What contribution can behavioral finance make to the explanation of stock market bubbles and crashes? Introduction Efficient markets hypothesis markets can adjust by themselves, because there are rational and Irrational Investors. But stock bubbles and crashes Just Like evils followed the world global economy in last decades. Redhead (2008) suggested that behavioral finance applies the psychology of decision-making to Investment behavior, and It can be useful to show the Irrational behavior of the investors causes the stock bubbles and crashes.
Redhead (2008) listed some systematic distortions that can be used to explain stock bubbles and crashes by behavioral finance method. They are representatives, narrow framing, overconfidence, familiarity and celebrity status. In this essay, I will try to understand that how these factors influence the stock markets. Representatives and narrow framing In this part, I will focus on representatives, and then study the knowledge about narrow framing.
Redhead (2008) believed that representatives can be helpful to explain the Investors to follow the market, and those behaviors of the Investors can lead to stock racket prices anomalies. Redhead (2008) also pointed out that there are two interpretations of the representatives. First interpretation is that recent prices movements are the representatives. Secondly, representatives also can be seen as that people will think about the patterns and tends. One mental shortcut, the representatives bias, involves overbalance on stereotypes (Shiftier, 2005) .
Greeter (1980) and Keenan and Taverns(1973, 1974) said that representatives would cause the investors to play against the Abbey’s rules. In stock markets, recent market prices become the representatives that help to explain the phenomenon for investors to chase the market. In fact, the representatives heuristic showed us that people trust the movement of the market prices will continue. In other words, If the prices kept on rising In last period, then Investors think the prices of course will rise In this period.
As a result, the prices will be pushed up by actives of investors purchase stocks and the investors will be more convinced. This cycles cause the stock prices inflate day by day. At last, stock bubbles occur. On the other hand, Investors will sell the stocks when they see the prices have been falling. The selling behaviors result the stock crashes. In both two processes, recent market prices become the representatives that help to explain the phenomenon for investors to chase the market. ‘OFF past prices. For example, companies which are looked profitable can made people believe that they can earn money from the companies’ stocks or bonds.
Non-expert investors would like to seek others’ investment strategies which looked like correct and follow those strategies. Otherwise, some heuristic simplifications can be seen as forms of the restrictiveness. Confirmation bias, which has been mentioned by Redhead (2008), dads investors to seek the information which can support their investment knowledge, skills and strategies. This style of information will make the investors much more unmoved in their investment decisions. Extrapolation bias is another systematic bias which can be classified in restrictiveness bias.
Dependent and Thales (1990) tested the anticipations changes in earnings and started the systematic bias which is named “Representatives bias”. Dependent (1993) conducted experiments of 38,000 forecasts that non-professional investors liked to focus on apparent past prices and would like to expect the prices to continue in the future. Michael Sterner (2006) reported a study of earnings surprises for US companies over ten years between 1983 and 1993 and found that investors always were overreaction in long-term. He investigated that people estimated the future earnings in a wrong way.
In other words, investors often could not appropriate valuate the earnings. Jadedness and Titman’s (1993, 2001) showed that buying stocks with high returns from the past 3 to 12 months (past winners) and selling stocks with low returns during the same past period (past losers) was a trading strategy that yields positive abnormal returns for the following 3 to 12 month periods. This finding is now widely known as the momentum effect. Roundhouse (1998) found that the momentum effect also exists in European countries. Therefore, the buying of past winners by U. S. Investors (Banged, 2000; Dean, AAA) might be viewed as rational if momentum profits exits. Evidence from Chinese stock market over the period 2006-2008 is very interesting. Figures of numbers of stock market accounts in Shanghai A-share market from 2006 to 2008 , which are from China Securities Depository and Clearing Corporation Limited, were 37,785,100, 56,458,700 and 6,365,400. But media investigated that more that investors quitted in 2008. The number of effective accounts was about 30 million. In same period, the Shanghai A-share Index was about 1700 point in April 2006, 4000 point in April 2007 and 3500 point in April 2008.
It seems that a large number of new investors were fascinated by pries rose from 2006 to 2007. Investors became optimistic, and then they started to buy the stocks. But a lot of investors also lost confidences in the price falling period from 2007 to 2008. Some experts suggest that a lot of investors exited in this period, and amount of accounts were abandoned. The recent performance of the Shanghai A-share Index really became a standard to Chinese investors. Reported the past return for the stocks that Chinese investor’s purchased.
