Introduction
Consider investors A and B who, respectively, have invested in stocks of XYZ (a manufacturing company) and ABC (an oil company). Both are knowledgeable and have enough information about investment. During the previous few years, both have been winners and the price of their stocks has increased on average. Investor A estimates that the XYZ stock will continue its improvement sharply in the near future due to the effectiveness of the corporationās performance and investor B estimates that the ABC stock will decline because of the poor performance of the company and the new environment of competition in the petrochemical industry. Consequently, investor A decides to hold his stock and investor B decides to withdraw. However, market movements ruin their estimations. The XYZ stock starts declining due to bad news about the company and in a few days its price decreases by more than 10%. While other participants estimate the prospect of the stock will be worse, investor A anchors to a specific price and believes that the stock will return. He always places great emphasis on his confidence and experience, which has led him to the best decisions and consequently he avoids consultations with advisors.
On the other hand, news of war in the Middle East increases the oil price and subsequently investorsāwithout paying attention to the fundumentall information of petrochemical companiesārun to buy their stock. Therefore, the excess of demand leads the stock prices to increase (in the petrochemical industry) and the price of the ABC stock will not be an exception. Although investor B, based on his fundamental analysis, knows that the ABC stock is not an appropriate investment to hold, he decides to ride the wave and starts buying more ABC shares of stock. He deliberately does so in order to maximize his profit. After a predetermined subjective period, he sells his position and gets out of the market. He enjoyed success from self-herding behavior (when investors deliberatly ride on waves) and transformed a loss into an achievement.
Loss and gain stories are a constant phenomenon in financial markets and two sides of the same coin in the stock market in particular. Sometimes, these stories are highly regarded as examples of different financial decision -making. However investors in the example above showed irrational behavior, which resulted in different outcomes. Anchoring (see below), overconfidence , loss aversion, and self-herding behaviors (or biases ) are evident in their decisions. An important point is that both investors were financially literate but acted against their own knowledge and understanding. The main questions, meanwhile, are how financial literacy can justify their decisions and what is the role of financial literacy in investorsā behavior?
This chapter focuses on the role of financial literacy in changing financial behavior and aims to answer the following questions:
- 1.What does financial behavior mean?
- 2.What are the most significant biases in the capital market?
- 3.How does financial behavior affect financial well-being?
- 4.What are the effects of financial behavior on the graph definition of financial literacy?
What Is Financial Behavior?
Conventional and modern financial theories assume that people are, for the most part, rational decision makers and they are predictable. The rationality assumption is mainly applied in the Efficient Markets Hypothesis and the Capital Asset Pricing Model. In addition, however, there are different occasions and many instances where emotion and psychology influence investorsā decisions, causing them to behave in unpredictable or irrational ways. The irrationality of investors showed that theories are subjective and a new concept of financial behavior emerged to explain how modern finance had failed.
In order to define financial behavior in the stock market, it would be useful to define the concept of behavior itself in this context. Behavior is the āactions or reactions of a person in response to external or internal stimuli.ā In addition, the field of investor behavior attempts to understand and explain investor decisions by combining the topics of psychology and investing on a micro level (i.e., the decision process of individuals and groups) and a macro perspective (i.e., the role of financial markets). The decision -making process of investors incorporates both a quantitative (objective) and qualitative (subjective) aspect that is based on the specific features of the investment product or financial service. Investor behavior examines the cognitive factors (mental processes) and affective (emotional) issues that individuals, financial experts, and traders reveal during the financial planning and investment management process. In practice, individuals make judgments and decisions that are based on past events, personal beliefs, and preferences (Ricciardi 2014). Therefore, financial behavior in the stock market can be defined simply as follows:
Financial Behavior describes the actions or reactions (decisions and judgments) of investors during financial planning and the investment management process in response to external or internal stimuli in the stock market.
Behavioral finance seeks to combine psychological theories with conventional economics and finance to provide explanations for why people behave irrationally in financial matters. It is the study of why individuals do not always make the decisions they are expected to and why markets do not reliably behave as they are expected. However, does behavioral finance go beyond exposing the irrationality of investors and offer solutions? For instance, does it provide tools that professional investors can employ to overcome behavioral biases such as groupthink or conformity? Indeed, it is unlikely to find a ācureā for bias , but if investors are aware of biases and their effects, they can possibly avoid major pitfalls. Behavioral finance holds the prospect of a better understanding of financial market behavior, and scope for investors to make better investment decisions based on an understanding of potential pitfalls.
Prior to explaining the role of financial literacy in financial behavior, it would be useful to review the most significant and well-known biases that investors show in the stock market.
Financial Behavior Biases
Research in psychology has found a range of decision -making behaviors called biases. These biases can affect all types of decision -making but have particular implications in relation to money and investing. The biases relate to how investors process information to reach the decisions and preferences they have (Shefrin 2000). Bias is defined as an unreasoned judgment. There can be many forms of biases that should be introduced. As a fundamental part of human nature, these biases affect all types of investors, both professional and naive. However, if they and their effects can be understood, investors may be able to reduce their influence and learn to work around them. This section introduces the most important biases which are shown by investors (not the market or market components). At the end of this section, all biases introduc...