Investment Psychology: The relationship between stock prices and investors' behavior

INVESTMENT PSYCHOLOGY: THE RELATIONSHIP BETWEEN STOCK PRICES AND INVESTOR’S BEHAVIOR
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Course: BABA Final Research Project
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Date: 7 Feb 2011

ABSTRACT
The relationship between investor behavior and stock prices is usually determined on a firm by firm basis (Bernstein, 2000, p.115). Investors’ behavior is also monitored through observation of the number of trading and investment in the stock markets. The following research paper intended to investigate investment psychology as well as the relationship between stock prices and investor’s behavior.
In order to acquire the results, a questionnaire was conducted and 250 respondents comprising of business class students, investors, traders and clients interviewed as part of the Questionnaire. Questionnaires, research and observation were the main methods of data collection as these are considered appropriate in acquisition of accurate and detailed information needed for the study.
Findings were analyzed qualitatively and conclusions were made accordingly.
INTRODUCTION
Majority of individuals find the task of beating the market to be quite easy as compared to that of beating themselves in terms of being able to master their emotions while attempting to think independently. Despite the fact that decisions based on natural instincts at times turn out to be the wrong course of action, every individual is comfortable buying stocks when prices are high and are expected to rise and selling when they are at their lowest (Arthur, 1995, p.2). Majority of researchers tend to believe that the study of Psychology in addition to other social sciences reveal truths regarding the efficiency of financial markets and explain majority of stock market anomalies, crashes and market bubbles (Lifson & Geist, 1999, p.49).
A decade ago, economics and psychology were considered to be entirely two fields with having no comparison or linkage. However, in comparatively, quite a recent phenomenon that economists are increasingly looking towards the field of cognitive psychology and neuroscience as to have a greater knowledge of the current and prospective behavior and trends of the investors (Alexander & Dharpe, 1989, p.104). This, in turn, assists them in viewing the forth coming decisions of investors on the basis of realistic assumptions that are made by critically analyzing the minds of the investors so that the results could reflect productivity.
The psychology of the investors in this realm works in a way that his mind focuses upon the recent and past happenings in the stock market and the on-going trends about the rise and fall of particular markets (Gunn, 2000, p. 76). The gravity and implications related to stock prices are quite serious in nature, which normally make the investors risk-averse and certainly, not agreeable to sudden change in decision making.
However, it is also seen as a trend that all investors reflect the same kind of attitudes towards financial facets of routine. Here, many theorists have made a distinct division between two general types of investors who might have certain differences in their financial behavior and investment psychology. The first being the rational investors who come under the umbrella of professional and informed traders, the latter being the laymen (Alexander & Dharpe, 1989, p.105).
There is a whole model of expectation formation that influences the investor’s decision in buying or selling. . Before getting into a detailed discussion, it is essential to note that buying and selling are two such behaviors of humans that demand from them a certain kind of responsibility and thus, a collection of present and previous knowledge is kept in mind to have a future standpoint. It is also said as an underlying concept that the analysis of investors’ behavior in investment is primarily based on the business success of the related business (Hirschey & Nofsinger, 2008, p.20).
This study is quite significant in the domain of knowing the psychologically plausible models having great potentials to answer the ever-popular economic questions in the context of prices and share. Moreover, on the basis of such a study, effective and lucrative contracts and formal deals could be made. To be familiar with the stick market valuation and the trend in business it is important to create a contrast of these with the investors, so that avoidable practices in the business could be efficiently and reasonably avoided (Hirschey & Nofsinger, 2008, p.21).
OBJECTIVES
Objectives of this study could be precisely stated in the following points:
To identify if any relationship exists between the stock prices and the investors’ investment behavior
To view the contemporary trend in the market with respect to investors’ psychology in taking part in investments and stock market pricing, by monitoring his/ her investment trend..
To analyze how one area of market influences the other and to what extent infer what circumstances.
To assess the past investment practices in the domain of business
RESEARCH QUESTIONS (5 strongly agree, 1 strongly disagree)
What leads to investors and traders in the stock market considering an investment and actual entrance to the market?
Do sources of information influence investment decisions?
Do markets reflect the expectations of market participants as a response to the emerging financial and economic environment?
Do markets reflect the attitude of market participants as a response to the emerging financial and economic environment?
Is trader behavior determined by stock market prices?)
Is investor behavior determined by stock market prices
Will the reaction of investors change when prices go up ?
Will the reaction of investors change when prices go down ?
Is your investment or trade successful last year?
Are market prices a reflection of the fears, hopes and expectations of majority of investors and traders at the stock market?
Do the investors have a investment plan before trading or investing in a stock market?
Does timean important factor in investment and trading in the stock market?
Is it hard for people to stand back and review their situation from a wider perspective before investing in a stock market?
Do market prices generally influence investors’ behavior?
Will lose 20 %in the stock cause mental pressure to the human?
Will people be attracted to the stock market with hearing the news from the others?
Will higher 10% prices lead to lack of caution in regards to investing and trading in the stock market?
Do the media i.e. newspaper, etc.have any influence on investors’ behavior or reaction towards stock prices?
