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Chapter 1
Theoretical Framework: Investment Decision Making
(Indian Perspective)
1.8 Investment: An Important Function of a Financial System
1.9 Investment: General Objectives
1.10 Saving and Investment Environment: Trends and Choices
1.11 Investment in Stock Market
1.12 Psychology of Decision Making (With Special Reference to Investment
Decision Making)
1.13 Models/Theories of Investment Decision Making
1.14 Standard Finance v/s Behavioural Finance
1.15 Conclusion
1.16 References
1.0 Investment: An Important Function of a Financial System:
“Someone’s sitting in the shade today because someone planted a tree a long time
ago.”
Warren Buffett, legendary
investor.
Financial system has to play an important role in the development of any economy.
The fact that the financial system provides an important contribution in the economic
growth of the country is empirically proven by many economists. A number of
economists have studied the impact of financial system on economic growth of a
country and proved that there is a positive impact of efficient financial system on the
economic growth of the country. The main economists among all these are Robinson
(1952), Romer (1990), King and Levine (1993), Levine and Ross (1997), Lunitel and
Khan (1999), Blackburn, Bose and Capasso (2001) and Lunitel (2001).
Arthur Lewis (1954) observed that the central fact of economic development is rapid
capital accumulation (including knowledge and skills with capital). Financial system
facilitates the capital formation process. The efficiency with which this process is
carried out by the financial system of the country determines the growth and
development of the economy. The process of capital formation consists of three
different inter connected activities, viz. Savings, Finance and Investment. Financial
system helps in this capital formation through transfer process that is transferring the
savings of the saving surplus units to the saving deficit units. As Rao has rightly
pointed out, “increase in savings, use of increased savings for a further increase in
capital formation constituted the strategy behind economic growth. This process of
increased capital formation leading to increased saving and increased saving leading
to increased capital formation will continue till saving, capital formation and income
reach desired levels after which saving and capital formation gets stabilized and there
would be a steady and self sustaining increase in national income.”
Financial system works as a link between the savers and the investors. Thus,
investment is the central function around which the activities of the financial system
revolve.
Investment is an activity whereby fund is placed in some opportunity or instrument
with the expectation of increase in its value and positive returns. In its broadest sense,
an investment is a sacrifice of current money or other resources for future benefits. An
investment process is a mechanism that brings together suppliers of funds and
demanders of funds.
In an economy, people indulge in economic activity to support their consumption
requirements. Savings arise from deferred consumption, to be invested, in anticipation
of future returns. Investments could be made into financial assets, like stocks, bonds
and similar instruments or into real assets, like houses, land or commodities.
Investing in various types of assets is an interesting activity that attracts people from
all walks of life irrespective of their occupation, economic status, education and
family background. When a person has more money than he requires for current
consumption, he would be coined as a potential investor. Numerous avenues of
investment are available today. One can deposit money in a bank account or purchase
a long term government bond or invest in the equity shares of a company or
contribute to a provident fund account or buy a stock option or a plot of land or invest
in some other form.
The two aspects of any investment are time and risk. The sacrifice takes place now
and is certain. The benefit is expected in the future and tends to be uncertain. In some
investments (like government bonds), the time element is the dominant attribute. In
other investments (like stock options), the risk element is the dominant attribute. In
yet other investments (like equity shares), both time and risk are important.
Almost everyone owns a portfolio of investments. The portfolio is likely to comprise
financial assets (bank deposits, bonds, stocks, and so on) and real assets (car, house,
and so on). The portfolio may be the result of a series of haphazard decisions or may
be the result of deliberate and careful planning.
1.1 Investment: General Objectives:
Each investor has unique investment objectives that are affected by short- term and
long-term needs and requirements.
The main investment objectives are increasing the rate of return and reducing the risk.
Other objectives like safety, liquidity and hedge against inflation can be considered as
subsidiary objectives.
1. Return:
The very primary motive of an investor is to earn a good rate of return on the
investment. Rate of return is calculated on the basis of two things: the price at which
the asset is purchased and the total income that an investor earns during the holding
period of an asset. The formula for calculating the rate of return can be put as under:
+ Dividend Capital Appreciation
100 * = Return
Purchase Price
Here capital appreciation is the difference between value at the end of the period and
the value at the beginning of the period and the purchase price is the value paid in the
beginning of the period.
2. Risk:
Investment in any security is done in the expectation of some return in future. There
are all chances that the actual return might fall short of expected return. This element
is known as risk. Thus, risk is the probability of not being able to earn expected return
from any security. In other words, risk is the variability in return or fluctuations in
return from time to time. The investment in case of which return varies widely from
time to time is considered to be more risky in comparison to the one in case of which
return does not change much. Investors try to minimize risk with the help of different
combination of securities.
Following are some of the secondary objectives that investors try to achieve while
dealing with investment activity:
1. Safety:
Safety of investment is another important objective. The selected investment
alternative should be covered under the legal and regulatory structure. Legal approval
ensures safety of investment. The fact is that even legally approved investment
avenues differ in terms of safety and security. Selection should be done keeping in
mind this important fact. Bank deposits and government bonds rank highest in terms
of safety whereas deposits with non-banking finance companies and equity shares of
private companies rank lowest in terms of safety.
2. Liquidity:
Liquidity of investment is ensured by marketability of the investment. The financial
assets which are trade able easily and at best prices in the organized markets are
known as marketable securities. An investor can meet emergency situation if the
investment can be converted into cash easily without much loss of time and value.
Thus, liquidity of an investment is an important consideration.
3. Protection against Inflation:
The rate of return from an investment should be high enough to protect an investor
against inflation. As every economy of the world experiences an inflationary
situation, it is important to earn return at a rate higher than the inflation rate to get
benefit in real terms. The stocks of growing companies assure appreciation in value
over a period of time so that investors are protected against inflation.
1.2 Saving and Investment Environment in India: Trends and
Choices:
Table: Gross Savings as percentage of GDP at market prices
2011-
12
2012-
13
2013-
14
Gross savings 33.9 31.8 30.6
Public sector 1.4 1.7 1.6
Private corporate sector 9.7 10.0 10.9
Household sector
Physical
Financial
22.8
15.5
7.3
20.2
13.2
7.0
18.2
11.0
7.2
Source: CSO
Note: Household physical savings include valuables
From the past trends in the savings rate (gross domestic savings as percentage of
GDP) available from the pre revised series, it is observed that it reached its historical
peak in 2007-08 (36.8 per cent), and then remained volatile, with a general downward
movement. While private corporate savings steadily declined, household savings
witnessed realignment in favour of accumulation of physical assets at the cost of
financial savings. Indications of compositional changes in savings can be seen from
the data for three years based on new series.
