Disposition Effect Essay

Capital markets provide a function which facilitates the buying and selling of long-term financial securities to increase liquidity and their value, Watson & Head (2013). Hence, the Efficient Market Hypothesis (EMH) explains the relationship that exists with the prices of the capital market securities, where no individual can beat the market by regularly buying securities at a lower price than it should be. This means that in order to be an efficient market prices of securities will have to fairly and fully reflect all available information, Fama (1970). Consequently, Watson & Head (2013) believe that market efficiency refers to the speed and quality of how share price adjusts to new information. Nevertheless, the testing of the efficient markets has led to the recognition of three different forms of efficiency in which explains how information available is used within the market. In this essay, the EMH will be analysed; testing of EMH will show that the model does provide strong evidence to explain share behaviour but also anomalies will be discussed that refutes the EMH. Therefore, a judgment will be made to see which structure explains the efficient market and whether there are some implications with the EMH, as a whole.

On the other hand behavioural finance defines the market dynamics and movement in terms of psychology of the participants in the trading process. Behavioural finance proposes that the amount of information available in the market regarding the factors that determine the output or profitability of a particular investment actually serve to determine the movement and output of the market itself (Fama, E.F., 1998).

Kahneman’s article is an analysis of intuitive thinking and how it guides our decision-making. Although primarily aimed at the field of psychology, it is an interdisciplinary article with applications in economic theorising. Kahneman attempts to differentiate between two systems of thought, one of intuition (system 1) and one of reasoning (system 2), and argues that many judgements and choices are made intuitively, rather than with reason (a slower and more deliberate process). Intuitive decision making, which encompasses heuristics, although generally more efficient and rapid, makes the agent potentially subject to errors due to framing effects or violations of dominance. The analysis of the studies and theoretical situations also provides criticism of the commonly held model of the rational agent within economics. The article also further conceptualises Kahneman’s theory, the Prospect Theory (Kahneman & Tversky, 1979), which has descriptive applications of people’s choice in decision-making situations involving risk and known probability of outcomes. These situations are typically unexplained by the more normative rational agent model.

Investing behavior should be driven by information, analysis, and self-discipline, not by emotion or ‘hunch.’

Investment analysis is said to be psychological in various aspects. The aspects of psychological biases examined are overconfidence, representative bias, prospect theory, mental accounting and risky shift.

The stock market is a risky business. Investing can make you wealthy beyond your wildest dreams, in which only a few investors have found the formula. Otherwise making the wrong decision

With attention to the previous information given, the principle of risk-return tradeoff is based on the thought that individuals are opposed to taking risk, meaning individuals would prefer to get a certain return on their investment rather than risking and getting an uncertain return. (Titman, Keown, & Martin, 2014) This principle tells us that investors will receive higher returns for taking on a bigger risk however; a challenge often seen in investors is how to calculate the tradeoff between risks and return with riskier investments. A higher expected rate of return is not always a higher actual return.

Loss aversion is the tendency for people to fear loss. The authors explain that this fear of loss can lead to unpredictable and often ruinous actions. It is shown that as the potential for loss increases, the stronger this force becomes. For example, many individuals encounter loss aversion when buying and selling stocks. During the Great Recession in the late 2000s, many stockholders experienced their stocks drastically drop in value. They feared if they sold their stocks, it would result in a tremendous loss of money. This fear of loss influenced many stockholders to hold on to their stocks hoping for them to rise back to their original value. Many stocks never increased in value after this incident. As a result, countless stockholders lost an immense amount of money. Loss aversion is an extremely strong force, however, it can be minimized by focusing on the big picture rather than short term consequences. If these stockholders had looked at the big picture and focused on studying the true value of each stock, they would have been able to minimize the amount of loss they would have to suffer.

