Behavioral Finance and Human Errors in Stock Market Decision-Making

Introduction: The Efficient Market Hypothesis and Its Critics

The stock market's dominant theory, the efficient market hypothesis (EMH), has been greatly criticized for its failure to account for human errors, heuristic bias, the use of misinformation, and 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 reflect 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 there is a need for a refined financial model that incorporates the behavior of the stock market's investors.

When explaining the EMH, Fama (1970) described three types: the weak type, the semi-strong type, and the strong type. The strong type indicates that stock prices reflect all available information, including both public and private data. However, Seyhun (1986, 1998) gathered significant evidence supporting the theory that insider information has enabled many investors to capitalize when trading on data not reflected 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 on 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 evidence of the predictability of returns disproves the weak form.

In the past, the EMH was the dominant force providing a theoretical basis for investment market research. Researchers revealed that prices appeared to follow a random walk model and that 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.

Understanding the Stock Market

Many researchers have suggested that stock prices are predictable on a fairly consistent basis, which has caused great debate over the accuracy of the EMH. EMH supporters hold that the predictability of stocks is the result of time-varying equilibrium expected returns generated by rational pricing in an efficient market that compensates for the level of risk assumed (Fama & French, 1988). Those who believe the EMH is inaccurate argue that the predictability of stock prices demonstrates that psychological factors, social events, human errors, and investor irrationality play a large role in the stock market—factors the EMH does not account for.

When certain anomalies, such as the January effect, the weekend effect, and the panic effect, were discovered to have a major impact on stock market performance, the EMH became a controversial theory. Such events were labeled anomalies because they were impossible to explain within the EMH framework. As a result, extensive research has been undertaken to prove that information alone does not determine stock prices, and researchers have been forced to reexamine the accuracy of the EMH and look for alternative means of predicting 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 paper examines the history of the stock market, existing research on various anomalies, the behavior patterns of investors, and the flaws of the EMH to determine the extent of the need for a revised financial market theory.

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 great deal of activity. 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 through insurance companies, banks, or pension funds. Therefore, it is of utmost importance to understand the stock market and 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, consumer goods, and media networks, among countless other products and services. They manage real estate and livestock, operate shopping malls and restaurant chains. All of these industries form the core of the system of private enterprise. As a result, the stock market affects every single person in America, and every single person affects the market.

A company's earnings performance is the single most influential factor in the stock market (Wurman et al., 1990). Its earnings gauge its profitability—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 typically includes the quarter's sales figures, profit, and average number of shares, as well as the figures from the previous year. The earnings per share figure is calculated by dividing net profit by the average number of shares.

Most investment strategies rely on the ability to successfully evaluate a company's earnings performance and compare the earnings of multiple companies in the stock market. A crucial factor in this comparison is earnings per share. Earnings Per Share and Relative Strength Rank are helpful factors enabling investors to identify companies with strong earnings and price performance. Many investors identify such companies 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—such as technology and product innovation—tend to be similar across that group.

The major investors in the stock market play a large role in its performance. Mutual funds involve investors who 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 come from IRA and retirement accounts. Banks are a rapidly growing sector of the stock market, as they 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 major investors 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 represent individual investors.

When these major investors make decisions regarding the stock market, they wield great influence over stock prices. 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.

There are a variety of macroeconomic factors that have a strong influence on the stock market. The Federal Reserve discount rate—the interest rate the Federal Reserve charges its member banks to borrow money—has a direct effect on inflation, economic growth, and stock prices. Basically, when the discount rate changes, the cost of borrowing money changes as well. If the discount rate drops, banks borrow more money, increasing the supply of money. If it increases, the opposite occurs.

The rate of unemployment is another key macroeconomic factor. Increasing employment is considered bullish for the economy, but if the unemployment rate drops too sharply, the cost of employing people rises. Higher labor costs mean higher costs of production, which translates to higher inflation. Higher inflation means higher interest rates, and higher interest rates are typically bad for stocks. Retail sales can serve as a measure of the economy's strength. Low retail sales often mean the economy is weak, which could cause a drop in Federal Reserve interest rates.

The Consumer Price Index (CPI) measures the average change in prices that consumers pay for a fixed amount of goods and services. The Federal Reserve monitors this data and uses it as a key measure of inflationary pressure on the economy. As a general rule, if the CPI's value increases, the money supply will tighten. The Gross Domestic Product (GDP) measures economic activity—the output of all goods and services created by labor and property in the United States—and provides important information on the current economic climate.

