Investor Sentiment and the Implications of Their Behaviour - Research Paper Example

Introduction The key central issue in behavioral finance is to understand and explain as to why the market participants actually make systematic errors. Due to these errors, not only inefficiencies in the markets are created but price distortions occur too. The overall sentiments of the investors and their behavior therefore play an important role in deciding how markets can actually behave and the factors which can contribute towards such behavior. There is also a general perception that the investor sentiments play a critical role in persistent economic problems including bank runs, price distortions in the market, inflated property values as well as other problems. The role of investor sentiments and how it can affect their behavior has been in relatively direct contrast with the modern portfolio theory. Modern portfolio theory indicates that the investors always act rationally and also take into consideration all of the available information. However, a large number of empirical studies have actually shown the irrational behavior of the investors as well as repeated errors in overall judgment. The behavioral finance as a field therefore focuses upon understanding as to how such cognitive behaviors can be explained besides exploring as to why such errors occur in investor judgments. Behavioral finance therefore uses the theories from psychology as well as sociology and other disciplines to actually explore and understand basic investor behavior and how it may have an impact on the market. This paper will focus upon exploring the issue of investor sentiments and how they can have an impact on the behavior of the investors. Investment Sentiments & Behavior Investor Sentiments are generally defined as beliefs in the future cash flows as well as the investment risks which cannot be otherwise defined by the facts at hand. This is based upon the assumption that the investors are actually subject to sentiments and their decisions are subject to the way their sentiments interact with their overall decision making process. What is also critical to note that betting for such sentiments however, can have a relatively high risk? As such there are fundamental trade-offs need to be made in balancing the role of sentiments and the risks taken based upon those sentiments.( Ackert & Deaves, 2010). There have been many episodes where the investor sentiments actually drove the prices up without the fundamentals of the company or market supporting the same. The internet bubble as well as the inflated prices of telecom stocks on NASDAQ indicates that the investor sentiments can actually drive the prices to higher levels without actually assessing the actual risks and rewards associated with particular stocks. The overall question of exploring and understanding as to whether the investor sentiments actually result into an impact on the stock prices has been decided. The renewed focus is on measuring the impact of investor sentiments and how it actually translates into the price and return changes in assets. Some of the variables or the psychological biases which are studied include overconfidence, representativeness as well as the conservatism. This also includes how the investors actually underreact or overreact to the past returns and the stock fundamentals.( Barberis, N. et al. 1998) There is an underlying assumption that the investors act rationally and every decision is actually driven by how investors actually rationalize. This underlying belief and assumption has driven much of the theory in finance and suggest that since investors are rational in their actions therefore all the assets are showing their intrinsic value. This assumption also suggests that the information is readily accepted by the investors and it reflects into the overall prices being experienced by the market. The arbitrage principle underlying the traditional finance theory also suggests that any price deviations will be corrected by the market participants in order to restore the equilibrium within the market. As such the assumptions underlying the basic investment theory clearly suggest that all the investors act rationally and markets are perfect in the sense that any distortions of the prices will actually be corrected by the market forces in order to restore the equilibrium within the market.( Bruce, 2010).  The existing models including Modern Portfolio Theory, Capital Asset Pricing Model as well as the Arbitrage Theory actually outlines the above assumptions and are quantitative models based upon rational expectations model. However, despite the widespread acceptance of these theories, large amount of empirical data and research suggests that investors may not be rational and their sentiments may play an important role in their overall decision making process. The new research therefore clearly indicates a link between the sentimental behavior of investors and how it can have an impact on the prices in the market.( Zarowin, 1989) The basic difference between behavioral finance and the arbitrage models is that behavioral finance assumes that there is a limit to the arbitrage and as such cognitive biases, beliefs and preferences play an important role in driving the overall behavior of the investors. The overall sentiments of the investors and the resultant behavior they cause therefore can have important consequences for the market as a whole and for the individual investors. Various research studies have outlined that the information is absorbed slowly in the market creating what is called momentum. This phenomenon suggests that investors not only underreact to the information available in the market but the stock prices also slowly absorb this information therefore at any given point in time, stock prices may not be reflecting all the publically available information. This therefore may also result into market inefficiencies because stock market returns as well as prices may not reflect and incorporate all the publically available information.