While the old series of savings is not strictly comparable with the new series (2011 –
12 base)for many reasons, including on account of the inclusion of ‘valuables’ as part
of savings, the three years’ data from the new series suggests that households’
acquisition of physical assets is on the decline. Disaggregated data further shows that
despite the annual addition to financial assets of households growing from 31.2 per
cent of gross savings in 2011-12 to 36.8 per cent in 2013-14, the rate of financial
savings of households did not pick up because their financial liabilities increased
simultaneously from 9.7 per cent of gross savings to 13.2 per cent. Data from the
Reserve bank of India (RBI) shows that, on one side, additional bank deposits of
households increased by 27.8 per cent during 2011-12 to 2013-14 while, on the other
side, bank advances to households increased by 25.9 per cent.
The retained profits of the private corporate sector adjusted for non-operating
surplus/deficit, defined as their savings under the national accounts, increased during
2011-12 to 2013-14. This is in contrast to the trend revealed by the old series which
had shown that private corporate savings was only 7.3 per cent of the GDP in 2011-12
and it declined to 7.1 per cent in 2012-13. The reliance on the MCA21 database with a
much larger coverage of companies than the RBI’s sample studies on finances of non-
financial corporation was only marginal.
Table: Ratio of Investments to GDP (at current market prices – per cent)
2011-
12
2012-
13
2013-
14
Gross Capital Formation 38.2 36.6 32.2
Public sector 7.6 7.2 8.0
Private sector
- Corporate sector
- Household sector
28.4
13.3
15.1
26.3
13.5
12.9
23.3
12.6
10.7
Gross savings 33.9 31.8 30.6
Savings investment gap -4.3 -4.8 -1.6
Net capital inflow 4.3 4.8 1.6
Source: CSO
Note: Totals may not tally due to adjustment for errors and omissions
Juxtaposing savings with investment, it becomes clear that it was the large saving-
investment gap of the consolidated public sector, complimented by a less pronounced
gap in the private corporate sector, which could not be fully defrayed by the savings
of households, that constituted the aggregate saving-investment gap. The gap between
domestic savings and domestic investment is definition ally equal to the current
account balance (net capital inflows in the above table). In view of the above, it is
clear that household financial savings need to be raised to keep the saving-investment
gap at acceptable levels.
Investment in India can be broadly classified into two categories- Risky asset class
and Risk – free asset class.
Risky Asset Class
1. Direct Equities:
It is a type of securities where the investor buys the ownership of company. Equities
are tradable (bought & sold) in the Stock Exchanges. Equities can be a good
investment option for a long term horizons as it beats all the asset class in terms of
returns over longer time frame. This can be considered as one of the riskiest asset
class as well. Equities are highly risky. The risk of loss of capital is very high. NRI
can also explore this avenue for Investment by opening up a bank account and trading
account in India. They can choose the option of repatriation or non- repatriation at the
time of opening an account.
2. Mutual Fund:
These are funds operated by an investment company which raises money from the
public and invests in a group of assets (shares, debentures, etc.) in accordance with a
stated set of objectives. It is a substitute for those who are unable to invest directly in
equities or debt because of resource, time or knowledge constraints. Benefits include
professional money management, buying in small amounts and diversification.
Mutual fund units are issued and redeemed by the Fund Management Company based
on the fund’s Net Asset Value (NAV), which is determined at the end of each trading
session. NAV is calculated as the value of all the shares held by the fund, minus
expenses, divided by the number of units issued. Mutual funds are usually long term
investment vehicle though there are some categories of mutual funds, such as money
market mutual funds which are short term instruments. Like Direct Equities, NRI can
also invest into mutual fund. It requires a bank account in India & KYC (Know Your
Client) to invest in Indian mutual funds. Mutual fund investment also offers option of
repatriation or non- repatriation.
3. Life Insurance:
Life insurance is a contract between a buyer and insurance company. Insurance
company pays a predominant amount to the nominee in case of death of a buyer. The
primary purpose of insurance is to protect the family (financially) in case of an event
of death of the earning member of the family. Life insurance was a traditional product
and it was giving fixed returns of 6%- 7% until the introduction of Unit Linked
Insurance Plan (ULIP). ULIP gives the benefit of risk cover as well as the returns of
equity market as it invests the premium into equity linked instruments. Now,
Insurance is also open for NRI investment. To buy insurance in India, NRI has to go
through few formalities. NRI needs to submit Proposal form (available in prescribed
format), Medical Report, and Proof of age and Income etc.
4. Commodities:
Commodities has emerged as one of the asset class in recent time. Government has
allowed investment into listed commodities. Commodity trading is in its nascent stage
in India. Currently, commodity trading is available in bullions, base metals and Agri
commodities. Investor needs to open an account with the broker to trade in a
commodity market. Commodity market is very risky. Investor with sound knowledge
should only invest in commodities. As of now, NRIs are not allowed to trade in
commodity market in India.
5. Real Estate:
Real estate is an ever green investment option in India. Most of the investors prefer
investment into real-estate; it can be a residential or commercial property. The thumb
rule of investment in real estate says investor should look at the property available at
15-20 Km away from the city with the time frame of 5- 7 years. Real estate
investment offers very low level of liquidity. It also generates higher rate of returns.
NRI can also invest into Indian real estate. They can buy and own property in India.
However, few Real estate Investment Trust are not open for NRI investment.
Risk Free Asset Class
1. Fixed Deposit:
A fixed deposit allows investors to deposit money into bank/corporate for a specific
period of time, which in return earns an interest. Rate of returns in fixed deposits are
higher than bank saving account. An investment into 5 year fixed deposit is eligible
for tax benefit under section 80 C. maximum of Rs. 1, 50,000. NRI can also avail this
facility and invest into fixed deposits offered by national as well as private banks.
2. NSC:
National Savings Certificate (NSC) offers a fixed interest. NSCs are issued by the
Department of Post, Government of India. NSCs are a practically risk free avenue of
investment as they are backed by the Government of India. NSC is available at
authorized post offices. NSCs have a maturity of 5 years and that of 10 years. It offers
a rate of return of 8.10% per annum for 5 years maturity and 8.8% per annum for 10
years maturity. NSC gives tax benefit under section 80 C. Minimum investment
amount is Rs. 100. The option is not available for NRI’s Investment.
