What contribution can behavioural finance make to the explanation of stock market bubbles and crashes?
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.
Readhead (2008) suggested that behavioural finance applies the psychology of decision-making to investment behaviour, and it can be useful to show the irrational behaviour of the investors causes the stock bubbles and crashes.
Readhead (2008) listed some systematic distortions that can be used to explain stock bubbles and crashes by behavioural finance method. They are representativeness, narrow framing, overconfidence, familiarity and celebrity status. In this essay, I will try to understand that how these factors influence the stock markets.
Representativeness and narrow framing
In this part, I will focus on representativeness, and then study the knowledge about narrow framing.
Redhead (2008) believed that representativeness can be helpful to explain the investors to follow the market, and those behaviours of the investors can lead to stock market prices anomalies. Redhead (2008) also pointed out that there are two interpretations of the representativeness. First interpretation is that recent prices movements are the representativeness. Secondly, representativeness also can be seen as that people will think about the patterns and tends. One mental shortcut, the representativeness bias, involves overreliance on stereotypes (Shefrin, 2005) . Grether (1980) and Kahneman and Tversky(1973, 1974) said that representativeness would cause the investors to play against the Bayes’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 representativeness 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.
However, resentativeness bias has many other implications, but not just the recent 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 resentativeness. Confirmation bias, which has been mentioned by Redhead (2008), leads 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 resentativeness bias.
DeBondt and Thaler (1990) tested the anticipations changes in earnings and started the systematic bias which is named “Representativeness bias”. DeBondt (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 Kaestner (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...
Please join StudyMode to read the full document