What is Behavioral Finance

Behavioral Finance

Finance which examines the actual decision-making processes of investors is known as Behavioral Finance. Many observers think that investors are not the rational utility-maximizing decision makers with complete information that Traditional Finance assumes they are. Behavioral Finance is the study of the psychology influence on the behavior of Investors or  Financial Analysts. Behavioral Finance focuses on the fact that Investors are normal and not always Rational, have limits to their self-control, and are influenced by their own biases.

Beliefs of Traditional Finance 

  1. Market and Investors both are rational.
  2. Investors have full control
  3. Investors care about utility Maximizing decisions

Behavioral Finance Traits 

  1. Investors are assumed as “normal” not “rational”
  2. They actually have limits to their self-control.
  3. Investors are generally influenced by their own bias

Behavioral Finance examines whether investors behave rationally, how Investor Behavior affects Financial Markets and how Cognitive Biases may result in anomalies. Behavioral Finance describes Investor Irrationality but does not necessarily refute Market Efficiency as long as Investors cannot Consistently earn abnormal risk-adjusted returns..

In 1990, Behavioral Finance emerged as a field of Financial Economics which explores how psychological behaviors, Traits, and Reactions of Investors impact the Investment Decisions making Process.

Behavioral Finance

Consider Investor behavior that creates some degree of systematic mispricing of securities and may explain some anomalies that tend to refute the efficient market hypothesis.

Investor Biases

1.Overconfidence Bias: Analysts are overconfident in their earnings forecasts and their (high) estimated growth rates of earnings lead them to overemphasize the impact of good news and tend to underestimate the negative value implications of bad news . This generally results in excess trading, higher expenses and taxes, more risk-taking and lower net returns.

2.Confirmation Bias: People seek out supporting information after making a decision and avoid or ignore new information that would call the decision into question. A belief that Reliance is a good company with high growth may be extended by investors to include a belief that Reliance stocks are ‘good’ stock.

What is Technical Analysis of Stocks?

Technical Analysis can be defined as an art and science of forecasting future prices based on an examination of the past. It is an analysis of historical market data, including price and volume. It is based on that prices are determined by the interaction of demand and supply. With the help of both  Behavioral Finance and Quantitative Analysis, Technical Analysis of Stocks aims to use past performance to predict future market Behavior. Chart Pattern and Technical (Statistical) Indicators are the two most common forms of Technical Analysis Stocks.

  • The time frame in which technical analysis is applied may range from Intraday(1-minute,5minutes,10-minutes, 15-minutes, 30-minutes or hourly), daily, weekly or monthly price data to many years.
  • Technical Analysis of Stocks is a blanket term for a variety of strategies that depend on the Interpretation of price action in a stock.

What makes Technical Analysis an Effective Tool 

The following theories given by Charles Dow makes Technical Analysis of Financial Markets 

  • Price discounts everything
  • Price Movements are not totally random
  • What is more important than why

There are essentially two methods of analyzing investment opportunities in the security market viz Fundamental Analysis And Technical Analysis. You can use Fundamental Information like Financial and Non-Financial aspects of the company or Technical Information which ignores  Fundamental and focuses on actual price movements.

Price Discounts Everything

Each price represents a momentary consensus of value of all market participants -large commercial interests and small Speculators, Fundamental Researchers, Technicians, and Gamblers-at the moment of transaction”-Dr. Alexander Elder.

Price Movements are not totally random

Technical Analysis is a trend following system. Most technicians acknowledge that hundreds of years of price charts have shown us one basic truth -price move in trends. If price were always random, it would be extremely difficult to make money using Technical Analysis.

Basic Assumptions in Technical analysis

1. Market Discounts Everything

Technical Analysis is criticized for considering only prices and ignoring the Fundamental Analysis of the company, economy, etc. Technical Analysis assumes that at any given time a stock’s price reflects everything that has or could affect the company -including Fundamental Factors.

2. Price moves in trends

“Trade with the trend ” is the basic logic behind the technical analysis. Once a trend has been established, the future price movement is more likely to be in the same direction as the trend than to be against it . Technical Analyst frame strategies based on this assumption only.

3. History tends to repeat itself 

People have been using charts and patterns for several decades to demonstrate patterns in price movements that often repeat themselves. The repetitive nature of price movements is attributed to market Psychology, in other words, market participants tend to provide a consistent reaction to similar market stimuli over time . Technical Analysis uses chart patterns to analyze market movements and understand trends

 

Candle Stick Chart of HDFC Bank

Importance of Technical Analysis 

Not Just for Stocks

Technical Analysis has universal applicability. It can be applied to any Financial Instrument like Stocks, Futures and Commodities, Fixed-Income Securities, Forex, etc

Focus on Price Fundamental Developments are followed by Price Movements . By Focusing only on price action, Technicians focus on the future.

