Behavioral Finance. How psychological factors can influence the stock market

The following work aims to research the psychological factors behind decision making amongst investors and the effects these can have in the stock market. The market has long been based on the thought of it being efficient and rational as proposed e.g. by the efficient market hypothesis and the capital asset pricing model. However, the relatively new field of behavioral finance opposes to this theory and sheds light on the importance of researching and understanding the effect psychological factors can have amongst economic agents and their decision making, which influences the stock market. Great emphasis is given to prospect theory by Amos and Tversky and the propositions of decision making under risk, which is what investors deal with on a daily basis; making decisions under risk given the uncertainty and unpredictability of financial markets. Herding and overconfidence appear to be those anomalies that investors present the most when making decisions and are straightly linked to market volatility and bubbles. Herding results in trend following behavior amongst investors, leading to overpricing of assets resulting in price bubbles. Overconfidence causes excessive trading without rationally accounting for transactional costs and leads investors to think they have greater capacity to beat the market. Nonetheless, other factors influence decision making as well. Representativeness results in decision making biased by the influence of stereotypes or trends, leading investors to forecast the market based on inaccurate or unreliable data. Availability makes investors more prone to focus on “attention getters” rather than other valuable information amongst the market as well as focusing on information that is clearer and easier to interpret. Anchoring leads investors to focus on reference points when analyzing asset prices. Investors let go of winner too early and retain losers longer due to biased decision making derived from the disposition effect. The extent to which assets are evaluated to have performed well depends on framing effects and personal preferences present amongst investors. Loss aversion and the endowment effect influence bid and ask prices as well as risk aversion amongst investors