Behavioral Finance Human Interaction a Study of the Decision-Making Processes Impacting Financial Markets Information Processing Term Paper

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Behavioral Finance and Human Interaction a Study of the Decision-Making

Processes Impacting Financial Markets

Understanding the Stock Market

Contrasting Financial Theories

Flaws of the Efficient Market Hypothesis

Financial Bubbles and Chaos

The stock market's dominant theory, the efficient market hypothesis (EMH) has been greatly criticized recently for its failure to account for human errors, heuristic bias, use of misinformation, psychological tendencies, in determining future expected performance and obtainable profits.

Existing evidence indicates that past confidence in the EMH may have been misdirected, as the theory's models do not show a thorough understanding of trading operations in a realistic light.

Researchers have suggested that a variety of anomalies and inconsistent historical results demand that traditional financial theories, namely the EMH, be reconstructed to include human interaction as a key decision-making process that directly affects the performance of financial markets.

This research paper aims to determine whether or not there is a need for a refined financial model that incorporates the behavior of the stock market's investors.

II. INTRODUCTION

When explaining the efficient market hypothesis (EMH), Fama (1970) described three types of EMH: the weak type, the semi-strong type, and the strong type.

The strong type indicates that stock prices are reflective of all available information, including both public and private data. However, Seyhun (1986, 1998) has gathered significant evidence to support his theory that insider information has enabled many investors to capitalize when trading based on data that is not included in stock prices.

According to the semi-strong type (Fama, 1970), security prices reflect all publicly available information. This type maintains that undervalued or overvalued stocks simply cannot exist, as new information is incorporated into stock prices quickly and efficiently. However, intraday data prompted tests that proved public information could have a tremendous effect stock prices in a matter of minutes (Patell and Wolfson, 1984).

The weak type indicates that past prices or returns are a reflection of future prices or returns. Studies revealing the inconsistent performance of technical analysts are used to support this theory. However, Fama (1991) showed that the evidence of predictability of returns disproves the weak form.

In the past, the EMH has been the dominant force in providing a theoretical basis for investment market research. Researchers revealed that prices appeared to follow a random walk model and patterns in returns were insignificant. However, when research shifted from predicting prices based on historical prices to forecasting based on variables, including dividend yield (Fama & French [1988]), the inadequacies of existing models came into question.

Many researchers have suggested that stock prices are predictable on a fairly consistent basis, which has caused a great debate over the accuracy of the EMH. EMH supports hold that the predictability of stocks is the result of time-varying equilibrium expected returns generated by rational pricing in an efficient market that makes up for the level of risk assumed in the market (Fame & French, 1988).

Those who believe that the EMH is inaccurate say that the predictability of stock prices shows that psychological factors, social events, human errors, and the irrationality of investors play a huge role in the stock market, which the EMH does not account for.

When certain anomalies, such as the January effect, the weekend effect and panic effect, were discovered to have a major impact on the stock market performance, the EMH became a controversial theory. Such events were labeled as anomalies because they were impossible to explain in the EMH.

As a result, extensive research has been undertaken to prove that information alone does not determine stock prices. Researchers have been force to reexamine the accuracy of the EMH and look for alternative means of predicting the stock market performance.

As all types of the EMH appear to have flaws and anomalies have been discovered, existing research suggests a strong need for a revised financial market theory. This research paper will examine the history of the stock market, existing research on various anomalies, the behavior patterns of its investors, and the flaws of EMH to determine the extent of the need for a revised financial market theory.

III. LITERATURE REVIEW

A. UNDERSTANDING THE STOCK MARKET

When the stock market is mentioned, most people picture the New York Stock Exchange's (NYSE) immense trading floor, a widely publicized area with well-dressed traders and a lot of action. However, this is only a small portion of what the stock market truly is.

In the United States, more than 50 million people own stock directly. More than 100 million investors take an indirect role in the market, whether it is through insurance companies, banks or pension funds. Therefore, it is of utmost importance to understand the stock market to figure out exactly how it works.

Nearly 3,000 companies have their stocks listed on the New York Stock Exchange (Gross, 1997). These companies are located across the United States and around the world. They produce automobiles, ballet shoes, entire networks and much, much more.

They manage real estate and livestock. They operate shopping malls and restaurant chains. All of these industries form the core of our system of private enterprise. As a result, the stock market affects every single person in America and every single person affects the market. This chapter will introduce the stock market in an effort to explain how it works.

The Earnings of a Company

A company's earning performance is the single most influential factor in the stock market (Wurman, et al., 1990). Its earnings gauge its profitability, which describes the positive difference between the sale of products or services, and the cost of production. Most businesses report their earnings every fiscal quarter.

A company's earnings information usually includes the quarter's sales figures, profit, and average amount of shares, as well as the figures for the previous year. The earnings per share figure are calculated by dividing the net profit by the average amount of shares.

Most investment strategies rely on the ability to successfully evaluate a company's earnings performance. In addition, strategies focus on comparing the earnings performance of multiple companies in the stock market.

A crucial factor in comparing companies is the earnings per share. Earnings Per Share and Relative Strength Rank are helpful factors in enabling investors to identify companies with strong earnings and price performance.

Many investors identify companies with strong earnings and price performance by identifying industry groups that are outperforming the market. In many cases, stocks from the same industry group will show similar price movement, mainly because developments within a particular industry, including technology and product innovation, are similar.

Market Influences

The major investors in the stock market play a large role in the market's performance. There are several major investors.

Mutual funds involve investors that buy shares in professionally managed funds that invest in many different vehicles, including stocks, bonds, futures and options (Wurman, et al., 1990). A great deal of mutual fund assets comes from IRA and retirement accounts.

Banks are a rapidly growing sector of the stock market, as banks buy many different forms of securities as part of their client financial services.

Companies, unions, government organizations, and private parties typically create pension funds as a means of investing in securities to finance the benefits received by retired workers.

Insurance companies are considered a major investor in the stock market, as premiums received from policyholders are invested in a variety of vehicles, including stocks.

Lastly, individuals are a large part of the stock market, managing their own accounts, and making their own decisions about which stocks to buy and sell. In many cases, brokers, money managers, and investment advisors often represent individual investors.

When these major investors make decisions and choices regarding investing in the stock market, they wield great influence over the prices of stocks. Institutions, including mutual funds, pension funds, and banks, purchase and sell stocks in large quantities. These large transactions significantly push prices up or down depending on the amount of buying or selling.

Like all products, stocks are subject to the laws of supply and demand. When demand for a stock increases, its price typically increases. On the other hand, stock prices tend to decrease when there is an abundant supply of shares or less demand.

Macro Economic Indicators

There are a variety of macro economic factors that have a strong influence on the stock market. The Federal Reserve discount rate, which is the interest the Federal Reserve charges its member banks to borrow money, has a direct effect on inflation, the economic growth, and stock prices.

Basically, when the discount rate changes, the cost of borrowing money changes, as well. Therefore, if the discount rate drops, banks borrow more money, which increase the supply of money. If it increases, the opposite occurs.

The rate of unemployment is another key macro economic factor. For example, increasing employment is considered bullish for the economy, but if the rate goes down too much, the cost of employing people rises. Higher labor costs mean higher costs of production, which translates to higher inflation. Higher inflation means…[continue]

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