Specifically, the prior 4-month return, prior 4-month abnormal return, prior I-year return, and prior I-year abnormal return are shown. Abnormal returns are again calculated as actual returns minus the market return. Positive returns in the period over 2006-2007 showed that stocks purchases increased, and positive abnormal returns showed that investors buy stocks that did better than the overall stock market. They believe Chinese individual investors tend to buy past winners yet underperformed, the behavior can best be described as an irrational extrapolation bias.
Narrow framing suggests that investors concern short term performances too much and forget the long term performances past. Keenan and Lavabo (1993) putted forward the concept of ‘Narrow Framing firstly. In fact, narrow framing may produce high risks in finance decision-making. Investors, who influenced by narrow framing, will Just look at the stocks which have good performances recently, but ignored these stocks’ performances may be poor in a long term. The really good stocks but not very good in the period may be gave up. Otherwise, narrow framing make an investment like a speculator.
Nicholas Barberries, Mining Hung, and Richard H. Thales (2006) gave us an example about narrow framing. They believe that narrow framing is a weapon in a financial gamble, and it will raise the investment risk. They found that narrow framing occurs when an agent who is offered a new gamble evaluates that gamble to some extent in isolation, separately from her other risks. Nicholas Barberries and Mining Hung (2006) studied the ‘Equity Premium Puzzle’. In this paper, they putted out an outcome that loss aversion and narrow framing are the reasons which cause the ‘Equity Premium Puzzle’.
Examples to support this opinion are the high premix consumers pay for telephone wiring insurance and chose the lower deductibles in car insurance contracts. Overconfidence I found an interesting phenomenon around me. As I said in last part, there was a bull market in China. And I found everybody around me, as my parents, my brothers and my classmates, was talking about the stock market. They looked like confident and believed they can earn much money from stock market. Some my classmates even invested all their money, which should had been their tuition fee, into the market.
But some months later, they became depressed. At last, they told me that they can not understand the reason they failed. I think that they were overconfident that time and I believe the overconfidence bias contribute to the stock bubbles. So in this part, I like to learn the overconfidence bias in stock market. Redhead (2008) suggests that overconfidence causes investors to invest beyond a rational level, and painful losses result when the market falls. He also says that investors with less experience will be overconfidence by last successful investments. Influenced by overconfidence.
If they are successful in the first some investments, hey will believe in their skills in a moment. People often be attracted by the profitable in a bull market, and they will success in this bull market, because almost stocks prices are rising. But they did not go through a bear market, so they do not understand that they are taking a great risk and ignored that they may fail. It means that investors, especially new investors, will be over optimistic on their knowledge, skills and strategies, when they were successful in last investments, especially in bull market.
As a result, they put more money to the stock market until the stock bubble burst. That is why A Wall Street adage tells us that don’t confuse brains with a bull market’ (Redhead, 2008). However, investors with a lot of experiences will lost themselves in stock strategies decision-making too. A reason is that they have enough experiences. They think the experiences can help them to follow the prices rising and avoid the crash risks easily when the stock prices start to fall. In fact, at first of the bubbles, they still are very careful, because they know that the crashes are terrible.
But when the bubbles continue a long term, they start to move restlessly. They begin to buy a large number of stocks again. It helps the prices move to the peak. In that time, they may sure that a large stock crash is coming, but when will it happen is uncertainty. Some rational and experienced investors may drop out or reduce their investment volume from stock market, but most investors become dizzy with recent successful investments. While they start to exit, a real crash occurs. Because experienced investors are overconfident and over-pessimistic in their senses that prices become falling.
They can not bear the loss too, and they active faster than new investors. I mean that experienced investors know more about the market, and know the deep meanings of he information which can effect the market movement, but their natures of chasing the profits can not change. In my opinions, regardless of whether the wealth of a investor’s experience, he or she will become overconfident and overconfidence can lead to over-pessimistic or over- optimistic. Overconfidence makes investors to by financial products more and more, or makes investors sell those products immediately.
Both actives produce prices move exceptionally. Dean(Bibb) pointed that overconfidence causes them to trade too much and hold underspecified portfolios. But what lead people to be overconfidence? Behavior finance shows us some factors, as self-attribution, hindsight bias, information which can be related to prices rising or falling, and illusion of control (Redhead, 2008). Firstly, psychological research tells us that decision-making was fundamentally influenced by self-attribution bias and this bias lead people in to overconfidence (Redhead, 2008).
