Arbitrage is an investment strategy that offers riskless profits at no cost. The hypothesis that actual prices reflect fundamental values is the Efficient Markets Hypothesis (EMH)

Behavioral finance argues that some features of asset prices are most plausibly interpreted as deviations from fundamental value, and that these deviations are brought about by the presence of traders who are not fully rational. Both "prices are right" and "there is no free lunch" are true in an efficient market; "no free lunch" can also be true in an inefficient market. Rubinstein (2001) and Ross (2001) point to the inability of professional money managers to beat the market as strong evidence of market efficiency Many investment professionals have embraced behavioral finance as an ally against standard finance. Fama (1991) says that market efficiency per se is not testable. Fama and French indicate that three-factor model when the CAPM (capital assetpricing model) produced anomalies inconsistent with market efficiency. Finance has no tests powerful enough to distinguish market inefficiency from bad asset-pricing models. The best practice is to accept market efficiency in the beat-the-market sense and reject it in the rational-prices sense Behavioural Asset Pricing Model

The BAPM (behavioral asset-pricing model) features the market interaction of two groups of traders, namely, information traders (ones who populate the standard CAPM; free of cognitive errors and have mean-variance preferences) and noise traders (live outside the CAPM, commit cognitive errors, and do not have strict mean-variance preferences). Behavioral investors consider building portfolios as pyramids of assets, layer by layer. The layers are associated with particular goals and particular attitudes toward risk Behavioral portfolio theory answers some portfolio questions and asks others. PSYCHOLOGY-THEORY DEVELOPMENT Psychology is the second building block of behavioral finance (Shleifer and Summers, 1990). Behavioral economists typically turn to the extensive experimental evidence compiled by cognitive psychologists on the biases that arise when people form beliefs, and on people's preferences, or on how they make decisions, given their beliefs The following portion discusses the recent development of psychology theories, which are directly related to behavioral finance field. Beliefs

In terms of people's beliefs, there are several psychological factors that affect investors' decision-making process: Overconfidence Optimism and Wishful Thinking Representativeness Belief Perseverance Anchoring Availability Biases Preferences

the vast majority of models assume that investors evaluate gambles according to the expected utility (EU) framework. Utility is defined over gains and losses rather than over final wealth positions, an idea first proposed by Markowitz (1952). it simply tries to capture people's attitudes to risky gambles as much as possible

EMPIRICAL EVIDENCE World wide

Barber and Odean (1999) highlighted two common mistakes investors make: excessive trading and the tendency to disproportionately hold on to losing investments while selling winners. They argue that these systematic biases have their origins in human psychology. Objective

The objective of Barber and Odean (1999) inter allia was to demonstrate that the systematic biases in investor decisions have their origins in human psychology approach

Different theories of behavioral finance were reviewed in order to formulate testable propositions concerning the effects of psychological factors on investment decisions in the stock market Findings

Barber and Odean (1999) found that the tendency for human beings to be overconfident causes the first bias in investors, and the human desire to avoid regret prompts the second. Daniel, Hirshleifer, and Subramanyam (1998) explained eventrelated security price anomalies according to the cognitive biases of investor overconfidence and self-attribution. Daniel and Titman (2000) explained the superior returns of a momentum investing strategy over the past 35 years as the result of investors overconfidence bias The behavioral models have been most successful in explaining stock price anomalies related to overreaction, under reaction, momentum strategies, herding behavior, firm size effect and BV/MV ratio effects.

Closed end mutual fund paradox The anomaly of closed end mutual funds is that the fund on the market is often sold at discounts or premiums to the net asset value. Lee, Shleifer and Thaler explain that there is a standard explanation for this discrepancy. Disregarding of agency costs, tax liabilities and liquidity of assets that are held within a closed end mutual fund, during the measurement of the assets value, are argued to result in over-valuing of assets held within closed end mutual funds (1991, p.75). Investor Sentiments

Therefore, Lee, Shleifer and Thaler believe that the true explanation for the closed end mutual fund paradox revolves around the existence of behavioural finance. They explain that if noise traders existed in the market for the buying and selling of shares in closed end mutual funds, over optimism or pessimism could be observed, resulting in the over and under priced shares of the funds Practical implications Poteshman and Serbin (2002) provide evidence that agents undertake clearly irrational actions like exercising options when it would be wealth-enhancing to sell them.

Stein (1989) and Poteshman (2001) provide evidence that agents in the options market do not react properly to volatility information about the stock market. Finally, Bakshi et al. (2000) provide evidence that agents often trade in a manner that causes option prices to move in a manner inconsistent with comparative statics obtained from traditional assumptions of rationality Empirical Evidence from Property Market

Behavioural property or real estate research is focused on examining the way that judgements and decisions are made in the property and real estate markets from the perspective of human behaviour However, much of the property behavioural research to date has been targeted towards identifying biases within the cognitive valuation process Bias within the valuation process is defined as the deviation from the standard procedures in information processing. It is this difference in information processing, which is suggested as one of the potential reasons for valuation inaccuracies (Brown, 1992). Diaz (1990a) introduced behavioural research in the property valuation field by investigating whether the U.S. residential valuers followed the normative valuation process in their routine valuation tasks. The findings suggest that the U.S. residential valuers, who participated in the study, deviated largely from following the standard deductive valuation process, in which the investigation begins with a 9 wide focus of the general market. The valuers were found to adhere more to an inductive process, in which the investigation begins with the analysis of the subject property. In Kenya

Yvan (2010) in a study examining whether the African Growth Opportunity Act (AGOA) legislation has had any impact on the market returns in Kenya identified that there are always some trade barriers or restrictions that are not removed by free trade agreements and that many companies listed on the NSE export their products to the United States under the AGOA agreement. In this study Yvan noted that the stock market reacts to different events. Psychological elements impact financial practitioners and therefore move the stock markets. Behavioral finance is the field of Finance that deals with the psychological effects on the behavior of finance practitioners. Events such as press releases, rumors, panics or euphoria can psychologically affect traders, thus affect the stock market Finance researchers have identified three behavioral issues in IPOs: The initial underpricing The long term underperformance The hot-issue market Objective of the study

The objective of this study was to examine whether the African Growth Opportunity Act (AGOA) legislation has had any impact on the market returns in Kenya Yvan(2010) carried out an empirical study which involved and analysis of companies listed in the NSE and factors that determined investment decision making. conclusion

The study concluded that apart from the AGOA treaty, the investment decisions in the Nairobi stock exchange market were based on other factors that included psychological factors AREAS OF FURTHER STUDIES the effect of investment decisions influenced by the psychological considerations to the financial performance of companies listed in the Nairobi securities market. Further research can be carried out to determine the effect of the psychological factors on market returns i.e. the degree of effect numerically of asset prices and behaviour Culture affects behaviour; there is therefore a gap on how culture affects financial decision and investment whether directly or indirectly. This could be tied to a region or a country to see patterns of investment and determine the main factors that affect investment decisions in such regions.

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