Support And Resistance Charting is a technique used in the analysis of Support and Resistance level 

Weaknesses of Technical Analysis 

Analyst Bias Technical Analysis is not hardcore science. It is subjective in nature and your personal biases can be reflected in the analysis. It is important to be aware of these biases when analyzing a chart.

Open to Interpretation Technical Analysis is a combination of science and art is always open to interpretation. Even though there are standards, many times two technicians will look at the same chart and paint two different scenarios or see different patterns.

Too Late You can criticize the Technical Analysis for being too late. By the time the trend is identified, a substantial move has already taken place . After such a large move, the reward to risk ratio is not great . Lateness is a particular criticism of Dow Theory 

Share Market: What is the Stock Market?

What is Stock Market

The market that purchases sell and issues regular stocks is known as the Stock Market. This sort of activity takes place through Exchange Traded Fund or Over The Counter Market (OTC). Exchange-Traded Market is the market for buying and selling stocks listed on the stock exchange such as NYSE, NSE, BSE, etc. Stock Exchange is another term for the Stock Market, the Share Market Subset. The major inventory exchange is the NYSE(New York Stock Exchange), Nasdaq, BSE(Bombay Stock Exchange) and NSE(National Stock Exchange).

In Stock Market Trading not only of shares or equity but also of other economic assets such as exchange-traded funds (ETF), corporate bonds and stock-based derivatives, commodities, currencies, Fixed Income Securities, etc.

Purpose of the Stock Market  

Two very significant purposes are served by the share or stock market. The first is to provide businesses with capital that helps them use the fund and grow the company. For instance, if a company issues 5 million shares that initially issue an IPO (Initial Public Offerings) with a face value of $20 per share, then the company receives some Investment Bank charges of $100 million of the capital to arrange such offers.

The secondary purpose of the Stock Market Service is to offer investors profit in the form of a regular dividend in order to gain profit there is another way in which investors can gain earnings by selling stocks greater than the Stock Exchange Purchase Price.

How  Stocks  are Traded  in Exchanges and OTC

Stocks are mostly traded on stock exchanges such as the New York StockExchange(NYSE) or the USA NASDAQ, NSE(National Stock Exchange) in India. Stock Exchange is the marketplace where investors buy and sell stocks or shares. Stock exchanges are regulated in the United States by government agencies such as SEC(Securities and Exchange Commission), SEBI(Securities Exchange Board Of India), which protects investors from fraud and keeps the exchange market smoothly functioning. You know about the scam of Harshad Mehta, an Indian stockbroker involved in a huge manipulation of stock.

While most stocks are traded in stock exchanges, some are traded on Over The Counter Market, where buyers and stock vendors are frequently traded through a dealer. OTC Market is not controlled by Govt Agencies

Types of Market 

1.Primary Market: It is the market where the first time on the market-fresh issuance of shares is traded. Under the Companies Act, 1956, if it results in a fraction of securities for 50 or more economic experts, a problem is referred to as open. Nonetheless, it is recognized as a personal scenario when the backer makes a securities problem to a select collection of individuals that do not exceed 49 and is neither a rights issue nor an open problem. 

2.Secondary Market: Secondary market is the market where shares are already issued that are traded or listed on the stock exchange on the primary market. Secondary market comprises equity, derivatives and debt markets. The secondary market is controlled by two media, namely the market of Over-the-Counter (OTC) and the market of Exchange-Traded. OTC markets are unofficial markets that negotiate trades.

Key Securities Market Indicators.

Index: An index is used to provide information on the budgetary, commodity or some other market value trends of products. The purpose of financial exchange documents is to capture the overall behavior of the value markets. The exchange of securities file is produced by selecting a collection of stocks that illustrate the entire market or a predetermined region or market section. NSE’s bluechip record is CNX Nifty.

Market Capitalisation: Market capitalization is described on the exchanges of the country as the value of all listed stocks. It is calculated daily. A specific company’s market capitalization on a specific day. The number of excellent shares and the closing cost of the share can be calculated as the product. The amount of excellent shares here relates to the stock’s problem size.

Market capitalization = share price closure * Outstanding number of stocks

Market Capitalisation Ratio:  The market capitalization ratio is described as GDP/divided stock market capitalization. It is used as a stock market size metric.

Turnover: By multiplying the traded quantity with the price at which the trade takes place, the turnover for a share is calculated. Similarly, we aggregate the traded value of all the businesses traded on the Exchange in order to calculate the turnover of the businesses listed on the Exchange.

Turnover Ratio:  The turnover ratio is defined as the total value of shares traded on the stock exchange of a country for a specific period divided at the end of the period by market capitalization. It is used as a measure of stock market trading or liquidity