According to many research studies, there are several characteristics of winning stocks. According to William O'Neil (1988), a professional investor, "The first step in learning to pick stock market winners is for you to examine leading winners of the past to learn all the characteristics of the most successful stocks." Research shows that, over the past four decades, the top-performing stocks have exhibited seven basic characteristics (Gross, 1997). First, a company consistently shows increases in recent quarterly earnings per share of at least 25%, and its three-, four-, or five-year annual earnings per share growth rate exceeds 25%.

Many successful investments are made when a stock hits a new high and is emerging from a period of price consolidation. New companies with new products or services and improving sales are often successful. Companies with a total number of shares outstanding between five and 30 million are often strong bets, as are top-performing stocks in leading industry groups. Stocks owned by at least one quality institution have also shown promise. When a stock performs well relative to the general market on a daily basis, it is usually headed in a positive direction.

According to William O'Neil (1988): "The stocks you select for purchase should show a major percentage increase in the current quarterly earnings per share when compared to the prior year's same quarter." Many of the most successful stocks have shown a significant percentage increase in current quarterly earnings per share compared to the same quarter the prior year. In a forty-year study, three out of four stocks showed earnings increases averaging more than 70% in the quarter prior to a major price advance (Wurman et al., 1990). The one that did not show a substantial current-quarter increase did so in the following quarter.

According to William O'Neil (1988): "Each year's annual earnings per share for the last three, four or five years should show an increase over the prior year's earnings." While evaluating a company's quarterly earnings is important, it may be even more important to evaluate a company's annual compounded earnings growth rate. Research shows that the majority of top performers had a three-, four-, or five-year average annual compounded earnings growth rate of 24% just before their greatest price moves. When buying stocks, investors are encouraged to look for companies demonstrating consistent long-term growth, or a three-to-five-year annual growth rate greater than 25%.

According to William O'Neil (1988): "The law of supply and demand is more important than all the analyst opinions on Wall Street." The law of supply and demand applies to all goods and services, including stocks. If a stock's supply is small and there is strong demand for it, the stock's price will increase. If a company has a large number of shares outstanding, it would take a large buying demand to increase the stock price. Conversely, companies with a small or moderate number of shares outstanding require only a moderate amount of buying demand to markedly influence their stock price.

When examining the stock market, it is important to understand the concept of short selling—essentially a form of reverse stock buying. Most people buy a stock hoping it will go up in price. However, with short selling, investors sell the stock before buying it in the hope that it will go down in price. According to William O'Neil (1988): "Short selling is a topic few investors understand, and in which even fewer succeed."

In short selling, an investor borrows shares from a broker, sells them in the open market, and collects the proceeds from the sale. The investor hopes that the stock will fall in price so that he can buy it back at a lower price, replace the shares borrowed from the broker, and make a profit. Investors tend to sell short if they believe that the market is headed for a dramatic decline or that a specific stock is about to drop.

A great deal of financial theory is based on the assumption that humans will act rationally and take into account all available financial data when making decisions. However, research shows that human behavior is often irrational and unpredictable. Peter Bernstein reported that evidence "reveals repeated patterns of irrationality, inconsistency, and incompetence in the ways human beings arrive at decisions and choices when faced with uncertainty" (1998, p. 224).

According to William O'Neil (1988): "Be objective and recognize what the marketplace is telling you... The fastest way to take a bath in the stock market or go broke is to try to prove that you are right and the market is wrong." The current condition and direction of the overall market heavily influences a stock's performance. Investors need dependable tools to determine exactly what type of market they are in—whether bullish, with rising prices, or bearish, with decreasing prices.

Over the past few years, the stock market has become increasingly price-volatile and liquidity-driven. Today's market seems to have little regard for fundamental values, reacting instead to the emotional mood of its investors, swinging in different directions at a fast pace. As a result, researchers have developed certain indicators that aim to weigh emotion in the market to determine when it could shift.

The Put/Call ratio is the number of put options traded divided by the number of call options traded (Gross, 1997). When large amounts of call options are traded, it shows that investors are confident in the market; when large numbers of put options are traded, it signals a lack of investor confidence. The Option Volatility Index (VIX) relates to the premium paid for options on the OEX and is expressed as a percentage of prices. The VIX usually decreases as the market rises and increases as the market falls. Researchers say that deviations from this expected behavior are the result of human emotions.

Another tool used to weigh market emotion is the tick number, which refers to the number of stocks on the NYSE trading on an up-tick—above the preceding price—minus the number trading on a down-tick—below the preceding price. High positive ticks usually occur at intraday highs, while high negative ticks tend to occur at intraday lows.

It could be expected that investors would feel more optimistic after the market closes up than when it closes down. Based on trading history from 1950 to 2000, an investor who held the S&P 500 index for the entire period would have seen a return of 491%. According to Palisades Research (2002), investor emotion was the greatest forecaster of the stock market over this period, averaging 27% per year for five decades with half the risk of the S&P 500.