3. Post office:
Post office monthly income scheme is a low risk saving instrument, which can be
availed through any post office. It provides an interest rate of around 7.80% per
annum (from 1st April, 2016), which is paid monthly. Minimum amount, which can be
invested, is Rs. 1,000/-and additional investment in multiples of Rs. 1,500/-.
Maximum amount is Rs. 4,50,000/- (if single) or Rs. 9,00,000/- (if held jointly)
during a year. It has a maturity period of 5 years. It can be pre maturely en-cashed
after 1 year but before 3 years at the discount of 2% of the deposit and after 3 years at
the discount of 1% of the deposit.
4. PPF:
A long term savings instrument with a maturity of 15 years and interest payable at
8.10% (from 1st April, 2016) per annum compounded annually. A PPF account can be
opened through a nationalized bank at any time during the year and open all through
the year for depositing money. Tax benefits can be availed for the amount invested
and interest accrued is tax free. A withdrawal is permissible every year from the
seventh financial year of the date of opening of the account. Loan facility is available
from the third financial year.
5. Bonds:
It is a fixed income (debt) instrument issued for a period of more than one year with
the purpose of raising capital. The central or state government, corporations and
similar institutions sell bonds. A bond is generally a promise to repay the principal
along with a fixed rate of interest on a specified date, called the maturity date.
In nutshell, the investment alternatives available to investors in India can be
specifically summarized as under:
Equity
Purchase shares from share market
Equity linked mutual funds (diversified fund)
Equity linked mutual funds (index fund)
Equity linked mutual funds (dividend yield fund)
Equity linked mutual funds (equity tax saver fund)
Equity linked mutual funds (sector fund)
Equity linked mutual funds (thematic fund)
Equity linked mutual funds (flexicap/multicap fund)
Equity linked mutual funds (contra fund)
Equity linked mutual funds (exchange traded fund)
Investing in equity through Unit Linked Plans (ULIP)
Investing in equity through a portfolio manager
Futures and options
Debt
Bank deposits
Central government bonds and T-bills
State government securities
Public Sector Undertaking (PSU) bonds
Company fixed deposits
Post office savings (kisan vikas patrika)
Post office savings (monthly income plan - MIP)
Post office savings (National savings certificate - NSC)
Post office savings (term deposits)
Post office savings (RBI savings bond)
Gold
Jewellery
Coins and bars
Demat gold
Real Estate
Residential property
Commercial property
Retail property
Franchisee property
Real estate mutual fund
Reverse mortgage
Art
Buying art work directly
Investing through Art funds
Medical Insurance
Life insurance
1.3 Investment in Stock Market:
Investment is that part of money whose nominal value increases along with the
inflation or time to increase its real value. The part of money that one parks in some
avenues like bank deposits, real estate, jewelry or stock market to get some return on
that capital in future is known as investing or investment. In India, investment in stock
market is one of the most preferred investment avenues. Indian stock market is among
the top 20 stock markets of the world and it is one of the largest Asian stock markets.
There are various avenues for investment. One may invest in the bank deposits, postal
deposits, real estate, jewelry, painting, life insurance, tax savings scheme like PPF,
NSC or stock market related instruments called securities like shares, debentures,
bonds, etc. However, return from each investment option depends on the associated
risk. The riskier the investment, the higher will be the return.
Stock market investments offer benefits like easy liquidity, flexibility of amounts
invested, disinvested, reasonable returns and a regulatory framework to safeguard
investors’ rights. Shares are the most popular form of stock market investments due to
their highest potential for capital growth. Statistics show that in recent decades shares
have made up an increasingly large proportion of households’ financial assets in many
countries. The major part of this adjustment has been in financial portfolios.
Different studies have been carried out by financial economists on the implications of
stock market development for various components of an economy. These include the
studies undertaken by Demirguc-Kunt and Maksimovik (1996), Stock market
Development and Financial Intermediaries: Stylized Facts by Demirguc-Kunt and
Levine (1996) and Stock Market Development and Long Run Growth by Levine and
Zervos (1996).
1.4 Psychology of Decision Making (Special reference to
Investment Decision Making)
“When it comes to investing, people generally follow their emotions and not their
reason.”
- Burton Malkiel (1973)
On January 27, 1999, Securities and Exchange Commission chair Arthur Levitt
warned that online trading was like “a narcotic” to many online traders. The
technology may have changed over the last seventy years, but human psychology has
not.
John D Watson (1913) introduced behaviourism, a radical new approach to
psychology. He held that the only interesting scientific issues in psychology involved
the study of direct observables such as stimuli and responses. He argued that the
environment rather than internal proclivities determine behavior.
Further B.F.Skinner developed the concept of behaviourism. In his research agenda,
the notions such as ‘thought’, ‘feeling’, ‘temperament’ and ‘motivation’ were
excluded. He denied the meaningful existence of such internal cognitive processes or
states. His experiments were primarily based on rats and pigeons. He argued that all
human behavior could be explained in terms of conditioning by means of
reinforcement or association. Eventually, however, a combination of evidence and
common sense led to the ‘cognitive revolution’ in experimental psychology, which
reinstated internal mental states as object of scientific inquiry.
All human beings have some specific patterns of thinking, and this may influence our
emotional state and behavior. Sometimes these patterns are not very accurate. These
are called cognitive distortions or cognitive errors. Its learning would enable us to
recognize our cognitive errors and thus our ability to ignore the negative thought or to
change it increases. And this helps us changing our emotions and behavior. Following
are some of the common cognitive errors that we are confronted to:
We tend to put our experiences into two categories only viz., good or bad.
Nothing is out in between these two.
We tend to over generalize in the sense that we believe that something will always
happen as it has already happened once in past.
When good thing happens, we do not take it to be important and we do not count
it. Thus, we tend to discount positive.
We all tend to come to conclusion pre maturely in the sense that we jump to the
conclusion even if we do not have complete information about the issue under
consideration.
We think that we know what others are thinking or feeling about you though there
is no evidence to believe so. People are overconfident so far as their mind reading
talent is concerned.
People have strong confidence in their ability of predicting future and while doing
that, they always tend to ignore other possible alternatives.
People tend to distort (either magnify or minimize) the importance of positive or
negative events.
We believe something to be true because we feel it to be true. This is called
emotional reasoning.
We tend to label our desires as our ideals. When we wish to do something, we tell
ourselves that we should do that.
We tend to label a person as good or bad on the basis of one behavior or mistake.
People tend to take blame on themselves for an unwanted happening even if they
would not have been able to make any difference in that in any way. This is called
personalization.
