The entropy theory implications in behavioural finance

Understanding the decisional phenomenon in the modern capital markets is impossible nowadays without the psychological component of the investor’s attitude. A large number of the behavioural finance theories are based on a limited number of psychological biases, in order to build the foundation of the investor decision. In this context, the proposed paper uses the entropy law (one of the universal laws applicable in informational field beginning from 1870) as a way to approach the investor’s attitude.entropy theory, behavioural finance, investor's attitude

Weak-form Efficient Market Hypothesis, Behavioural Finance and Episodic Transient Dependencies: The Case of the Kuala Lumpur Stock Exchange

This study utilizes the windowed-test procedure of Hinich and Patterson (1995) to examine the data generating process of KLSE CI returns series. Unlike previous studies, the present one relates the evidence to the popular weak-form EMH and behavioural finance, with the hope of offering some plausible explanations to the controversy arises between these two camps. Our econometrics results indicate that linear and non-linear dependencies play a significant role in the underlying data generating process. However, these dependencies are not stable as the results suggest that they are episodic and transient in nature. Along the line of our interpretations, we are able to offer some plausible explanations as to why weak-form EMH generally holds in KLSE, though the presence of linear and non-linear dependencies implies the potential of returns predictability. Specifically, these significant dependencies show up at random intervals for a brief period of time but then disappear again before they can be exploited by investors. Looking from a micro perspective, we are able to rationalize the co-existence of weak-form EMH and behavioural finance in KLSE when the statistical properties of random walk, linear and non-linear dependencies, which also co-exist in the time domain, are interpreted in the framework of information arrival and market reactions to that information.Data generating process; Weak-form EMH; Behavioural finance; Kuala Lumpur Stock Exchange; Malaysia.

Essays in behavioural finance

This thesis studies the role of contrast effects and biased expectations in financial decisionmaking and financial markets. The first study explores the role of skewness preferences in dynamic decision-making at the hands of salience theory. Previous research suggests that otherwise risk-averse people are willing to take risks if the outcome distribution is positively skewed. Salience theory can explain this by assuming that states with high contrasts between the outcomes attract attention and their probability is overestimated. Skewness preferences are particularly important in dynamic setups because these allow agents to endogenously create skewness through the choice of their stopping strategy. I extend salience theory to a dynamic setup and show that it predicts that agents will take gambles if the expected value is not too negative. Moreover, if they gamble they choose stopping strategies that yield positively skewed outcome distributions. These predictions differ both from expected utility theory and other behavioural models. I test the predictions experimentally and find broad support. In the second study, I examine whether the earnings forecasts of analysts after a firm announces its earnings depend on the earnings surprises of companies that announced shortly before the firm. Evidence from a plethora of domains suggests that the interpretation of information depends on how it compares to contrasting information. Thus, the earnings of a given firm might look worse the better other firms perform. I find that positive earnings surprises of other firms make analysts revise their forecast of a firm’s earnings upwards but, at the same time, make their forecast more pessimistic relative to the true earnings. This result is in line with a positive news channel in combination with a contrast effect channel of the other firms’ earnings surprise on the analysts’ forecasts. In the third study, I develop a method to test if a given return predictor reflects mispricing rather than risk. Asset pricing research has uncovered hundreds of characteristics that can predict the cross-section of returns, but the nature of many of these remains elusive. If a predictor is linked to returns through risk, it should be unrelated to changes in the market’s expectations about firm profits. Alternatively, return predictably can be explained by biased expectations. If a return predictor captures this form of mispricing, it should predict changes in expectations in addition to returns. I use the earnings forecasts of professional analysts as a proxy to the market’s expectations and test for 173 return predictors if they can also predict forecast revisions. I find that around 40% of predictors can do so and, thus, reflect mispricing

Bubbles and crashes in a behavioural finance model.

