Investors think and act “rationally” when it comes to buying and selling stocks according to economic theorists. The economists have opined that the financial markets are stable and efficient due to the stock prices that seem to follow an expected pattern and the overall economy portrays trends toward “general equilibrium”. According to Shiller (1999), in real world, the investors do not investigate and act rationally.
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Investors speculate stocks between unrealistic highs and lows because of their attitude of greed and fear. This type of investors behavior is known as “behavioral finance” which explains on how emotions and cognitive errors influence investors and the decision making process. The behavioral finance is a study of the markets which related to a psychology aspect where it concerns more on the reason why people buy or sell the stocks and also in the event where they do not buy stocks at all. This study encompasses research that revised the traditional assumptions of expected utility maximization with rational investors in efficient market. The two pertinent points of behavioral finance are cognitive psychology and the limits to arbitrage (Ritter, 2003). Cognitive refers to a situation where how people think and the limit to arbitrage when market is inefficient. Behavioral finance uses models in the case of some agents in a situation of not fully cautious either because of preferences or because of mistaken beliefs i.e. the loss averse agent. Herbert Simon (1947, 1983) indicated that many of the basic theories of behavioral finance related to a series of new concept of ‘bounded rationality’. It is related to cognitive limitations on decision-making. As a result, human behavior is made on the basis of simplified procedures or heuristics (Tversky and Kahneman, 1974). A study has been done by Slovic (1972) on investment risk-taking behavior and he found that, man has limitations as a processor of information and shows some judgmental biases which lead people to overweight information. People also tend to be overreact to information (De Bondt and Thaler, 1985, 1987). Investors typically become distressed at the prospect of losses and are pleased by possible gains: even faced with sure gain, most investors are risk-averse but faced with sure loss, they become risk-takers. Thus, according to Khaneman, investors are “loss aversion”. This “loss aversion” means that people are willing to take more risks to avoid losses than to realize gains. Loss aversion describes the basic concept that, although the average investors carry an optimism bias toward their forecasts (“this stock is sure to go up”), they are less willing to lose money than they are to gain.
There is a need for imperfect decision-making procedures, or heuristics (Simon, 1955, Tversky and Kahneman, 1974). Hirshleifer (2001) argues that many or most familiar psychological biases can be viewed as outgrowths of heuristic simplification,
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