The study of decision making processes has evolved over a long time period of more
than 300 years wherein different disciplines have contributed. The contributions range
from providing mathematical foundations for economics to routine applications in
many areas such as finance, medicine, military and even cybernetics. As a result,
decision theories have embodied several prevalent concepts and models, which exert
significant influence over almost all the biological, cognitive, and social sciences
(Doyle & Thomason, 1999).According to Kay (2002), it is essential to comprehend
the nature and origins of human intuitions to understand the intricacies of decision
making.
Psychological research has made considerable progress over the last few decades
developing robust theories of how people behave, which have been summarized into
the categories of drive (fundamental motivations as described by Maslow’s hierarchy
of needs), cognition (how humans analyze data and draw conclusions), and affect
(emotional responses to environmental stimuli, and how these responses affect
behavior).
The decision making phenomenon has been a frequently studied topic by several areas
of human knowledge. According to Hoch, Kunreuther, and Gunther (2001), although
more than three decades of systematic research on decision science have provided
insights on a variety of issues, many areas of the decision making field still need to be
uncovered. Here, a brief account of existing decision models and theories of decision
making is given:
Basically decision making theories and models can broadly be put under two main
categories: Descriptive/Cognitive and Normative/Logical. Descriptive models take the
base of cognition to explain decision making whereas normative theories comprise of
rationalistic components that explain how decision makers should take decisions.
Rubinstein (1998) has explained a simple three-step process of decision making as per
rational decision making methodology:
(a) Analyzing the feasibility of the alternative,
(b) Pondering the desirability of the alternative, and
(c) Choosing the best alternative by combining both desirability and feasibility.
According to Stein and Welch (1997), cognitive psychology provides tools for
analyzing simple rules people use when reacting to intricate and poorly structured
dilemmas. There exists filters and simplifying mechanisms through which people
process information and interpret their surrounding environments.
Some specific cognitive decision models are described here under in brief:
1. Attribution Theory: Schemata, Heuristics, Bias:
This theory is one of the products of cognitive psychology. According to this theory,
schema has its influence in determining how people interpret new information based
on their preexisting beliefs. Geva and Mintz (1997) have given the definition of
schemata:
“It is a working hypothesis about some aspect of the environment and may be a
concept of the self (self schema), other individuals (person schema), groups (role
schema), or sequences of the events in the environment (scripts).”
Once schema is formed, people would tend to resist the change. Another important
element of this theory is heuristics. These are the rules people use to test their
schemata and to process the information. Because of the use of heuristics, cognitive
biases occur and this finally results into attribution errors.
2. The Theory of Choice:
According to Stein and Welch (1997), “the fundamental assumptions of psychological
theories are realistic in the sense that they accord empirical evidence, although some
questions arise with respect to how well psychological theories travel from the
laboratory to the real world. More problematic, psychological theories generally do
not specify their scope conditions. In addition, they are often logically inconsistent
with one another.”
3. Prospect Theory:
In the words of Hogarth (1994), “prospect theory has two main elements: a value
function that works similarly to the utility function in the expected utility theory and a
decision weight function to analyze the weights that are attached to the probabilities
of choice.
It is a theory of decision making under conditions of risk. Decisions are based on
judgements. Judgements are assessments about the external state of the world. They
are made especially challenging under conditions of uncertainty, where it is difficult
to foresee the consequences or outcomes of events with clarity. Decisions involve
internal conflicts over value trade-offs. They are made difficult when choices promote
contradictory values and goals. Prospect theory directly addresses how these choices
are framed and evaluated in the decision making process.
Prospect theory has probably done more to bring psychology into the heart of
economic analysis than any other approach. It was developed by Kahneman and
Tversky (1979). In its original form, it is concerned with the behavior of decision
makers who come across choice between two alternatives. The definition in the
original text is: “Decision making under risk can be viewed as a choice between
prospects or gambles. ”Thus, while making decisions under risk, one has to choose
between two alternative actions which are associated with specific probabilities
(prospects) and gambles.
4. The Ambiguity Model:
In prospect theory, decision phenomena are connected to alternatives that are attached
to losses and gains keeping in view a specific reference point, whereas in the
ambiguity model, decision making progresses through a multi dimensional evaluative
process. According to prospect theory, people identify the exact probabilities
connecting choices to results. But according to Hogarth (1994), choice is affected by
the perception of ambiguity as people tend to be unclear about the probabilities of
events that could affect outcomes.
Thus, descriptive and normative decision making theories possess different
characteristics and follow specific methodologies so far as the selection of a course of
action is concerned.
1.5 Models/Theories of Investment Decision Making:
Basically there are two broadly categorized theories of investment:
1. Traditional Finance/Efficient Market Hypothesis (EMH):
“If the EMH holds, the market truly knows the best.” - Andrei Shleifer
In the 1960's Eugene Fama submitted his Ph.D. dissertation. In it he argued that in
any market that has “many well informed agents” i.e. traders, the current price reflects
all of the available information. By 1970 this idea evolved into the first of three
papers (“Efficient Capital Markets: A Review of Theory and Empirical Work”) he
would publish paper that would come to be known as the Efficient Market Hypothesis
or EHM for short.
EMH was considered to be the dominant investing theory from the early 60s to the
mid 90s. The theory dominated the thinking of academic financial economists at that
point of time as it was widely accepted theory during that time period.
EMH was introduced by Markowitz in 1952 and then subsequently named by Fama in
1970. It is based on the assumption that the financial markets incorporate all
information and thus, the share prices prevalent in the market truly reflect all
information. In 1978, Michael Jensen, a Chicago graduate and one of the creators of
the EMH declared that there is no other proposition in economics which has more
solid empirical evidence supporting it than the Efficient Market Hypothesis.
EMH is the first and foremost a consequence of equilibrium in competitive markets
with fully rational investors. It is the most prominent financial theory. According to
Statman (1999), it is the body of knowledge built on the following pillars:
(i) Arbitrage principles of Modigliani and Miller
(ii) Portfolio principles of Markowitz
(iii) Capital asset pricing theory of Sharpe
(iv) Option pricing theory of Black, Scholes and Merton.
A well-known story explains the argument of efficient market:
A $ 100 bill was noticed by a professor of Economics and a student. The student tries
to pick it up but the professor prevents him from doing so saying “Don’t bother – if it
were really a $ 100 bill, it wouldn’t be there.”
In the context of above story, it can be said that efficient markets would allow
investors to earn above-average returns only on taking above-average risks. In other
words, efficient markets are the ones that do not allow investors to earn above-
average returns without accepting above-average risks. (Malkiel, 2003).
