Finance is an integral, interesting and inseparable part of our lives. An increase in financial awareness over the years has led a lot of people to invest in properties, gold, stocks, derivatives, bonds and other securities. Making an investment is one of the most important decisions in one’s life; and choosing a security can get quite tricky in these times of uncertainties. The factors affecting the general pattern of investments in the securities market can be predicted through Traditional Finance Theory and/or Behavioral Finance Theory.
Traditionally, the movements in the markets are tracked assuming that the investors are perfectly rational and the market trends are logical and systematic, hence it is called the Traditional Finance approach. Certain assumptions are made under Traditional Finance – the investors can gather all the information they need about the market & make their decisions accordingly, the decisions of the investors are not affected by their emotions, and that the markets are a perfect representation of unbiased, cogent & logic driven investors. It is also called Efficient Market Hypothesis (EMH) wherein the prices of the stocks fully reflect the information available regarding them.
Behavioral Finance, on the other hand says that the investors and the market cannot be perfectly rational and unbiased in their investment decisions; and such decisions are affected by their emotions or sentiments. It is not just a part of finance, but a combination of Behavioral Economics, psychology and microeconomics. It has given acceptance to the fact that investors, being humans, cannot be perfect and work on their instincts; hence the market is inefficient in representation of stocks based on their true intrinsic value.
Behavioral finance has been prevalent in some form or the other since the past few decades. When behavioral economics was adopted by the financial services industry, it came to be known as behavioral finance.
Fitful irrationality of the investors and inefficiency of markets can be seen in the case study below: –
GameStop Short Squeeze
Short-selling a stock means borrowing shares from a broker and selling them in the first place, with an agreement to return the shares later. When the price falls, the shares are bought back and the difference amount is the profit.
A short squeeze occurs when a stock or other asset jumps sharply higher, forcing traders who had bet that its price would fall, to buy it in order to avoid even greater losses. Their desperateness to buy only adds to the upward pressure on the stock’s price.
A group of retail investors on reddit ‘Wallstreetbets’ rallied the stock prices of GameStop corporation, a gaming company from $17.25 to $347, a whopping 1700% surge between 14th to 28th Jan’21. The motives of the traders were diverse. Some believed GameStop’s stock was undervalued. Others were simply riding the crest of the surge. Others wanted ‘Melvin Capital’, a hedge fund that was shorting GameStop, to be punished. With total Assets Under Management (AUM) worth $8 billion, Melvin Capital had short-sold the stock down to 127% of the total available shares!
The outcomes of this saga were terrible:
- The GameStop stock became extremely volatile. After reaching a height it could not sustain, the price of the shares fell down drastically nearer to where they used to be.
- Melvin Capital lost 49% of its total investments, in the first quarter of the year.
- Market algorithms were breached.
Clearly, the price of the stock didn’t soar due to any factor fundamentally related to the company, but it soared because of revenge, herd mentality and greed; which are some common human behavioral traits. The matter of the fact is and that today’s investors do whatever they feel like doing, something which is beyond being tracked by the data we are supplied with.
The 2020 market crash in India also tells us that emotions, sentiments and instincts play a large role in investment decisions; which are ignored in the main theme of traditional finance.
Behavioral finance is much helpful than traditional finance on these days of bubbles and busts because of its wider scope: –
- Helps in Understanding market anomalies.
- Identify investors’ personalities.
- Identifying types of bias affecting investment decisions.
- Identification of risks and framing of hedging strategies.
A set of differences between Traditional and Behavioral finance can be observed in the following table: –
|Basis||Traditional Finance||Behavioral Finance|
|Main Theme||Investors are assumed to be rational.||Investors are normal, not rational.|
|Market||The market is assumed to be efficient.||The market is inefficient and has anomalies.|
|Risk-taking||Investors seek to maximize utility of their investments.||Investors are risk-averse & try to avoid losses as well as make profits .|
|Self-control||Investors are always under self-control.||There are limits to the self-control of the investors due to emotions and biases.|
|Behaviour||It tells us how the investors and markets are supposed to behave.||It tells us how the investors and markets actually behave.|
|Bias||Investors are supposedly unbiased.||Investors are affected by personal bias.|
In conclusion, Behavioral finance is the true picture of finance as it accepts the imperfections of the people and the markets. Modern investors are affected by herding instinct, overconfidence, illusion, hindsight bias etc. which cannot be simply ignored as in case of Traditional finance, pertaining to the large-scale impacts they can create. The idea of assuming investors as rational is not valid anymore; and it is high time that we focus on the behavioral aspects of wealth management.