What Contribution Can Behavioural Finance Make to the Explanation of Stock Market Bubbles and Crashes?

2943 Words Aug 25th, 2011 12 Pages
M11 EFA BEHAVIOURAL FINANCE

What contribution can behavioural finance make to the explanation of stock market bubbles and crashes?

Name: Yuan Cao
SID: 2925215
Email Address: caoy5@uni.coventry.ac.uk

TABLE OF CONTENT

1 INTRODUCTION…………………………………………………………..3
2 BUBBLES AND CRASHES…………………………………….………….4
3 SOCIETY AND PSYCHOLOGY………………………………………….5
4 BEHAVIOURAL FINANCE FOR UNDERSTANDING BUBBLES AND CRASHES…………………………………………………………………......7
4.1 Overconfidence……………………………………………………………7
4.2 Representativeness and Momentum………………………………….….9
4.3 Familiarity and Celebrity Stocks………………………………………..10
4.4 Narrow Framing and positive feedback trading……………………….12
4.5 Confirmation bias and denial……………………………………………12
4.6 Mental
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For example, an article on ShangHai Security News reports the individuals’ herding behavior leads to Shanghai composite index rush to 6000 point and plunge below 2700 points.(Liang Yufeng 2006) Unintentional herding arises from investors analyse the same information by using same method, which often happen in fund managers. John R.Nofsinger (2011) found that the trading of institutional investors mainly drive the herding in stock markets. Walter and Weber(2006) found that mutual fund managers bought stocks then price rises and sold then falls. (Keith Redhead2008) Therefore, individuals may follow the strategy of institutional investors and result in unintentional herding.

In a bull stock market, blind and over chase rising lead to generate the bubbles; In a bear market, blind and hasty sell out stocks lead to crashes. The herding behavior results in the great volatility of stock prices and decrease the stability and efficiency of the stock markets.

Investors predict current risk in stock market base on the past outcome, so they are willing to take more risks after gains and less risk after losses. ( John R. Nofsinger 2011: 35) These effects are called ‘house money’ and snake bite’ effects. Gamblers do not regard the new money as their money after gaining in the stock market, and they would like to use profit to invest and bet when stock prices rise. So house money effect contributes to bubbles. Conversely, gamblers are willing to
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