Prospect theory is an important alternative descriptive theory for decision-making under unreliable situation (Kahneman and Tversky 1979), which includes real life selection and psychological analysis between choices that involve risk. Prospect theory, which efforts to explain individual make decisions between risky replacements based on the value of potential gains and losses (Wakker 2010), advanced from expected utility theory, which explains that investors want to maximize expected utility of wealth when unclearly situations (Blavatskyy 2007). According to Kahneman and Tversky (1992), more recent researches perceived nonlinear preferences in choices that do not involve definite events in prospective theory. The concept of framing effect refers description invariances (Kahneman and Tversky 1992). To be specific, individual always makes the same decision in identical choice conditions. Also, decision makers have tendency to

Decision making is the act of choosing the best solution to a problem depending on its value and the preferences of the decision maker. In the first part of this essay, we will explore the Expected Utility theory and the Prospect Theory, which are normative and descriptive approaches to making decisions with inherent risks. The first part of the essay argues that Expected Utility Theory is a less viable hypothesis to decision making and is fundamentally flawed compared to the Prospect Theory in description and function. Prospect theory is a better model for decision making because firstly, decisions are not often made objectively and can be affected by decision weights. Secondly, individuals are not risk averse as suggested by the utility theory, but are instead loss averse. Lastly, individuals evaluate decisions not by their final resting utility, but instead they react dependently based on their reference point. The second part of the essay will delve into the topic of heuristics that emerge in investment decision making. The main biases that investors make include disposition effect, anchoring and adjustments bias and overconfidence.

Further influence of EMH on financial practice seems to be active in attitude of investors towards diversified portfolios. As theory implicate “public information cannot be used to earn abnormal returns” (Arnold, 2009) thus traders are becoming more sceptical about outcomes of fundamental analysis. The most reasonable action is to create well-matched selection of securities that would rule out analysis and transaction costs, making returns proportionally greater. The vast majority of investors were convinced by those trends and decided

Efficient Market Hypothesis has been controversial issues among researcher for decades. Until now, there is no united conclusion whether capital markets are efficiency or not. In 1960s, Fama (1970) believed that market is very efficient despite there are some trivial contradicted tests. Until recently, both empirical and theatrical efficient market hypothesis was being disputed by behavior finance economist. They have found that investor have psychological biases and found evidences that some stocks outperform other stocks. Moreover, there are evidences prove that market are not efficient for instance financial crisis, stock market bubble, and some investor can earn abnormal return which happening regularly in stock markets all over the world. Therefore, the purpose of this essay is to demonstrate that Efficient Market Hypothesis in stock (capital) markets does not exist in the real world by proofing four outstanding unrealistic conditions that make market efficient: information is widely available and cost-free, investor are rational, independent and unbiased, There is no liquidity problem in stock market, and finally stock prices has no pattern.

The efficient market, as one of the pillars of neoclassical finance, asserts that financial markets are efficient on information. The efficient market hypothesis suggests that there is no trading system based on currently available information that could be expected to generate excess risk-adjusted returns consistently as this information is already reflected in current prices. However, EMH has been the most controversial subject of research in the fields of financial economics during the last 40 years. “Behavioural finance, however, is now seriously challenging this premise by arguing that people are clearly not rational” (Ross, (2002)). Behavioral finance uses facts from psychology and other human sciences in order to

Some researchers explained the small firm effect as mispricing from the measurement or method error of assets price model, but Roll (1983) finds this is not the case. He believed that the frequency of trading and holding period can affect the beta estimates. The risks of small firm were undervalued and returns were overvalued for small firms in short holding period (Roll 1983). Furthermore, as small firms are traded not often, the daily stock returns were delayed, the risk was undervalued (Roll 1983). However, Reinganum (1982) use

During this time period, prices for the stocks increase substantially, accordingly reducing risk premium demanded by the traders. Also, shares should amount from 30 to 55 percent of the entire investment portfolio to optimize the investor’s expected profitability. Proximity of the evaluated results to the reality reveals excellence of the myopic loss aversion model (Siegel and Thaler, 1997).