Behavioral Investment Strategies - Coursework Example

Behavioral finance: Behavioral investment strategies Name Course Tutor Date Introduction Behavioral finance is a new field that tries to blend the cognitive and behavioral psychological theory with the contemporary economics and finance. It seeks to explain why individuals make irrational financial decisions while running their business enterprises. The concept of behavioral financial takes into consideration a range of psychological variables. It also explains how consequent emotional reactions to these variables can affect both the individual and entire economic conditions. From the conventional finance theory, individuals and institutions are rational when it comes to financial investment; this means that they are wealth maximizers (Cartwright, 2011: 5). Nevertheless, in many instances, emotions and psychology tend to affect their decisions, making them to behave in an irrational and unpredictable manner. Therefore, this field is majorly concerned with the bounds o0f rationality of economic agents. The central subject in the field of behavioral finance is giving an explanation why investors tend to make systematic errors while trying to find the best options to invest in. In addition, this concept also seeks to investigate on how other investors arbitrage these market inefficiencies (Levy, 2002:1). When investors seek to maximize their investments, they make errors in their decisions; these errors influence the prices of the products and the returns on these products resulting to market inefficiencies. Many scholars have examined the financial markets hoping that they are going to find the best investments strategies that have good results. All of these scholars have based their theories on one assumption that state that both individual and institution investors act in a way that maximizes their profits. However, many researches show that investors are always irrational. This paper focuses on the concepts of behavioral finance and strategies used by investors to choose the best investments options in the security market. Brief overview of behavioral finance The concept of behavioral finance is based on two main theories, which are rational and logical. These theories are capital market asset pricing model (CAPM) and efficient market hypothesis (EMH). Generally, these theories assume that individuals in most cases behave rationally and predictably (Shefrin, 2002: 17). Actually theoretical evidence shows that these two theories and other rational theories played a vital role in explaining particular events. Nevertheless, with time, other economists started to realize some anomalies and unique behaviors that could not easily be explained by these theories (Cartwright, 2011: 5). The fact that these theories could explain some idealized events, things worked differently in the world since the world proved that market participants behaved quite irrationally and unpredictably. As mentioned earlier, the main assumptions with conventional economics is that individuals are rational in that they seek to maximize their investments in any option they intend to opt for. According to these conventional theories, emotions and other extraneous factors do not affect investors when it comes to deciding on an investment option (Cenet.org.cn, 1999:1). When the modern academics found some anomalies in the world, they were prompted to focus on cognitive psychology to account for the irrational and illogical behaviors that the conventional finance failed to explain. Behavioral finance seeks to explain peoples’ actions while modern finance explains the actions of the economic man. We have three factors that are acceptable in the research and identification of the behavioral variables since they are related to behavioral finance. The first factor is known as heuristic factor; this factor explain that investors tend to make economic decisions basing on the individual set of ideas or values that sometimes may be or may not be related to the financial economic principles (Cartwright, 2011: 5). Actually, the heuristic factors do not have o follow a logical pattern or based on factors such as performance history; in most cases, these factors seem to be irrelevant to any outsider. The second factor that is considered when studying behavioral finance is the framing factor. This factor refers to the manner in which the financial problem is presented to the investor. From the many behavioral financial theories, the manner of presentation of the financial situation to an investor tends to influence his/her decision making greatly. (Shefrin, 2002: 19). The facts underlying is that if the financial situation is presented to the investor in a negative approach, the investor would likely to react negatively hence being irrational in his decision-making. On the other hand, I the situation is presented to him in a positive manner even if it is hard and challenging, the investor would likely to make his decisions rationally (Cartwright, 2011: 5). Therefore, framing as a factor explains to us why different investors tend to behave differently to certain situations that they encounter in the investment process. The third factor is explaining behavioral finance is known as market inefficiency. It is the basic and most logical factor of behavioral finance (Cenet.org.cn, 1999:1). This factor tries to examine the outcome of the event in the market place and thereafter it identifies the contributing elements that the academicians may have or have not identified in playing a particular role in the outcome. This means that market inefficiency is a bit critical in the analysis of the behavioral finance. We have seen that behavioral finance is the study of how mental errors and emotions influence the choosing of the investment stocks on the market (Cenet.org.cn, 1999:1). Mental errors and emotions can easily cause the overvaluing or undervaluing of the stocks and bonds the investor. This has resulted to the creation of the investment strategies that tend to capitalize on the irrational investor behavior. The mental mistakes that are done by the