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

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M11 EFA BEHAVIOURAL FINANCE

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

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

TABLE OF CONTENT

1 INTRODUCTION…………………………………………………………..3 2 BUBBLES AND CRASHES…………………………………….………….4 3 SOCIETY AND PSYCHOLOGY………………………………………….5 4 BEHAVIOURAL FINANCE FOR UNDERSTANDING BUBBLES AND CRASHES…………………………………………………………………......7 4.1 Overconfidence……………………………………………………………7 4.2 Representativeness and Momentum………………………………….….9 4.3 Familiarity and Celebrity Stocks………………………………………..10 4.4 Narrow Framing and positive feedback trading……………………….12 4.5 Confirmation bias and denial……………………………………………12 4.6 Mental Accounting……………………………………….……………….13 5 CONCLUSIONS…………………………………………………………....14 6 REFERENCES………………………………………………………………15

1 INTRODUCTION

The phenomenon of Stock market bubbles is that the price of stocks has a sharp rise in a continuous process, the rise of initial price make investors believe that the prices will continue to rise, and then their probability-weighted expectations of gain attract more new investors. Moreover, the purpose of their trading is they intend to profit rather than to use it. Therefore, the generation of bubble is from speculation activities of pursuing profit than investment activities. The occurrence of stock market bubbles against the assumption of the efficient market hypothesis is that investors are rational. (Keith Redhead2008) But in real life, the participants in stock market are not only rational investors who pursue the dividends but also most of participants are the irrational speculators who pursue the high profit of ascending stock price. Therefore the stock market will be inefficient when the irrational investors are more than rational investors in stock market. Therefore, the investors’ psychology and behaviour have important and considerable influences on the fluctuation of stock price.

2 BUBBLES AND CRASHES

Some writers argued that most bubbles and crashes have common characteristics. Stock prices have large and rapid increases, which leads to share prices rising to unrealistically high levels.(Keith Redhead2008:541) For instance, the Nikkei stock index closed at 13,083 at the end of 1985 and closed at 38,919 at the end of 1989. In these four yours, the Nikkei stock index accumulatively increased 197.45%. At the initial stage of bubbles, the emergence of new theories or products would justify for the high rise of stock prices. For instance internet was used in the late 1990s. The persistent and large increase in share prices leads to people believe the prices would continue to rise, so investors buy more shares and intend to gain the huge profit, then the most of investors become to speculators. In the investors, most of them do not have the knowledge of finance, and they just imitate the judgments and behaviours of others. Such herd behaviour push price to unrealistically high levels. (Keith Redhead2008) Keynes’s (1936) beauty contest can be used to explain the stock market bubbles, and the view argues that investors imitate the behavior of others and ignore their own judgment because they want to maximize their profits from the rising stock market. (Keith Redhead2008)

3 SOCIETY AND PSYCHOLOGY

In the society, many investors tend to follow others’ behavior and ignore their own judgment. In a certain time, if the most of investors in financial market conform to the other investors’ behavior, and their behaviours represent the consistency and convergence, such behavior leads to form of herding, and the phenomenon of herding has a great impact on efficiency and stability in financial market, though it increases investors’ short-term benefits. However, herding behavior can help explain the bubbles and crashes.

Herding can be distinguished to intentional and unintentional herding. ( Walter&Weber2006) Intentional herding arises from some investors...
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