The worst loss for the long-term holder of the S&P index took place in 1973–1974, with a decrease of nearly 50% and a recovery period of over seven years (Palisades Research, 2002). An emotion-based trader's worst drop, by contrast, took place in 1984, with a decrease of 24.7% and a recovery period of over two years. These worst cases did not coincide with each other, suggesting that there is synergy in combining long-term investing with a sound emotion-based program. This shows that emotion has a very significant effect on the stock market. While emotional force is not the single driver of the stock market, it is a powerful factor that must be recognized.

The stock market is viewed as an efficient and rational model, despite the fact that various outbreaks of hysteria have influenced it tremendously throughout history (Gross, 1997). Stocks have been massively undervalued and overvalued by both individual and professional investors. As a result, the fundamental theories of the stock market have been questioned, as have the intrinsic values upon which shares are supposedly based. When stocks are overvalued, the market usually corrects them. However, these revaluations have resulted in some of the most severe stock market crashes in history, with dire consequences.

Fundamental analysis values shares according to three factors (O'Neil, 1988): the state of the economy, the state of the industry in question, and the earning power and potential performance of a specific company. Fundamental analysts seek stocks that are, in their opinion, overvalued or undervalued, and then sell or buy those shares in the hope of turning a profit when more investors recognize the stock's value.

Rational pricing of stocks is very important for resource allocation and to ensure that prices will eventually correspond to their long-term competitive equilibrium (Journal of Economic Perspectives, 1990). Speculative bubbles show that the pricing of stocks is often irrational. The role of expectations in the pricing of securities is often blamed for this irrationality. Eugene Fama, when looking at the 1987 crash from a rational pricing perspective, said that all explanations were "driven by a change in expectations about conditions." Still, no good reason has been found for why expectations would change in the first place.

It appears that investors are not as concerned about market fundamentals as they are with the behavior of their peers. During the 1987 Wall Street crash, when $1 trillion was lost in a single day, The Economist blamed the "psychology of the mob" for the bull market and the crash that followed: "Just before the stock market crash, commodity analysts were saying that metal prices were rising because of 'market fundamentals'. Come the crash, they threw their fundamentals out of the window, and indulged in old-fashioned panic instead" (The Economist, 1987).

Contrasting Financial Theories: EMH and Behavioral Finance

One of the most frustrating problems researchers face is that "there is no scientific way to show that security prices are rational or irrational." The fundamental economic theory accepts that all investors act rationally. However, in many cases, rationality breaks down and this economic theory has nothing to do with the market. Some of these cases include the Great Depression, Black Monday, and the 2000 tech boom.

When investors put money in the stock market, they hope to generate a return. It is the ultimate goal of every investor to outperform—or beat—the market. In 1970, Eugene Fama coined the term "market efficiency," which suggests that at any given time, prices completely reflect all available information on a given stock (Heakel, 2002). Therefore, according to the EMH, it is impossible to beat the market because prices already incorporate all relevant information, meaning no investor has access to data unavailable to everyone else.

The EMH has caused a great deal of controversy and debate among researchers and financial professionals, largely because its implications are profound. The majority of investors assume that the stocks they are buying are worth more than they are paying, while the stocks they are selling are worth less than they are selling them for. However, if the EMH is correct, then buying and selling stocks in an attempt to outperform the market is actually based on luck rather than skill and knowledge.

Fama's theory argues that in an active market with knowledgeable investors, stocks will be appropriately priced and will reflect all available information (Heakel, 2002; Fama, 1995). An efficient market is best described as one in which large numbers of educated investors actively compete, each trying to predict future market values of individual stocks. In an efficient market, no investor has an unequal or unfair advantage over another, as all are supplied with the same information. This competition creates a situation in which actual prices of individual stocks already reflect the effects of information based on both past events and expected future events.

According to Robert Higgins, author of Analysis for Financial Management (1992, p. 147): "Market efficiency is a description of how prices in competitive markets respond to new information. The arrival of new information to a competitive market can be likened to the arrival of a lamb chop to a school of flesh-eating piranha, where investors are—plausibly enough—the piranha. The instant the lamb chop hits the water, there is turmoil as the fish devour the meat. Very soon the meat is gone, leaving only the worthless bone behind, and the water returns to normal. Similarly, when new information reaches a competitive market there is much turmoil as investors buy and sell securities in response to the news, causing prices to change. Once prices adjust, all that is left of the information is the worthless bone. No amount of gnawing on the bone will yield any more meat, and no further study of old information will yield any more valuable intelligence."

