Behavioral Finance: Exploring Irrational Behaviors of Investors

BEHAVIORAL FINANCE 1
Behavioral Finance
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BEHAVIORAL FINANCE 2
Behavioral Finance
Introduction
The financial market is more dynamic now than ever. This paper explores the new behavioral
theory that is increasingly being used to explain some irrational behaviors that investors make.
To bring out some of the empirical stock findings that recent studies have revealed, two articles
are used analyzed, and other sources used to provide more evidence.
Empirical Stock Observation
The empirical stock explanation that the two papers are trying to is pervasive irregularities
(Barberis et al., 1998). It is noted that empirical studies in finance have revealed two forms
psychological reactions investigated by two popular psychological biases: confidence about the
accuracy of private information, and biased self-attribution (Daniel et al., 1998). According to
Barberis et al., these two psychological biases, investor overreaction, and under-reaction are part
pervasive irregularities (1998). On the other hand, Daniel et al. formulate a theory of securities
market under- and overreaction to explain this observation in the empirical stock market (1998).
The two article notes that overreaction demonstrates a negative log-lag autocorrelation,
correlated mispricing and management actions, and high price volatility. On the contrary, under-
reaction results in short-lag autocorrelations, short-term changes in earnings, and negative
relationship between future revenues and long run past stock market. Basically, the two articles
argue that investors' overreaction results into overreactions to good news in the market hence
causing overvaluation of the surety market, despite the market return being average. On the
other hand, under-reaction is caused by short-term (one year or less) reaction of prices to goods

BEHAVIORAL FINANCE 3
news hence assuming a higher average return on the firm’s securities after the announcement of
preferable news.
Importance of Behavioral Explanation
For a long time, traditional finance has been used to explain actions taken by investors in the
market (Chaudhary, 2013). However, efficiency in the market cannot be achieved. With the
ever-changing economic cases, investment in various firms is increasingly becoming a
complicated decision to make. A significant number of investors have rational projections and
want to derive maximum utility from the investments they make (Yuen, 2017). On the contrary,
in the short run, people are not always rational and may not tend to maximize profits.
Consequently, the insufficiency of the traditional financial theories necessitates behavioral
explanations.
Generally, human beings are subject to several behavioral inconsistencies which, sometimes,
proves counterproductive to the optimization of profits principles hence resulting in irrational
tendencies (Chaudhary, 2013). Accordingly, behavioral finance interlinks behavioral and
cognitive psychological theories with traditional financial concepts to explain the reason behind
some irrational financial decisions. The explanation is more applicable in the stock and securities
market than other investment avenues (Nour et al., 2017). Besides, the portfolio theory has a
number of gaps that are demonstrated by human behavior.
People are more convinced by the information they have on their minds. Additionally, the beliefs
they hold on currently have a significant impact on every decision that they make in the course
of investment. Admittedly, there is a high probability that any information, no matter how
irrational it is, that agrees with their belief system stands a high chance of grabbing their