investors incorporate on how the brain solves particular problems and in most cases, the brain is prone to making mistakes. The two main mistakes often committed by the investors are, overreacting and under reacting to new information. One of the tools that cause overreaction is representativeness. Representativeness is a tool the brain uses to classify events rapidly (Cenet.org.cn, 1999:1). Here, the brain assumes that objects with few similar traits are likely to be the same even if they are different. Since representativeness is a tool that aids the brain to arrange, organize, and process information in large volumes, a shortcut can easily lead the investors to overreact (Levy, 2002:1). In the same manner, representativeness would cause investors to make errors in the financial markets. When a particular company has been performing poorly for quite some time, the investors tend to develop negative attitude towards such a firm and avoid investing their resources in them. This means that the investors will overlook the company and its stocks would be undervalued. Anchoring is also a tool that plays a significant role in the decision-making by individuals. This tool causes under-reaction by the investors (Cenet.org.cn, 1999pp 1). Anchoring is a mental tool that aids the brain in solving complex problems by selecting an initial reference point and gradually adjusts to the right answer as the additional information is received. Anchoring causes investors to under react on new positive information. In most cases, anchoring causes securities on the financial markets to be mispriced since the investors are often reluctant to the positive information they receiving thinking that this is just a temporary situation that would go soon. Like in other discipline, the field of behavioral finance has particular individuals who did a thorough research and examination of the critical issues in the field and came up with credible empirical and theoretical contributions (Shleifer, 2000:11). Just to mentioned a few of these scholars in cognitive psychology, Daniel Kahneman and Amos Tversky are referred to as the fathers of this field of behavioral finance. They focused most of their work on the cognitive biases and heuristic behaviors that make people engage in unexpected irrational behaviors. Another academician who contributed a lot in this field is Richard Thaler, in the course of his studies; Thaler realized more and more limitations in the field of conventional economics the way it relates to investors’ behavior (Shleifer, 2000:11). When he read the publications of Tversky and Kahneman, he realized that psychological theories could be applied in the explanation of the irrational behaviors the investors tend to exhibit on the financial market. He went and collaborated with them and they all blended economics and finance with the concepts of cognitive psychology such as biases, mental accounting and the endowment effect to explain some of the anomalies seen in the financial market investment. Behavioral finance strategies Behavioral finance strategies use information-based strategies. Investors try to generate higher returns on their investments through finding better information from the firms. However, having an advantage through this method of gathering enough information from the companies, by the investors is becoming a bit difficult since anybody now can easily get or access enough information because of the internet. Behavioral finance strategies take the advantage of using human behavior since it changes slowly. The approach of the brain to solving complex problems and the tools used to solve these problems are unlikely to change soon. In most cases, behavioral finance investors wait to take an advantage when a certain mistake is made. Let us now look at some of the behavioral finance strategies that are used by investors to make their investment decisions. Contrarian strategy First, we have the contrarian strategy. SA contrarian investor is the one who tries to make profits through investing in a way that differs from the conventional wisdom. Such an investor believes that particular crowd behavior among the investors would lead to exploitable mispricing in the stock market (Andrew &Craig,1990:1). When many people looks at a certain company in a negative way due to its poor performance, the stocks of such companies can be underpriced and the risks be overstated and also understate the profitability of such stocks. Therefore, the contrarian investor takes an advantage of this to do the opposite by investing in such securities (Lakonishok, Shleifer &Robert, 1994:1). When he buys these stocks and sells them off when the company recovers, he is certainly going to make good amount of profits. Conversely, high optimism can also result to unjustifiable high valuation of the stocks eventually leading to drops in case the high expectations do not materialize. For a contrarian investor, he buys these stocks but sell them off without waiting for the maturity date (Andrew &Craig,1990:1). By doing this, he can sell them at a better price than when he would have sold at the maturity date since most investors would be waiting to sell them off. Actually, a contrarian investor does not have a negative perspective over every stock (Lakonishok, Shleifer &Robert, 1994:1). He also does not always believe that the stocks are overvalued. However, a contrarian investor seeks the chances to purchase or sell off the stock at the time the majority of the investors tend to be doing the opposite way in case when that stock is mispriced (Andrew &Craig,1990: 1). These kinds of investors are seen during market declines where other investors are reluctant in buying the stock. The commonly used indicator on the financial market by the contrarian investor is the volatility index. Volatility indexes also referred to as fear indexes gives the numerical measure on how the optimistic or pessimistic market participants are (Andrew &Craig,1990:1). High index indicates that there is a pessimistic perspective by the investors over particular stocks. Whereas a low index shows that, the investors are