According to the random walk theory, price movements do not follow any patterns or trends, and past price movements cannot be used to predict future ones. This theory dates to 1900, when French mathematician Louis Bachelier concluded, "The mathematical expectation of the speculator is zero," calling this condition a "fair game." However, Bachelier's thinking was so advanced that it was ignored for decades; his dissertation was translated into English and published in 1964. The random walk theory states that any investment strategy that tries to consistently beat the market is doomed to fail, and the EMH suggests that, due to high transaction costs in portfolio management, it would be more profitable for investors to invest in an index fund.

There are three forms of the EMH. The "weak" form states that all past market prices and data are fully reflected in securities prices, making technical analysis obsolete. The "semistrong" form states that all publicly available information is fully reflected in securities prices, making fundamental analysis obsolete. The "strong" form states that all information—including insider information—is fully reflected in securities prices, so no investor can gain an advantage.

To fully understand the EMH, it is important to consider the potential role of investors. According to the EMH, the role of the investor involves analyzing and investing according to individual tax considerations and risk profile (Tini-C, 1979, pp. 141–153). Financial analysis involves a variety of factors, including age, risk profile, tax bracket, and employment. In an efficient market, an investor's role is to create a portfolio to meet individual needs, rather than striving to outperform the market.

Some EMH supporters think it is impossible to outperform the market, while others believe it is possible if stocks are divided into categories based on risk factors. For example, some investors view small-cap stocks as riskier investments with higher returns, and value stocks as riskier than growth stocks with correspondingly higher returns.

Many financial managers insist that markets are not efficient, which is understandable since their jobs rely on the belief that they can outperform the market. Even with thousands of studies on the EMH, it is difficult to determine whether outperformance is the result of skill or chance. For instance, with thousands of financial managers, it can be expected that one or more will significantly outperform the market. Still, this presents a challenge for investors—to identify an outperformer before it happens, rather than in hindsight. It must also be noted that even the strongest performers from one period can underperform in the future, and many studies reveal little or no correlation between strong performers from one period to the next. The lack of consistent performance persistence among investors supports the EMH.

The classic investment theory is based on the belief that all investors act rationally based on consideration of available information (Neil, 2002, p. 18). This means that they weigh the pros and cons of their options, consider all probable outcomes, and choose the best solution. Rather than making quick decisions, they examine the long-term picture and stick to their original plans, making systematic deposits to their portfolios to take advantage of dollar cost averaging. While they are aware of current conditions, they do not act hastily based on the economic climate.

Behavioral finance theories view investor strategy differently (Neil, 2002, p. 18). Behavioral finance takes into account that investors are human beings and therefore are not always completely rational. They do not always look at all available information and rarely approach decisions in a systematic, practical manner. Often, they misinterpret information and act in the wrong way even with the right information.

There are several basic tenets of behavioral finance: increasing levels of confidence have not been proven to correlate with greater success; many investors believe they can consistently time financial markets even when evidence shows they cannot; investors tend to place too much weight on recent experience; and people have a tendency to view other people's decisions as the result of disposition while viewing their own choices as rational.

Research suggests that markets often fail to behave as they should if trading were actually dominated by fully rational investors, suggesting that markets are not completely efficient. Behavioral finance experts aim to explain how emotions and human errors influence investors and their decision-making processes. Researchers believe that the study of psychology and other social sciences can be useful in understanding the efficiency of financial markets, as well as explaining stock market anomalies, market bubbles, and crashes.

Behavioral finance provides great insight into investor actions. Behaviorists believe that investor behavior is neither random nor totally irrational. Instead, they believe that non-rational behavior falls into predictable patterns and can be prevented. As a result, behavioral finance gives investors the tools and techniques to counteract destructive decisions.

Psychographics is a term used in behavioral finance to describe the psychological characteristics of individuals and an individual investor's strategy and risk tolerance (Tini-C, 1979, p. 181). An investor's background and past experiences play a key role in investment decisions. The Bailard, Biehl & Kaiser Five-Way Model places investors in five categories (Investor Home, 1999): "Adventurers" are risk-takers and are usually difficult to advise; "Celebrities" prefer to be where the action is and are easy targets for brokers; "Individualists" avoid extreme risk, do their own research, and act rationally; "Guardians" are usually older, more careful, and more risk-averse; and "Straight Arrows" fall between the other four personalities and tend to be more balanced.

In summary, people trade for both cognitive and emotional reasons. They trade because they think they have information when they have nothing but noise, and they trade because trading can bring the joy of pride. "Trading brings pride when decisions turn out well, but it brings regret when decisions do not turn out well. Investors try to avoid the pain of regret by avoiding the realization of losses, employing investment advisors as scapegoats, and avoiding stocks of companies with low reputations" (Statman, 1988, p. 318).