Loss aversion, overconfidence of investors and their impact on market performance evidence from the US stock markets.
| Autor | Bouteska, Ahmed |
| Cargo | Report |
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Introduction
Market efficiency is defined as the integration of available information into financial asset prices. The efficient markets hypothesis (EMH) is based on the idea of investor's rationality which is supposed to be perfect. However, numerous studies have revealed results quite different from the market efficiency theory predictions, which may explain some financial market anomalies. As these anomalies have become increasingly important phenomena, a new paradigm began to emerge - the behavioral finance.
De Bondt and Thaler (1985) have challenged the EMH and highlighted the emergence of the behavioral finance theory. Their study shows that the stock market is not efficient because of the incorrect market transmission of investor's emotions such as pride, doubt, fear and hope. They also revealed that the rapid course of events causes irrational investors behavior. In fact, the investor's sentiment creates movements in the market, which generate an evolution of prices of different assets above or below their reasonable values. Thus, the behavioral finance poses the fundamentals of an alternative financial theory, assuming that investor's behavior is not perfectly rational. We then notice that the advantages and challenges of modern finance are to explain the phenomena qualified as behavioral biases.
The behavioral theory of finance is based on two basic assumptions. The first is that investors are not fully rational in the sense that their demand of risky financial assets is influenced by emotions as well as by beliefs. However, this latter is not justified by economic fundamentals which make the expectations mostly biased. The second assumption is the limited effectiveness of arbitrage which is carried out by fully rational investors. As a consequence, a debate prevails between the EMH and the fundamentals of the behavioral finance.
We note that the behavioral finance affects the investor's behavior and therefore their strategic investment choices. Focusing on the US context, the following figure illustrates the evolution of the Dow Jones Industrial Average (DJIA) market index over the past 10 years on the New York Stock Exchange (NYSE). The (DJIA) index is one of the oldest, most wellknown and most frequently used indexes in the world, and obviously the first on the (NYSE). It was created in 1986 by Charles Dow and Edward Jones when they started their own company: the Dow Jones & Company. They subsequently estimated that industrial values have the most important potential on the stock market. From Figure 1, we notice the rapid evolution of this index. According to the basic hypotheses of the behavioral finance, this strong evolution is due to the psychological behavior of investors that explains the stock market anomalies. As Isaac Newton (1720) affirmed: "I can calculate the motion of heavenly bodies but not the madness of people".
Generally, the company goes through several situations. It can be in a performance stage when its stock market price is quite important, as it might be in a risky situation when its stock market price is very low. In classical financial models, the agents have always been considered rational and competent, but in reality, when a problem arises at the level of decision-making, these agents resort to mental calculation and this leads sometimes to a mistreatment of information. This mistreatment is then explained by investors' behavioral biases, which in turn affects the stock market price of the company. Behavioral biases of investors can of two kinds: the biases of pessimism and the optimism. Therefore, these biases will affect the investment choices, and consequently, the company performance. In this way, we ask the following question: How loss-aversion and overconfidence biases of investors affect the performance of US companies?
Empirical studies have documented the influence of investor sentiment on financial markets, but the underlying economic market performance remains unclear. The literature lacks a consensus about the best measure of sentiment or on whether sentiment in fact affects stock market performance. While existing studies test the impact of sentiment on individual stocks and portfolios of stocks whose valuations are highly subjective and difficult to arbitrage, this paper takes a different approach. This study links psychological research and a traditional modified basic model to investigate the influence of investor sentiment on market performance. Two dimensions of sentiment are examined: loss-aversion sentiment and overconfidence sentiment. For this end, we developed two panel data models that were administered to a sample of 154 US companies from two different sectors of real economic activities--the industry sector and the service sector--using quarterly data for the period between January 2006 and December 2016. By relaxing the assumption of investor rationality and using panel regression, we show that investor sentiment has the ability to predict stock market performance of companies. The investor sentiment provides an incremental predictive power for the market performance in both sectors of activity, namely, industrial and services, compared to other variables routinely used in the literature. Overall, there is a positive impact between overconfidence and market performance of industrial firms, but the impact does not hold similarly at the service sector. The evidence also suggests that the investor loss-aversion sentiment strongly and negatively affects economic performance in the US market. Furthermore, we show that the overconfidence sentiment generally persists that US investors are culturally more prone to overconfidence-like behavior and therefore it may have a greater influence on market performance than the loss-aversion sentiment. This result is important for portfolio managers; investors' sentiment can mislead market performance of a company, and it is, by the way, is a good predictor of securities overvaluation. Finally, this is a key result for financial market regulators, and the relationship between investors' sentiment and market performance can be useful to anticipate periods characterized by excessive investors' confidence and to adequately prevent prominent followed periods of stock market crises.
The remainder of the paper is organized as follows. Section 2 reviews the literature on the loss-aversion and overconfidence biases, and it develops our hypotheses. Section 3 describes data and methodology. In Section 4, we present our empirical results and interpret them. Finally, we conclude in Section 5 and present some limits and key features for future research.
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Literature review and hypotheses development
2.1 Loss aversion: a psychological bias that reflects pessimism
The loss-aversion bias was explored by the theory of prospects (Kahneman and Tversky, 1979). It consists in the matter that investors do not value the gain and loss in the same way. The investor under this bias uses gain to make a decision rather than loss because he tries to avoid the risk linked to loss. An investor is subject to loss aversion if he thinks that when he did not realize a loss for the securities he holds on stock market then he realized a gain. He . wants to get profit quickly from his gain by selling the security because price evolves very rapidly he sells the asset which worth less in the market by the price he had bought it. The importance of this bias is due to his influence on investor's decision-making in purchase and sale of securities.
Giving that loss aversion is a particular case of regret aversion, Shiller (1998) advanced that there is a human tendency to feel the pain of regret when having made errors, even for small errors, and for wishes to avoid the regret pain. Aftalion (2002) proposed an example of regret aversion:
"Paul owns shares of firm A. During the previous year, he had thought of selling them to buy in their place shares of firm B, but had renounced to his idea. If he had pursued, he would have earned $20,000. Georgette owned shares of firm B, which it sold them to buy shares of firm A. If she had kept shares of firm B, she would have been richer by $20,000" (p. 63).
The first investor is loss-averse and he does not want to sell. The second has sold and he is not subject to loss aversion. Aftalion (2002) asserted that the majority consider that the second investor normally must be less happy. We can note that mentally, the effect of loss on investor's behavior is more important than the effect of gain, what characterizes the loss aversion and explains the pessimism of investor subject to this bias. So, when investors are very sensitive to loss, they always seek to avoid it which influences absolutely their decision-making Focusing on strategic buying and selling decisions of investors' securities, the winning shares are much more sold than losing shares, which explains the fear sentiment of loss that can affect the investor.
Many researchers like Chau et al. (2011) and Rephael et al. (2012) have used the prospect theory to understand decisions made by the investor. They relied on normative models in which investors, based on certain criteria, maximize the utility function. In an early application of prospect theory and in terms of risk premium, Benartzi and Thaler (1995) illustrated an important gap between the returns of stocks and bonds. Their contribution using simulations is based on the Mehra and Prescott (1985) study. Always in the context of risk premium, these researchers have based on the determination of the frequency of portfolio valuation which makes investor indifferent between having a portfolio of stocks by assuming its loss aversion. It has been shown that the valuation interval has an impact on investor's feeling of loss aversion: the more the evaluation interval is narrow, the greater the loss aversion is confirmed, and the more the securities lose power to attract investor. Barberis et...
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