optimistic about the performance of particular securities (Lakonishok, Shleifer &Robert, 1994:1). Therefore, the contrarian investors often have a keen eye on the performance of the indexes to determine which stock is likely to earn them good returns when invested in. Momentum strategies This is a system of the purchasing stocks that have high profits over the past three to twelve month; selling the securities that have poor returns again over the past three to twelve month. Reports reveal that this strategy gives a yield returns averaging 1% per month for the proceeding three to twelve month (Chan, Jagadeesh, &Lakonishok, n. d:1). The validity of this claim is hard to justify since the economists find it hard to reconcile this phenomenon using the efficient market hypothesis. There are two main hypotheses that tend to explain this assumption in terms of efficient market. First, there is an assumption that states that momentum investors face similar risks for opting to this strategy hence the high profits tend to be the compensation for this risk (Chan, Jagadeesh &Lakonishok, d:1). The second theory has the assumption that momentum investors tend to exploit behavioral limitations in other investors. In other words, momentum investing aims to capitalize on the continuation of the existing trends in the market. The momentum investors often believe that an increase in the stocks will be followed by increased gains and a reducing stock will be followed by reducing gains (Chan, Jagadeesh &Lakonishok, n. d: 1). This strategies looks to get gains in the investment through investing in hot stocks and selling cold stocks. Investors investing using momentum strategy strive to establish the trend of each stock. When the trend in upward, it means the stock is profitable and the upward direction would continue hence there are hopes for the more gains in future. (Chan, Jagadeesh &Lakonishok, n. d: 1). While the downwards trend stocks ,means that the stocks is loosing valuing and implies that less gains would be gotten from such stocks. Thus, they opt buying the upward stocks and sells off the downwards stocks. Earnings surprise strategy This strategy occurs when a particular firm reports on quarterly or annual profits that are above or below the analysists expectations. Analysists who work for a variety of financial firms and the reporting agencies tend to base their expectations on a variety of sources (Henry & Charles, 1979:1). Earnings surprise sometimes can have a huge impact on a company’s stock price. Reports reveal that positive earnings not only do it lead to hike in the stock price, but it also lead to the immediate gradual increase over time (Henry & Charles,1979:1). It is obviously known that a negative earnings surprise would usually lead to the decline in the share price. Many investors would attempt to trade in stocks based on the earnings announcement. In most cases, this surprise would lead to the sharp reaction to the stock and this reaction in the securities tends to depend on the closeness of the analysis of the investors. (Myers Jonathan, n. d: 1). The main idea behind this trading strategy is that if the stock had a positive surprise, then the chances for it to have a better return are very high in case the earnings surprises increases where compared to the previous quarter performance. Earnings announcement by a company often communicates the earnings surprises. On the other hand, an earnings surprise is the difference between the actual earnings reported by the management of the company and the market expectations or the actual number. When there is a positive surprise, this means that the actual earnings are higher than the expected earnings on the market (Henry & Charles, 1979:1). While the negative surprise means that, the actual earnings are less that the expectations on the market. Another way in which earnings surprises can be affected negatively it is when the market analysts evaluate it and this can prompt to overreaction to the extreme. Merger strategy This is an investment strategy that is often associated with hedge funds. There are two kinds of merger strategies; we have cash merger or stock merger. In a cash merger, the investor who is acquiring the stock suggests purchasing the securities of a particular firm for a certain price in cash (Myers Jonathan, n. d: 1). The stock of the firm trade below the purchase price until the acquisition is completed. The purchaser buys the stock of the firm again when the acquirer ultimately purchase the stock. On the other hand, the stock merger proposes to purchase the target stock in exchange with the stock of the targeted firm. The arbitrageur can again short sell the acquirer and purchase the stock of the target firm. The whole of this process is called the setting of the spread. When the merger has been completed, the targeted stock would be converted to the stock of the acquirer basing on the exchange ratio determined by the merger agreement. In case the strategy is risky free, many investors adopt it immediately and when there is any possible gain would disappear due to the competition. Nevertheless, the risk arises from the possibilities of failing deals (Myers Jonathan, n. d: 1). Some of the obstacles may cause failure are; other parties in the deals being unable to satisfy the conditions for the merger, failure to obtain shareholders approval, failure to receive antitrust and other clearance regulatory. Human brain is at work to cause influence, other than dealing in the most profitable stocks, the work of the brain can also be exploited using arbitraging approach. Actually, this strategy is a long term but for hedge funds, it is an ideal method an investor can adopt for investment (Montier, 2007:74). Merger arbitrage is a kind of event driven investment which is a strategy that seeks to exploit the pricing inefficiencies that may happen before or even after a firm’s event such a s bankruptcy, acquisition merger or spinoff. Arbitrage in the hedge fund world is commonly known as simultaneous buying and selling of the two similar stocks whose prices in the opinion of the by trader