Self-attribution bias leads people to believe they were successful with their professional skills and knowledge, and were failure because of others’ actions or bad luck. The similar experience. This is the hindsight bias. It means that people often compare vents results to their forecasts, and think that their forecasts are correct. However, they always ignore the wrong forecasts. So in their memory, they are right again and again. Branch Fishhook did many researches about this bias. He compared the foresight and hindsight in 1975, and found that hindsight is greater certainty then foresight to assessment of the actual results.
Thirdly, information, which can be related to prices rising or falling, is evidence that support the investment will profitable or unprofitable. Grapevine news or some ‘secret’ information particularly plays important roles in this place. Those news seem quite real and useful, even they are not real correct. Especially, the news can support the investors’ forecasts. But investors who gained this kind of news become overconfident. At the end, illusion of control can lead to overconfidence. Outcome sequence and acquisition of information contribute to illusion of control (Redhead, 2008).
Profitable outcome always comes first, then the unprofitable outcome. This leads people to tend to take a serious risk. Information is always hard to understand by non-professional investors. Both of them make people think the investments are under control. This life will lead to overconfidence. Familiarity and celebrity stocks At the mention to familiarity and celebrity, I have two shopping experiences. First, I was needed to make a choice among some restaurants. Most of them were new to me. I never went there and had a dinner. But some were familiarity to me, because I always have a dinner there.
At last, I choose those restaurants which I had been. Second, I like to buy I was really like to buy a BMW car. The reason is that it is famous but there are not other reasons. I think the first example is due to familiarity bias and second one is an example of celebrity bias. Buying shares is Just like shopping, so I agree the Mr. Redhead’s opinion that familiarity bias and celebrity bias are live in stock markets. Best (2005) studied the recent Internet stock bubbles, and he found that familiarity bias and celebrity status are two important factors which influenced the investors’ investment behavior (Redhead, 2008) .
Familiarity bias in stock market means that people like to buy the stocks which close to the investors (Redhead, 2008). For example, Ginsburg and Wombat are both supermarkets who performed excellently in their native countries. Ginsburg is famous in I-J, and Wombat is famous in China. While these two companies become available in a same stock market in the same time, it seems that English investors will buy the Kingsbury shares and Chinese investors will buy the Wombat’s shares. To know the internet and believe it will become a great tool which can bring them vast amounts of wealth.
In fact, internet is widely used by people in their lives from sass, and people start to familiar the internet. At last, this familiarity leads investors to expect to seek from profits from those dot. Com companies. Stock prices of many dot. Com companies, like Amazon, became crazy and rising unbounded. Just as the stock bubbles in sass. Automobile technology and radio technology start to be used by common people. As a result, one of the biggest bubbles occurred in that time. But does familiarity always contribute to stock bubbles? In fact, I do not think so.
When I look in the bubbles in sass and sass, I found that both technologies which born in that time were new to the people lived in that period. Although those technologies became familiarity to people in that time, they did not attract the investors again after a long time. I mean that some important technologies can lead people to fanatical when people found they are so closed, but the great mass fervor will become dull even cold. So familiarity may have different impact ways. As my first example at the beginning of this part, I would feel boring if I Just go one restaurant all the time.
I believe there are three steps. In first step, when a new thing come to us, people do not know what it is and will it bring us profits. In this step, there is no familiarity, investors will stand by. In the second step, people found this general really perfect and it starts to be used widely, and they can gain profit by this new thing. So investors become enthusiasm and want to chase the profits which bring by the new moment. In this step, bubbles are produced. At the third step, investors will lose the investment interest.
Crashes may cause this change, or there is a newer one, but reason of deeply familiarity comes first. Sarah E. Bonnier, Arturo Hugo and Beverly R. Walter suggest that celebrity analysts cause the investors’ reaction to earnings forecast revisions. Those celebrity analysts are superior performers, famous and familiar to investors. Comparing other analysts’ opinions, their outlooks and predicts are sounded more realistic and feasibility. Next, the analysts’ views are broad by media. Best (2005) also pointed out that media is an important role in the dot. Com stock bubbles.
While these views have been board, social moods become to influence the market prices and create a bubble or crash. Conclusion In conclusion, stock bubbles and crashes occurred again and again, particularly, in the past three decades. Just when everyone puzzled, behavior finance showed us some systematic biases, such as representatives, narrow framing, overconfidence, familiarity and celebrity status, which can be used to explain the stock bubbles and crashes. With the development of the world, some biases may develop and some new biases may come out.