The key terms to explain the concept of EMH are: Efficiency, Integration, Reflection,
Market and Information. So far as the term ‘Market Efficiency’ is concerned, the first
mention was found in George Gibson’s (1989) book “The Stock Markets of London,
Paris and New York”. In this book, he states: When shares become publicly known in
an open market, the value which they acquire may be regarded as the judgement of
the best intelligence concerning them.” But EMH got prominent acknowledgement as
prominent financial model in Eugene Fama’s Ph D dissertation in the 1960s.
According to Fama (1970), “Efficient markets are markets where there are large
number of rational profit maximizers actively competing with each trying to predict
future market values of individual securities and where important current information
is almost freely available to all participants.” According to him, “In an efficient
market, on the average, competition will cause the full effects of new information on
intrinsic values to be reflected ‘instantaneously’ in actual prices.”
According to Timmermann and Granger (2004) “A market is efficient with respect to
the information set, Ωt, search technologies, St, and forecasting models, Mt, if it is
impossible to make economic profits by trading on the basis of signals produced from
a forecasting model in Mt defined over predictor variables in the information set Ωt
and selected using a search technology in St.”
According to Robert C. Higgins (1992) “Market efficiency is a description of how
prices in competitive markets respond to new information. The arrival of new
information to a competitive market can be likened to the arrival of a lamb chop to a
school of flesh-eating piranha, where investors are - plausibly enough - the piranha.
The instant the lamb chop hits the water, there is turmoil as the fish devour the meat.
Very soon the meat is gone, leaving only the worthless bone behind, and the water
returns to normal. Similarly, when new information reaches a competitive market
there is much turmoil as investors buy and sell securities in response to the news,
causing prices to change. Once prices adjust, all that is left of the information is the
worthless bone. No amount of gnawing on the bone will yield any more meat, and no
further study of old information will yield any more valuable intelligence.”
Karz(2012) states that ‘Fama persuasively made the argument that in an active market
that includes many well-informed and intelligent investors, securities will be
appropriately priced and reflect all available information.” P. Samuelson is another
noteworthy researcher who contributed for developing the concept of EMH.
According to Eugene Fama, there are three distinguished forms of market efficiency:
Strong Form: In this state of efficiency, market does not allow investors to realize
competitive advantage in investing processes as stock prices fully reflect all
information, viz., public, personal and even confidential.
Semi-strong Form: In this form of market efficiency, all public information gets
reflected in stock prices. Public financial information includes announcements of
listed companies, balance sheets and other financial statements of the companies,
etc.
Weak Form: In this state of market efficiency, all past prices are integrated in the
current prices of the stocks. Thus, past prices cannot be used for predicting future
price movements.
Following are the main postulates of EMH:
When individual stocks and aggregate stock market fully reflect available
information and can integrate it in current stock prices, they can be characterized
as efficient. In efficient market, Information is not exclusive but it is available to
everybody in the market. And that is why all investors can be regarded as
investment experts or market specialists as availability of information is not a
privilege to any one investor in the efficient market. According to Malkiel (2003),
“The accepted view was that when information arises, the news spreads very
quickly and is incorporated into the prices of securities without delay.” Moreover,
new information is directly available to markets and is easily reflected in stock
prices, therefore it does not provide any extra gain or abnormal profit to investors.
In the words of Fama, “In an efficient market, on an average, competition will
cause the full effects of new information on intrinsic values to be reflected
‘instantaneously’ in actual prices.” In an efficient market, even active fund
managers are not able to earn above average return by exploiting confidential
information. The market itself is efficient enough to anticipate future movements
in an unbiased manner, and thus there is objective and informed integration of
information into the market price. Thus, stock price reflects all information –
public as well as insider, not leaving any scope for maximizing returns from non-
stop trading.
In the framework of EMH, fundamental analysis is more helpful rather than
technical analysis for stock assessment. As past prices are fully integrated into
current prices of the stocks, graph representation or analysis of past prices will not
result into any extra profit. Random Walk Hypothesis has been advocated by the
researchers and academicians to reduce the importance of technical analysis.
According to this hypothesis, the stock prices take a random walk and thus cannot
be predicted. Following are the views of the experts on random walk of stock
prices:
According to Kendall (1953), “Stock price fluctuations are independent of each other
and have the same probability distribution.”
According to Lo & Hasanhodzic (2010), “Stock prices are commonly perceived as
random and unpredictable.”
According to Malkiel (1973), “The market and stocks could be just as random as
flipping a coin.”
According to Shiller (2000), “Stock prices approximately describe random walks
through time: the price changes are unpredictable since they occur only in response to
genuinely new information, which by the very fact that it is new, is unpredictable.”
According to EMH, all investors in market are rational. According to Lucca
(1978), “In markets, in which all investors have ‘rational expectations’, prices
fully reflect all available information and marginal-utility weighted prices follow
martingales.”
Thus, according to EMH, rational market actors can value securities rationally.
Rational valuation of securities implies that securities are valued at their fundamental
values, i.e., net present values of its future cash flows discounted by a risk factor. It
means that security price fully reflects all the available information and consequently
all the relevant information is valued properly in the price formation.
According to Shleifer (2000), “Even if there are some investors who are not rational,
their trading activities will either cancel out with one another or will be arbitraged
away by rational investors.”
Thus, it implies that markets are always rational and efficient even though all
investors do not act rationally all the time. When investors do not act rationally, it
leads to deviation in equilibrium prices. But this is a temporary and short-term
deviation only as irrational actions of investors are counterbalanced with each other.
This happens because there is no communication between investors and their
transactions are not interdependent. Moreover, irrational investors cannot exist in the
market for long. According to Spyrou (2003), “Irrational investors proceed to
overpriced or underpriced investments, they seem to achieve lower returns than
rational investors; thus, they are bound to lose money, their assets are likely to
diminish, and consequently their status in the stock market will diminish, as well.” On
the other hand, the involvement of rational investors in arbitrage process results into
price equilibrium and efficiency. This implies that market continues to be efficient
and profit-maximizing.
Market actors are acquainted with the well defined subjective utility function
which they try to maximize. The assumptions underlying the subjective expected
theory are (Simon, 1983):
(i) The decision maker has a well defined utility function which can be
assigned some cardinal number to reflect the possible future events;
(ii) The decision maker faces a well defined set of alternatives to choose from;
(iii) The decision maker is able to assign a consistent joint probability
distribution to all future sets of events;
(iv) The decision maker will maximize the expected value of his/her utility
function.
According to Jones (1993) and Shleifer (2000), an efficient market can exist if the
following conditions hold:
(i) A large number of rational profit maximizing investors exists who actively
participate in the market, hence value securities rationally.