Finance; Model; Working;

CLASSICAL LASSICAL AND BEHAVIOURAL FINANCE IN INVESTOR DECISION

Conceptual model of individual investor behavior presented in this paper aims to structure a part of the vast knowledge about investor behavior that is present in the finance field. The investment process could be seen as driven by dual mental processes (cognitive and affective) and the interplay between these systems contributes to bounded rational behavior manifested through various heuristics and biases. The investment decision is seen as a result of an interaction between the investor and the investment environmentinvestor behaviour; financial decisions making; cognitive modelling,;sentiments; market efficiency

Bubbles and Crashes in a Behavioural Finance Model

We develop a simple model of the exchange rate in which agents optimize their portfolio and use different forecasting rules. They check the profitability of these rules ex post and select the more profitable one. This model produces two kinds of equilibria, a fundamental and a bubble one. In a stochastic environment the model generates a complex dynamics in which bubbles and crashes occur at unpredictable moments. We contrast these "behavioural" bubbles with "rational" bubbles.exchange rate, bounded rationality, heterogeneous agents, bubbles and crashes, complex dynamics

Biases of professional exchange rate forecasts: Psychological explanations and an experimentally based comparison to novices

The empirical performance of macroeconomic exchange rate models is more than disappointing. This dismal result is also reflected in the forecasting capabilities of professional analysts: all in all, analysts are not in a position to beat naïve random walk forecasts. The root for this deficient outcome stems from the fact that professional forecasts are to a large extend influenced by actual changes in exchange rates. A reasonable explanation for this behaviour can be taken from the behavioural finance literature. To test whether this characteristic tends to be general human behaviour in an uncertain environment, we analyse the forecasting behaviour of students experimentally, using a simulated currency series. Our results indicate that a topically oriented trend adjustment behaviour (TOTA) is a general characteristic of human forecasting behaviour. Additionally, we apply a simple model to explain professional and students forecasts. --Foreign exchange market,forecasting,behavioural finance,anchoring heuristics,judgement,expertise

A Study on Behavioural Finance in Financial Markets

There are mainly two facets of financial market study viz. Traditional Finance and the recent development known as Behavioural Finance. Traditional finance foundation is mainly based on efficient market concept, Investor rationality concept and the modern portfolio theory developed by Markowitz. The traditional finance theories were not so been challenged until 1990. Researchers started pointing out shortcomings of the existing theory and challenged the investor rationality concept in particular. A new paradigm, as a result, known as behavioural finance emerged. In this paper an attempt has been made to present the shortcomings of the traditional finance theories as pointed out by researchers and also assesses the role and significance of behavioural finance in financial markets

Investor sentiment in the theoretical field of behavioural finance

Investor sentiment is a research area in the theoretical field of behavioural finance that analyses the sentiment of investors and the way it influences stock market activity. Recently, there has been an increase in the number of publications in this area, which indicates its incremental relevance. To date, there is no consensus on the theoretical structure of behavioural finance nor on the investor sentiment research area. We have used co-citation, bibliographic coupling and co-occurrence analysis to provide an overview of the structure of investor sentiment. Therefore, this study contributes to defining the theoretical structure of investor sentiment by identifying the foundations of the research area and main journals, references, authors, or keywords, which represent the core of knowledge of this research area. The results obtained suggest that investor sentiment is related to efficient market theory and behavioural finance theories. Furthermore, investor sentiment is a relevant research field, especially since 2014. Advances in computer science or theories based on physics or mathematics can help to better define the influence of investor sentiment on stock markets. This study advances research on investor sentiment within the field of behavioural finance, thus showing its relevance

Behavioural Finance and Aggregate Market Behaviour: Where do we Stand?

This paper selectively reviews the literature on behavioural finance, focusing on the aggregate market implications of the behavioural biases that this literature has identified. Advocates of behavioural economics and finance argue that economic agents behave in a way which departs significantly and systematically from the axioms of expected utility theory. The paper surveys the main “anomalies” identified by this literature in the light of their possible implications on aggregate market behaviour. In particular, the anomalies are categorised into (i) those derived from cognitive limitations (bounded rationality), (ii) those determined by the interference of agents’ emotional state, (iii) those determined by choice bracketing, and (iv) those which suggest that a pre-determined set of preferences does not exist altogether. Moreover, prospect theory is surveyed in particular detail, as it has become a serious challenger to expected utility in economics and finance due to the empirical support, its mathematical tractability and its being consistent with rational expectations. Finally, the paper claims that while convincing evidence against market rationality in the beatthe- market sense is yet to be provided, many indications are now available that financial markets may indeed be “irrational” in other reasonable and relevant meanings.Behavioural finance; anomalies; prospect theory; market rationality