( Thaler, 1993) Deviation from what is called rational risk premia caused mainly by the investor sentiments may result into different anomalies within the market. Various research studies have outlined the overreaction of the investors for the firms who experienced consistently good news in the market. Studies indicated that the firms which have consistently underperformed other firms however can achieve better investor response if investor bias exists due to over-reaction or under-reaction to different pieces of information existing within the market.( Goldberg & Nitzsch, 2001).  Another important attribute of investor sentiments is the over-confidence which normally arises from the self-attribution. This phenomenon has been observed in many empirical research studies based upon psychological theories and indicate that the investors normally over-estimate their own abilities under different contexts.( Shleifer, 2003) One of the key sources of extracting information in financing markets is based upon interpreting the information given by the companies, interviews of CEOs as well as other related information. It is however, important to note that interpreting such information and translating the same into actionable results may vary and depend upon the ability, skills and sentiments of the investors which can be different for each investor.( Forbes, 2009).  It has also been suggested that the investor sentiments play a critical role when they react to different types of information. It has been suggested that the investors react differently to private as well as public information. Stock prices tend to overreact to private information whereas they underreact to the publically available information thus showing relatively different investor sentiments towards the information which is available.( Nofsinger, 2011).  The Attribution Theory indicates that as the investors tend to update their information and become more aware of their overall reaction to different news in the market, they tend to further over-react or become over-confident in their abilities. Further, individuals also tend to attribute higher to the events which confirm to their actions and hence a sort of over-confidence emerges within the investors. Based upon the principles of internal dissonance, investors tend to suppress the information which actually conflicts with their past choices.( Daniel, K. et al.1998) Investor sentiments towards the new and young start-ups often lead to higher expectations and was the precise cause of the internet bubble during 1990s. The over-excitement of the investors towards such low-value and low capitalized firms tend to create high price bubbles causing the market to inflate without any solid fundamentals. It is however, also important to note that the modern behavioral finance also categorize the investors into two types. The one group comprises of investors who are rational and sentiment free and second group of investors whose actions are driven by the sentiments. These sentiments therefore play an important role in deciding how the overall behaviors of the investors can have an impact. The types of stocks can also play a role in deriving the overall investor sentiments. ( Augen, 2011).  Conclusion Investor sentiments play an important role in deciding market returns as well as prices. Earlier theories of finance focused upon the key assumption of investors acting rationally and markets also responding to the same. However, recent research suggests that investors may not be entirely rational and may react to the news differently according to their capabilities. There have been many historical episodes where investors either overreacted or underreacted to the market information. There have been different cognitive biases which actually create distortions in the market and may further create inefficiencies in the market. The rational expectations model indicates that the investors act rationally however investor sentiments and the resulting behavior may suggests that investors may not act rationally under all circumstances. References 1. Ackert, L. F., & Deaves, R. (2010). Behavioral finance: psychology, decision-making, and markets. Mason, OH, South-Western Cengage Learning. 2. Augen, J. (2011). Trading realities: the truth, the lies, and the hype in-between. Upper Saddle River, N.J., FT Press 3. Barberis, N. et al. (1998) A model of investor sentiment. Journal of Financial Economics, 49 p.307-343. 4. Bruce, B. R. (2010). Handbook of behavioral finance. Cheltenham, UK, Edward Elgar 5. DANIEL, K. et al. (1998) Investor Psychology and Security Market Under- and Overreactions. THE JOURNAL OF FINANCE, . LIII (6), p.1839-1885. 6. Forbes, W. (2009). Behavioural finance. New York, Wiley 7. Goldberg, J., & Nitzsch, R. V. (2001). Behavioral finance. New York, John Wiley. 8. Nofsinger, J. R. (2011). The psychology of investing. Boston, Prentice Hall. 9. Shleifer, A. (2003) Inefficient Markets: An Introduction to Behavioral Finance. Oxford: Oxford University Press. 10. Thaler, R. H. (1993). Advances in behavioral finance. New York, Russell Sage Foundation. 11. Zarowin, P. (1989) Does the stock market overreact to corporate earnings information?. Journal of Finance, 44 p.1385-1400.. Read More