LITERATURE REVIEW
Prospect Theory
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This theory was created by Kahneman and Tversky in 1979 (Alexander & Dharpe, 1989, p.106). It is said to be the result of the critique on expected utility theory and the descriptive model which are discussed in detail below. In the realm of this theory, the theorists assigned values to profits and losses rather than assigning it to the final assets. This theory was generated after viewing that decision makers usually look good to the outcomes that are on the certainty platforms rather than signifying those based on probability (De Bondt, 1998, p. 831). Thus, the theorists used decision weights in the theory rather than focusing on probabilities.
Moreover, after reviewed of the literature, it states that according to this principle that the behavioral patterns of the people work in the pattern of considering the gains and losses rather than the worth that comes as a final result. Relating this to the model of stock prices and the behavior of investors, the investors are more interested in making the money in an impulsive act rather than the amount of money that they could get at the end.
Decision Theories
There are three kinds of decision theories given by experts and scholars and is said to be given by Bayesian (Alexander & Dharpe, 1989, p.107). These include:
First is descriptive decision theory. In simple words they work to describe how the decision makers maker decisions on the basis of whatever knowledge they wish to consume. It is said to reflect authenticity and simplicity since it is upon the decision maker’s open choices to reflect his opinions (Arthur, 1995, p. 2).
Second is prescriptive decision theory, which advocates how the decision makers should base their assumptions and take a standpoint. Since, it is usually, a set of prescribed rule and codes, it might become complicated for the decision makers who in turn reject it to apply.
The third kind of decision making theory is normative decision theory. This may sound quite ideal and impractical to some since it gives us a framework about the prospective behavior of an ultimate intelligent person regarding his models and expectation on decision making (Alexander & Dharpe, 1989, p.107). It also gives hints to the development of the other two decision theories. Since, it takes a human itself to base its assumptions it is quite vivid and simpler than the other two.
Expected Utility Theory
It is said that the development of this theory has had a complicated process and it took quite some years to give it a concrete concept which back to Bernoulli, 1738 (Cont & Bouchaud, 2000, p.170). The modern version of the Expected Utility Theory (EUT) refers to the era of mid-1920s. It revolves around the decision making process of the decision maker in which he bases his perception on a contrast of the prospective risks and uncertainties (Dorn & Huberman, 2005, p.437). The contrast is further made by the multiplication of their specific utility values with their probabilities. Thus, this theory revolves around the practice of decision making under great prospective risks. It is applied in the domain of making rational choices on the basis of stored knowledge or present observations (Gunn, 2000, p.79). It also holds an assumption that people who are reasonable in their attitude are likely to follow this theory’s context. The mathematical aspect of EUT can be referred to as additivity and linearity (Alexander & Dharpe, 1989, p.109).
Regret Theory
Regret theory was given in 1982 by Loomes & Sugden. It comes under the umbrella of alternative theories. Understanding this theory, it’s important to understand that it is based primarily on two concepts or assumptions. First, there are a number of people who go through the experience of regret and alternatively happiness or rejoice. Here, the element of sensations is put to focus. Second, that whenever the decision makers make any decision under the realm of uncertainty, they knowingly experience either or both of those sensations (Arthur, 1995, p.3). This theory is said to be comparatively simpler than the prospect theory.
Thus, this theory is more on the point of feelings and experiences than on rationality. The feeling that the decision maker experiences can either be rational or irrational. So, we can not suggest whether the decision made under uncertainty is merely an irrational decision. Moreover, the regrets are realized at the end of the happening which already has taken place (Dorn & Huberman, 2005, p.438). For instance, an investor who had put his stakes over some business and suddenly he comes to know about the failure of stock prices would regret after it has taken place; nevertheless, the next time when the same sort of happening takes place, his intuition and the regret feeling that he had experience once would influence his present decision making process.
On such background, it is also said to be static in nature (Dorn & Huberman, 2005, p.440) since it is a one-time decision making realm. However, the developments and progress made under this study show that investors future regrets could be minimized in a way when lessons are learnt from early decisions that actually failed or did not work so for him. Thus, the investor becomes conscious about putting his money on any other business the next time he does so. Moreover, the concept also concerns the regret that he has already made making him think about the otherwise good situation if he hadn’t invested in a failing business (Alexander & Dharpe, 1989, p.110).
Weakness of Regret Theory
Regret theory is limited in the domain of being dependent merely on a case when the probabilities are known and existent (Bernstein, 2000, p.116). Moreover, it bases its assumptions and frameworks over non-observable and non-seeable circumstances.
Efficient Market Theory
The Efficient Market Theory (EMT) or Efficient Market Hypothesis (EMH) was first coined by Eugene Fama in the year 1970. The concept that actually started to take place was upon the information that was readily disseminated by the security markets regarding the stock market or any specific stock of some individual (Gunn, 2000, p.80). Thus, it advocated that as soon as some news regarding the stock arises at a certain point in time, it spreads to the prospective individual investors or companies and the decision that is subsequently, made is thus, dependent on the present news rather than what happened the other day or the day before. Thus, if the news of an overvaluation of stock market spreads, the reflexive behavior of the investors would be accordingly.
The recent developments in this theory also suggest that such an approach is termed as random walk. Since, the characteristic of news itself lies in its unpredictability and randomness, in the same way, the price changes would also take place in the same manner. And, when the news disseminates, an i...