not according to the expectations of the investor. Therefore, the investors act on the assumption that the prices will reverse to true values with time. This makes the investor to sell them at short the overpriced, stocks, and purchases the underpriced securities. Apparent high-risk strategy This strategy involves dealing in the investments that are considered requiring wide berth as they result to big losses (Montier, 2007:83). The factors behind this strategy is that misinformation among the investors, market pressures and lack of the knowledge in investment influence the thinking of the investors in such a way that lead them to overreacting to any prevailing condition (Myers, n. d:1). For the implementation of the strategy to be successfully, there must be a commitment in overcoming these factors and rationally focusing on the proposed investment. Junk bonds are examples of such securities, which involves high risks but tremendous returns when traded successful. These kinds of securities are not for everyone, but for those people who have a deep knowledge to trade them successful. Apparent high-risk strategy demonstrates that there are various investments when we look them closely; they are safer o trade in than they first appear (Myers Jonathan, n. d: 1). Investors’ behavior, overreaction tends to overweigh the importance of extraneous information such as media hype and opinions from the experts. These stops the investors from giving the junk bonds or similar high-risk options as they cautiously consider their own merit. The main rationale behind investing in high risk securities such as junk bonds is that higher relative risk can translate to higher relative income. The world of fixed income is quite complex in that the market risks that are involved in investing in high risks securities are widely misunderstood (Montier, 2007pp:56). Investors are said are not willing to pay more price to invest in risky securities but they are willing to pay more for low risk securities. As the many investors seek safety in their investments options, the demand tend to push the prices higher and the yield of such securities go lower. When the economy begins to look healthy, the investors tend to move out of the perceived safety to the risky positions (Myers Jonathan, pp. 1). This in turn pushes risky securities such as junk bonds higher and the interests rates for safer securities move higher while the prices drops due to lower demand by the investors. Conclusion The conventional financial investments are based on the theories, which tend to describe individuals to behave rationally and logically. However, some events happened which these theories could not provide a sufficient explanation, therefore, academicians started to question the validity of these theories because of the anomalies that existed. Behavioral finance came into the existence and its concepts try to explain some of the anomalies that have existed in the financial market. Generally, behavioral finance strives to identify the conducive market conditions, which seem to overreact or under-react to the new information. When the investors commit some mistakes, they cause mispriced securities (Cenet.org.cn, 1999:1). The main goal of behavioral finance strategies that we have discussed is to finding the opportunities to invest in before many investors come to realize their errors and benefit from the rise in price when they later on realize. However, there are some critics of behavioral finance. Most of these critics argue that even if conventional economics cannot address some of the anomalies found in the market, market efficiency should not be totally ignored to favor behavioral finance. They asserts that many of the anomalies seen in the financial market investments are short lived thus, they can be corrected with time. Bibliographic references Andrew, Lo. &Craig MacKinlay. (1990).When are contrarian profits due to stock market overreaction?. The review of financial studies. Accessed on web. 9th Dec 2012. Retrieved from http://ideas.repec.org/p/fth/pennfi/4-89.html Vol. 3 No.2 Chan, Louis, Jagadeesh, Narasimhan &Lakonishok, Josef. (n. d). Momentum strategies. Accessed on web. 8th Dec 2012. Retrieved from http://www- stat.wharton.upenn.edu/~steele/Courses/434/434Context/Momentum/MomentumStrat egiesJ F96.pdf Cartwright Edward. (2011). Behavioral economics. Routledge. London. UK Cenet.org.cn. (1999). Introduction to behavioral finance. Accessed on web. 9th Dec 2012. Retrieved from http://web.cenet.org.cn/upfile/1236.pdf Henry, Latane. & Charles, Jones. (1979). Standardized unexpected earnings. The Journal of finance. Accessed on we 9yth Dec 2012. Retrieved from http://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.1979.tb02136.x/abstract Lakonishok, Josef, Shleifer Andrew &Robert Vishny. (1994). Contrarian investment, extrapolation and risk. The Journal of finance. Accessed on web 9th Dec 2012. Retrieved from http://www.regie-energie.qc.ca/audiences/3630-07/Audience3630/Engag/C-8- 32_ACIG_JLakonishok_3630_6sept07.pdf Vol. 49. No.5 Levy, Haim. (2002). Fundamentals of investments. Financial times prentice Hall. Acessed on web. 9th Dec 2012. Retrieved from http://www.ebay.com/sch/sis.html?_itemId=341184787991&_nkw=Fundamentals%20of %20Investments%20:%20Haim%20Levy%20%28Paperback,%202002%29 Montier, James. (2007). Behavioral investing :A Practioner’s guide to applying behavioral finance . Oxford University press. Oxford. UK Myers Jonathan.(n. d). Investment strategies and human behavior. Acceesed on web 9th Dec 2012. Retrieved from http://www.psychonomics.com/research/a&s/strategies.html Shefrin, Hersh. (2002). Beyond greed and fear: Understanding behavioral finance and the psychology of investing. Oxford University press. Oxford. UK. Shleifer, Andrei. (2000). Inefficient markets: An introduction to behavioral finance. Oxford University press. Oxford UK. Womack, Kent. (1996). Do brokerage analysts’ recommendations have investment value? Accessed on web on 9th Dec 2012. Retrieved from http://www.jstor.org/discover/10.2307/2329305?uid=3738336&uid=2129&uid=2&uid=7 0&uid=4&sid=21101542158577 Read More