(ii) If some investors are not rational, their irrational trades are canceling each
other out or rational arbitrageurs eliminate their influence without
affecting prices.
(iii) Information is costless and widely available to market participants at
approximately same time. Investors react quickly and fully to the new
information, causing stock prices to adjust accordingly.
According to Merton H. Miller (1999), efficient market hypothesis says that no simple
rule based on already published and available information can generate above normal
rates of return. In his opinion, “the efficient market hypothesis of finance remains as
strong as ever, despite the steady drumbeat of empirical studies directed against it. If
you find some mechanical rule that seems to earn above normal returns – and with
thousands of researchers spinning through the mountains of tapes of past data,
anomalies, like the currently fashionable ‘momentum effects’, are bound to keep
turning up – then imitators will enter and compete away those above normal returns
exactly as in any other setting in economics. Above normal profits, wherever they are
found, inevitably carry with them the seeds of their own decay.
Warren Buffet gives an advice with his characteristic wisdom, “Most investors, both
institutional and individual, will find that the best way to own common stocks (shares)
is through an index fund that charges minimal fees. Those following this path are sure
to beat the net results (after fees and expenses) of the great majority of investment
professionals.”
According to Martin Sewell, “The efficient market hypothesis (EMH) asserts that
financial markets are efficient. On the one hand, the definitional ‘fully’ is an exacting
requirement, suggesting that no real market could ever be efficient, implying that the
EMH is almost certainly false. On the other hand, economics is a social science, and a
hypothesis that is asymptotically true puts the EMH in contention for one of the
strongest hypotheses in the whole of the social sciences. Strictly speaking the EMH is
false, but in spirit is profoundly true. Besides, science concerns seeking the best
hypothesis, and until a flawed hypothesis is replaced by a better hypothesis, criticism
is of limited value.
2. Behavioural Finance:
EMH lost its significance among research scholars and financial markets with the
advent of Behavioural Finance in the early 90s. Since then, there has been a
movement towards incorporating more behavioral science into finance. The theory of
behavioral finance came into existence not as a supplementary approach but as a
contradictory approach.
It challenges the Efficient Market Hypothesis and concentrates on how investors take
decisions and actions in market on the basis of their interpretation of the information
which is available to them. Thus, BF helps in understanding the behavior of investors
in the market and the actual practices that are prevalent in the market. Indirectly it
helps investors in taking correct financial decisions in the face of challenges and
complexities of financial market place.
Thus, basically Behavioural Finance is a field where an attempt is made to describe
how human psychology and particularly human behavior affects investment decision
making. The term Behavioural Finance is explained differently by different scholars
and experts:
“BF is the study of how psychology affects financial decision making and financial
markets.”- Shefrin (2001)
“It is simply ‘open-minded finance.” – Thaler (1993)
In terms of Alexakis & Xanthakis (2008), investors are not optimal decision makers
as their financial-investing decision making is affected by psychological processes.
According to Sewell (2001), “BF is the study of the influence of psychology on the
behavior of financial practitioners and the subsequent effect on markets. Behavioural
finance is of interest because it helps explain why and how markets might be
inefficient.”
Psychologists Daniel Kahneman and Tversky are considered as forefathers of BF.
They advocated that heuristics and biases affect judgement under uncertainty (1974)
and formulated Prospect Theory in their work “Analysis of Decision under Risk”
(1979). Thaler is another important contributor in the field of BF and he suggested
that prospect theory can be the basis of an alternative descriptive model in his work
“Mental Accounting and Consumer Choice” (1985).
Ricciardi and Simon (2000) define the field in the following fashion:
“BF attempts to explain and increase understanding of the reasoning patterns of
investors, including the emotional processes involved and the degree to which they
influence the decision making process. Essentially, behavioural finance attempts to
explain the what, why and how of finance and investing, from a human perspective.”
Thus, BF is a science that strives to give explanation and improve insight into the
overall judgement process of investors.
BF researchers explain how and why people and markets do what they do by bridging
the gap between classical economics and psychology. The objective of BF is to close
the gap between how investors actually make decisions and how they should make
decisions.
Behavioural phenomena are both ubiquitous and germane: ubiquitous because you
will find them wherever people are making financial decisions; germane because
heuristic driven bias and framing effects are very expensive.
The basic foundations of BF are market anomalies and framing. Apart from that, an
important premise is heuristics which refers to the acquisition of knowledge or
desirable outcome by employing smart guesswork instead of using specified formulas.
Heuristics are rules of thumb or short cut problem solving techniques developed on
the basis of experience. Investors use heuristics for their decision making particularly
when it is difficult to make judgement due to poor information or complex investment
circumstances or market instability. Following is an explanation of some heuristics
that explain the irrational behavior of investors:
People try to find common elements in two unrelated events thereby the
connection between a new event and an existing one can be established so that it
can be decided to what extent one represents the other one. In the words of
Tversky and Kahneman (1974), “People often judge probabilities by the degree to
which A is representative of B, that is, by the degree to which A resembles B.”
This is called representativeness heuristic.
Taking decisions on the basis of an initial anchor is called anchoring. In the words
of Slovic & Lichtenstein (1971), “In many situations, people tend to make
estimates by starting from an initial value that is adjusted to yield the final answer.
The initial value, or starting point may be suggested by the formulation of the
problem or it may be the result of a partial computation. In either case,
adjustments are typically insufficient.”
People develop herd behavior in decision making as they try to join group while
taking decisions in the market. According to Banerjee (1992), “People will be
doing what others are rather than using their information.”
People have tendency to remain too confident about their abilities and knowledge
and they overestimate their skills and abilities which leads to incorrect selection of
investment options. This is called overconfidence. According to Plous (1993),
“No problem in judgement and decision making is more prevalent and more
potentially catastrophic than overconfidence.” According to De Bondt and Thaler
(1995), “Overconfidence is perhaps the most robust finding in the psychology of
judgement.”
Apart from the above heuristics, investors’ behavior is observed to be affected by
some illusions which are explained in the Prospect Theory, a theory that enhances and
supplements Behavioural Economic Theory. This theory was developed by
Kahneman and Tversky in 1979. According to this theory, people do not value gains
and losses at par but they are valued differently. And the decisions are based on
perceived gains rather than perceived losses. According to this theory, people violate
the principles of expected utility theory. This theory says that investors take incorrect
decisions as their decision making is dominated and influenced by some fallacies
which can be described as under:
People are found to be risk-averse for losses rather than for gains. In the words of
Kahneman and Tversky (1984), “Losses loom larger than gains.” This is known as
loss aversion.
