The Behavioral Finance Paradigm And Its Derived Explanations Of Stock Market Bubbles And Crashes

As Chapter 10 questions, if further evidence continues to surface that capital markets do not always behave in accordance with the efficient market hypothesis, then should we reject the research that has embraced the EMH as a fundamental assumption? In this regard we can return to earlier chapters of this book in which we emphasised that theories are abstractions of reality. Capital markets are made of individuals and as such it would not (or perhaps, should not) be surprising to find that the

Investment analysis is said to be psychological in various aspects. The irregularity observed in financial markets in recent times has yet again brought to question the practical application of traditional financial theory and the Efficient Market Hypothesis. There is therefore the need to put this base of accepted finance theory under scrutiny. The foundation of one of the broadly examined problems with traditional financial theory is the effect of psychological influences on individuals’ behavior towards investment. According to Slovic (1972), Daniel, Hirshleifer ,Subrahmanyam (1998) and Hilton (2001), they believe that financial markets are functioning at a rapid and increasingly cut throat environment and have been transformed in several ways, one of which is technological. The growing rate of technology has had an immense effect on trading and investment. Technology has aided in allowing information to be easily accessible to investors, but there has been little focus on the issue of interpreting the information skillfully. It is important to note that the appropriate use of information is a crucial part in making investment decisions.

Markets are places which people come together to trade stuffs, and stock market is an exchange where investors come together to buy and sell shares of publicly-treaded companies. (“The Financial Importance of the US Stock Market”) It’s good for our society in a great many ways, but it also can be harmful since people’s desire of money are fully exhibited in stock market. The Great Crash, happened in 1929, was not the event of one day but a series of events stretched initially across the week from October 23 through October 31. (Klein 326) This crisis had seriously impacted the U.S. by losing nearly 90 percent of the value of the stock market at that time. (Bierman) However, different from other events happened in the history, both government and normal people tended to blame the speculators at that time and avoid further investigations of it, but is the cause

Now that the two theories have been explained, let’s look at some historical examples from Malkiel that really paint the picture in chapter 2. The first speculative craze noted was over tulips in the seventeenth century in Holland. The tulips were brought from Turkey and the Dutch valued the beauty and rarity of the new flowers. Thus the prices for the flowers inflated. As the prices rose merchants would by stockpiles to sell to the public. The more expensive they got the more the public believed they were making smart investments. People would sell off the personal belongings to get their hands on the bulbs. The mania surrounding the bulbs created a bubble that would soon burst. The prices got so high some people decided to cash in and sell them to make a handsome profit. Soon others joined in causing a snowball effect and the prices tumbled. Eventually there was no demand and they were worthless. Many went

Investments don’t always work as planned on Wall Street. However, financial markets send signals regarding the future of the economy. Markets can move in advance of information available to the general public. In a broad view, markets seemingly anticipate political events. In other times, the markets will anticipate economic events long before the investing public understands what’s emerging in the general economy. The market is also effective at discounting a transformational event. When the market excessively anticipates all future revenues and all the future profits that would accrue to the phenomenon, a bubble or mania develops. The repetitive nature of the phenomenon, or investment fad,

This financial theory was best defined in the 1970s by Eugene Fama in his article ‘Efficient Capital Markets: A Review of Theory and Empirical Work’. In this article Eugene declared that no one could “beat the markets” as a result of all current stock prices being unpredictable since they quickly reflect all information about the stock as it becomes available and the potential prices of stock are also unpredictable as it is dependent on all future information, which is not currently available. Therefore, investors are unable to use technical or fundamental analysis to achieve above-average returns.

Gittman (2004, pp. 312) divided stock into two types, such as common stock and preferred stock. He also showed that dividends are the outcome of investment. So, common stocks are an ownership claim against primarily real or productive asset (Higgins, 1995), but he also said that if the company prospers, stockholders are the chief beneficiaries, if it falters, they are the chief losers. Smith (1988) presented that stocks are one of the most popular forms of investment. People buy stocks for various reasons: some are interested in the long-term growth of their investment by buying low priced stock of a new company in the hope of substantially growth of share price over the next few years. Another reason he suggested that in a well established firm stockholders expect the stock growth will be stable over the long run. (Smith,1988).

In the previous chapter, the researcher has covered some basic information about the stock market. Hence, in this chapter, the current situation that the Chinese stock market is suffering from and factors contributing towards this crisis will be analysed. At the end of this chapter, readers will have an idea how a market which was stable for many years could become unsteady within such a short period of time.

Behavioral finance has also discuss about how certain groups of investors behave, and what kinds of portfolios they choose to hold and how they trade over time. It is simply to explain the actions of certain investors, and these actions also affect prices. Some of the actions of investors and the behavioral ideas are insufficient diversifation, naive diversifation,excessive trading, the selling and buying decision.

Collecting, analysing and interpreting financial data has always been the important objectives of the members in the financial markets, ranging from governments, big time billionaire corporations to even the small individual financial analysts. This is because by gaining a keen understanding of the current financial situation in the market, another objective can be pursued, which is forecasting. One of such forecast is regarding investor expectations in the market. Investors often refer to individuals who commits money to investment products with the expectation of financial return. Since most investors become the main pillars of finance for corporations, by gaining an understanding of

Academics noticed flaws with the efficient market theory paying attention to the volatile stock price abnormality. Despite these anomalies appearing minor in nature, it

The phenomena behind equity risk premium discussion for 35 years, was first took place in Robert J. Schiller’s work done on volatility of equity prices. The research conduct by Schiller (1982), highlighted the difficulty of explaining the historical volatility of stock prices. The results of Shiller’s paper stunned the profession at first as most of economists felt discount rates were close to constant over time. The intuition behind the unpredictability of volatility, later named volatility puzzle by scholars who have studied this paradox as well. Just after 3 years from Schiller work on historical volatility, Mehra and Prescott (1985) introduced the equity premium puzzle. It is mainly based on the lack of evidence for a high risk premium in terms of consumption growth. In other words, investors require and have high returns which have low covariance with consumption growth. Using Schiller’s data collected on the volatility puzzle, they have found out that between 1889 and 1978, the consumption growth rate, the indicator for opportunity cost of investors is insufficient to explain 6% risk premium. Moreover, it was so high that the findings suggested only a risk premium of 0.35% on top of the risk-free rate. Behavioural finance approached this puzzle based on preference of investors. The decision making process of investors on investing on equities and why do they require high risk premium and fear equities this much. One of the leading papers on the

This research tries to address the problem from an investor’s point of view, which kind

Investment is one of the most essential ways to manage and appreciate capital. It is well known that investment has risk, and higher return with higher risk. The risk is coming from a bunch of factors. Systematic risk and unsystematic risk are two terms which distinguish the effective range of the investment market. Systematic risk describes widely effect which individual cannot manage, control and avoid. What people can do is to reduce lost to the minimum. Unsystematic risk is also called as “ special risk” which it is more individual and investor can control even avoid it. Thus, this paper will focus on the what kinds of factor will bring systematic risk and how these factors affect the investment market. Three fundamental aspects will

The purpose of this composition is to supply, in a form suitable for laymen, guidance in developing a better understanding of the meaning behind financial market anomaly and its implications on the established assumption that markets are rational. It is vital for an investment bank client to be aware of the large amount of controversial evidence challenging traditional hypotheses of asset-pricing bahaviour and, primarily, to become sensitive to investment strategies predicting likely abnormal returns. In order to participate intelligently in the equity market, one should, in any case, be forearmed with an adequate knowledge of how one recognized and persistent financial market anomaly has evolved over time and influences