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Summary Behavioural Finance
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A complete summary of the Behavioural Finance slideshow and notes given for the module by the lecturer (2018).
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By: christopher-bischof • 5 year ago
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Financial Management 244Behavioral Finance
As indicated in chapter 9, a market is said to be efficient if, at any given time,
security prices:
Fully reflect all available information (historic, public and private) about the
company in question.
Rapidly adjust to new information.
Are in equilibrium.
Historic information is available to all information. This includes historic share prices,
dividend payments and trading volume.
Public information is available to all investors. This includes information contained in
a company’s most recent integrated report, on their website and in SENS (Stock
Exchange News Service) announcements.
Private information is available only to insiders. This includes details of upcoming
mergers or special dividend, specific legal disputes, and events regarding to the
company’s securities.
According to the efficient market hypothesis (EMH), security prices react within
minutes to new information. Information is regarded as ‘new’ if it relates to something
that the market did not know before and information that could affect the company’s
value.
If the news exceeds the markets expectations, it is considered good news.
Given increased demand for the share, the price will increase.
If an announcement falls short of the market expectation, it is considered bad
news, the share price typically falls in such a case.
If an announcement is in line with the market’s expectation, the share price
generally does not react.
According to section 77 of the Financial Markets Act (No. 19 of 2012) an ‘insider’
means a person who has inside information:
Through being a director, employee or shareholder of an issuer of securities
listed on a regulated market to which the inside information relates.
Through having access to such information by virtue of employment, office or
profession.
Where such a person knows that the direct or indirect source of the
information was a person contemplated in the above.
A company director, employee, advisor or even a journalist becomes an insider
when they are made aware of a proposed transaction that could affect the price or
value of a listed security.
As shown in Chapters 9 and 10, a share’s price is in equilibrium if its expected return
equals its required (CAPM) return and if its intrinsic value equals its market value.
In an efficient market, active investors cannot outperform passive investors.
, Financial Management 244
Active investors create their own portfolio based on selected trading rules
and/or investment criteria.
Passive investors invest in tradable market indices (called tracker funds)
which mirror a particular stock market.
Although most markets are efficient most of the time, some anomalies have been
observed. Academics are turning to the field of behavioral finance ($) to explain
these anomalies. One of the basic premises of behavioral finance is that investors do
not always act rationally.
A rational decision is one that is based on, or made in accordance, with logic or
reason. Rationality can be used to solve problems and draw conclusions.
An irrational decision disregards logic and reason. It could be made due to emotional
distress or cognitive deficiency.
A great deal of academic research has been undertaken to determine why people
exhibit irrational behavior. Some of the pioneers include Leon Festinger, Amos
Tversky, Daniel Kahneman and Robert Shiller.
In contrast to traditional financial theories, which suggest how investors and financial
managers should make decisions, behavioral finance describes how they actually
make these decisions. Emphasis is also place on the role that emotions play in
decisions making.
Irrational Behavior
Irrational behavior () can occur when investors and financial managers follow
others wen making decisions. This is called herding.
Errors can creep in when they engage in mental accounting. Mental accounting
refers to treating money differently based on its source and/or purpose.
Sub-optimal decisions can occur when investors and financial managers use
heuristics when making decisions (affect and familiarity).
Irrational behavior can occur when investors and financial managers exhibit certain
biases. These include anchoring, conservatism, status quo and confirmation.
Costly mistakes can be made when investors and financial managers exhibit
overconfidence, illusions of control and excessive optimism.
Irrational behavior can occur when investors and financial managers make decisions
to avoid regret (prospect theory).
Herding
Herding (the bandwagon effect) refers to following others (the herd/crowd) when
making decisions. Stated differently, people tend to mirror the decisions of those
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