There is another phenomenon called mental accounting. According to it, people
have tendency to create different mental accounts and register events in those
separate accounts.
There is a tendency of people to postpone the selling of stocks so as not to finalize
losses as investors have strong desire to avoid pain incurred by a poor investment
decision. This is called regret aversion. In the words of Pieters & Zeelenberg
(2004), “People can anticipate emotions such as regret, because they compare
possible outcomes of a choice with what the outcomes would have been, had a
different choice been made.”
Apart from all these considerations, judgement and decision making in the field of
investment are affected by cognitive biases of investors. Its generation and
development depends on personality, culture and socio-economic environment.
Thus, BF has emerged as a new dominant model to explain investment decision
making.
1.6 Standard/Traditional Finance v/s Behavioural Finance
Traditional Finance may be represented as ‘1 + 1 = 2’
Behavioural Finance may be represented as ‘1 + 1 + emotion = 2 or 8 or 50 or 0’.
Traditional Finance: Nobody can beat the market
Behavioural Finance: Except for those of us who do!
Traditional and conventional economics and finance are based on the assumption that
people are wealth maximisers and they always act rationally trying to increase their
own well-being. Thus, people do not get affected by emotions or any such extraneous
factors while making economic choices. But this assumption does not stand true in
real world. The widely noticed fact is people behave irrationally most of the times.
Logically speaking, the behavior of people spending lakhs of rupees behind
purchasing lottery tickets when the chances of winning are so remote is senseless.
Traditional finance has failed to explain such anomalies and that the very reason why
BF has come into existence to look into cognitive psychology to explain such illogical
and irrational behavior of people while making their economic decisions. Traditional
researchers support the existence of Homo Economicus, the one who makes perfectly
rational decisions, applies unlimited processing power to any available information
and holds preferences well-described by standard expected utility theory. Thus, it can
be concluded that the traditional theories explain the behavior and actions of
‘economic man’ whereas behavioural finance explains the behavior and actions of a
‘common man’.
Dr Peter Wohrmann (2004) explained the difference between traditional finance and
behavioural finance in terms of asset management.
Traditional Finance and Asset Management:
(i) The Rational Investor has no emotions, always looks ahead, has perfect
foresight and reacts correctly to news. His anticipation principle is: ‘Every
trend is already anticipated in current prices. Prices fluctuate according to
news. News are unpredictable. So prices are unpredictable.’
(ii) Random Walk says that asset prices fluctuate like repeatedly tossing a fair
coin. According to it, the best asset management is a passive buy & hold
strategy.
(iii) Econometric Evidence is available to prove the tenet of traditional finance.
(Lo & MacKinley, 1999- Momentum & Reversal, Over and Under
reaction)
Behavioural Finance and Asset Management:
(i) The Behavioural Investor, its characteristics and predictability can be
explained in terms of Mental Accounting, Loss Aversion and Equity
Premium, Representativeness Bias, Gambler’s Fallacy and Momentum &
Reversal, Anchoring, Under reaction and Post Earnings Announcement
Drift, Favourite Long-shot Bias and Skew Trading.
(ii) New Econometric Methods are developed for trading.
He concluded that traditional finance suggests a passive asset management.
Behavioural finance points at robust anomalies. New econometric methods help to
exploit predictability in active asset management.
In nutshell, the difference can be explained as:
People are assumed to be ‘rational’ in standard finance; they are assumed to be
‘normal’ in behavioural finance;
Utilitarian characteristics are considered important by people in standard finance
but value expressive characteristics are not given importance by them;
Rational people have a standard pattern to be followed. They have total self
control, they are not confused by cognitive errors, they are not averse to regret and
they are always averse to risk. People in behavioural finance do not follow this
standard pattern of behavior.
Meir Statman said that, standard finance is with rational people in it and they are
computer-like whereas behavioural finance is with normal people in it and they are
sometimes smart and sometimes stupid. He explained the difference between standard
finance and behavioural finance as under:
Foundation blocks of standard finance are:
Investors are rational
Investors should construct portfolios by the rules of mean-variance portfolio
theory (and actually do so)
Markets are efficient
Expected returns are determined only by risk (measured by beta)
Foundation blocks of behavioural finance are:
Investors are normal
Investors construct portfolios by the rules of behavioural portfolio theory (and it is
pretty wise to do so)
Markets are not efficient (but are not as easy to beat as many normal investors
think)
Expected returns are determined by more than risk
He further says, “Market efficiency has two meanings. To some, market efficiency
means that there is no systematic way to beat the market. To others, it means that
security prices are rational – that is, reflect only ‘fundamental’ or ‘utilitarian’
characteristics, such as risk, but not ‘psychological’ or ‘value expressive’
characteristics such as, sentiment. . . I argue that finance scholars and professionals
would do well to accept market efficiency in the beat-the-market sense, but reject it in
the rational-pricing sense.
Standard finance asks for too much when it asks for market efficiency in the rational
sense, and investment professionals ask far too much when they insist that the primary
contribution of behavioural finance is its potential help in beating the market.”
According to Kahneman and Riepe (1998), “People deviate from the standard
decision making model in a number of fundamental areas. We can group these areas,
somewhat simplistically into three broad categories: attitude towards risk, non-
Bayesian expectation formation and sensitivity of decision making to the framing of
problems.” Following are the areas whereby EMH and BF are differentiated and they
are the areas in which BF has challenged the practical validity of EMH.
According to Baker and Nofsinger (2002), the difference between traditional and
behavioural finance is an issue of how each discipline is developed. Traditional
finance has developed in a normative way; it concerns the rational solution to the
decision problem by developing ideas and financial tools for how investors should
behave rather than how actually they do behave. In this respect, behavioural finance is
descriptive because it offers explanations for what actually happens rather than what
should happen.
1. Information Access:
EMH considers markets as information ally efficient. Each and every individual in the
market has an access to the available information and thus investment news cannot be
exploited by anybody who is involved in a particular investment process.
However, this tenet of EMH has been challenged and invited controversy on two
aspects: Access and Availability. All investors can be assumed to have an access to
information theoretically but practically it seems to be an impossible proposition.
Investors having different lifestyle and different daily routine cannot be assumed to
have same available time and same method to access information. People cannot
catch up with the changes in the world characterized by rapid movements of events,
globalised markets and the growing number of the available investing methods.
Today, there are different channels through which information is being disseminated
but people cannot understand and evaluate all available information. Even all who are
actively involved in stock market analysis are not equally competent and efficient. In
practice, a continuous flow of information on changing investment contexts makes an
investment field a battle with winners and losers.
2. Availability of Information:
According to EMH, same amount of information is available to all investors in the
market at the same point in time. But practically, it is not so. Practically, investment
information is available to only some investors and moreover, some amount of
information is available to only speculators long before general public comes to know
about it. On the basis of such information with which majority investors are not aware
speculators try to take advantage.
3. Role of Fundamental Analysis:
There are two methods with the help of which security analysis can be done so as to
take investment decisions: Fundamental analysis and Technical analysis.
In investment processes, it is advisable to analyze the fundamental components of the
company before including the securities of the company in the portfolio. To promote
confidence relationship with the company whose securities are to be included in the
portfolio, it is important to assess its fundamental financial data. Fundamental
analysis is the most widely accepted model by economists but it is replaced by semi-
strong form efficiency by EMH.
4. Importance of Technical Analysis:
Technical analysis studies the past market data to forecast direction of prices. But
EMH suggests that investment decisions should be based on current information and
current prices. Practically speaking, investment decisions do get affected by the
historical direction and development of a company. Though past market data should
not be considered only as base for investment decision making but it should not be
totally ignored also as suggested by EMH.
People in general and investors in particular strongly support the premises like
‘history repeats itself’ and ‘economy is running in a circle’. And this is the reason
why EMH and Random Walk theory have been challenged.
5. Uniform Investment Behaviour:
EMH treats all individuals involved in investment and in the stock market are all
uniform and exactly similar. Investors are assumed to be colourless group of people
having same investing characteristics and attitudes. Investment behavior is not
affected by any demographic variable. But the reality is far different as investors’
differences in terms of their personality, investing culture and investment attitude do
influence their investment behavior.
6. Investors as Investment Machines:
Individuals investing in the stock market are assumed to be rational by EMH.
Investors are concerned with expected-utility outcomes and profit maximizers. This
implies that investors are well preserved machines. As all investors in the market
follow the same investing rule of rationality, they are compared to stock market
soldiers marching in a parade. But reality says that in investment processes, rationality
is always a destination and investors keep trying to reach there and create competitive
advantage in the process. To conclude, investors should not be perceived as robots
investing in ‘war stocks’ as postulated by EMH.
7. Emotions and Investment:
According to EMH, emotions do not have any place in the world of rational investors.
Whereas emotions are backbone of the theoretical framework of BF and it establishes
strong correlation between emotions and market events.
In real world, emotional involvement of investors forms beliefs and attitudes and
these attitudes and feelings affect investing processes. There are different forms of
investment viz., investment in family, investment in career, investment in knowledge,
etc. Emotions play important role in all these forms of investment so they do affect
financial investments also.
8. Investing Bubbles:
EMH does not support emergence of investing bubbles but it has been a reality in
stock market. Regular appearance and long duration of investing bubbles raises doubt
against the existence of efficient market and rational investors. According to Stiglitz,
“The crisis has provided numerous examples of markets that cannot be described as
efficient in any reasonable way.” Not only such financial anomalies but even calendar
effect anomalies prove the dominance of BF over EMH. Moreover, participation of
rational investors in arbitrage process is not very efficient resulting into very slow
adjustment in the stock prices.
9. Traditional Financial Theories and Contemporary Financial Theories:
Investment field has drastically changed over the last few years with the introduction
of new investment tools, new investment culture, new investment practices and even
new investment rules. These all have led to the drastic changes in the investing
profiles as well. In spite of all these changes, EMH has remained unchanged in its
approach. It is undoubtedly clear fact that the concepts of efficiency and rationality do
not change over a period of time but the efficiency and rationality of investors do
change as a result of modifications that have come in the investing activities. There
has been an emergence of several new investing tools which cannot exist in an
efficient market. In nutshell, in the changed environment, the narrow considerations
of EMH should be replaced with a new theoretical framework. BF model is
evolutionary in the sense that it goes on getting modified as per the changes coming in
the investors’ behavior.
10. A Naïve Hypothesis:
Theoretical perspectives of BF are more complicated as it is an interdisciplinary
framework that puts together elements from different disciplines like psychology,
anthropology, sociology, history, etc. On the other hand, EMH is comparatively
simplified approach. As BF combines elements from different disciplines, it becomes
sound and comprehensive as a theoretical framework. And it is implied that
investment decision making should be based on such sound framework to become
successful.
EMH has been very popular among investors for years due to its prominent
characteristics of optimism and emphasis on positive results of investment decision
making. But it leads to serious implications for investors. On the other hand, BF does
not seem to be widely accepted by majority investors due to its complex nature. But
the comprehensive nature of BF has greatly facilitated the work on investing decision
making as it has put in it several important aspects from various other disciplines.
1.7 Conclusion:
Financial system plays a major role in the economic development of the country. The
relationship between development of financial system and that of the economy is
studied by many researchers. The conclusion of their studies is strong influence of
financial system on the development and progress of the economy. Investment
function is a very important pillar of the well developed financial system. Investment
ensures channelization of savings in an appropriate direction. The much needed
capital formation takes place as a result of investment activity. From the view point of
investors, important objectives of investment are return, risk, safety, liquidity and
protection against inflation. On examining the past trends of savings and investment
in India, a positive development that was observed is small increase in the financial
savings of the household sector in last some time. But to fill the savings-investment
gap, there is a need to increase financial savings of household sector further. Many
investment alternatives are made available to investors in India to make this happen.
Stock market investment is one such alternative as it fulfills all the important
objectives of investors. It has proved an important tool to mobilize savings of
individuals for the development of the economy. Investing, being a mental process,
reflects pattern of thinking of an investor while taking decisions in the stock market.
Investors have different patterns of thinking and this pattern of thinking segregates
rational investors from irrational ones. Experts have developed various descriptive
and normative decision theories to help us understand behavior of investors at the
time of their decision making.
So far as investment decision making is concerned, there are two contradictory
models to explain the behavior of investors. Traditional Finance or EMH (Efficient
Market Hypothesis) portrays investors to be completely rational while taking their
investment decisions. The main contributors are Eugene Fama and Markowitz. The
main postulates of this model are: existence of efficient market, information
availability to all, fundamental analysis, etc. On the other hand, Behavioural Finance
has emerged as a discipline to justify that investors do not act always rationally while
taking investment decisions. The contributors in this field are Daniel Kahneman and
Amos Tversky, Shefrin, etc. Basically, the difference is: EMH explains ‘what should
be’ and BF explains ‘what it is’.
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