An Appraisal of the Behavior of Stock Market Investors

Why was this Research conducted?

The purpose of this thesis was to conduct a research on behavioral factors and decision-making processes that affect the investments of private investors. My purpose is to establish what factors lie behind the speculative bubble during January 2009 to December 2010 and further investigate whether the investment objectives and factors influencing investment decision-making are different today than during the speculative bubble.

Methodology of this Research:

The primary data in this thesis consists of the survey in the form of a questionnaire (consists of 17 questions) directed at active 40 (Sample Size = 40) private investors of Dhaka Stock Exchange. This research was conducted during January 2012 to March 2012.

THEORETICAL FRAMEWORKS

Behavioral Finance

Behavioral Finance
Behavioral finance is a new paradigm of finance, which seeks to supplement the standard theories of finance by introducing behavioral aspects to the decisionmaking process.

Loss Aversion
This can also be expressed as the phenomena in which people will tend to gamble in losses, i.e. investors will tend to hold on to losing positions in the hope that prices will eventually recover. Loss aversion refers to the fact that people tend to be more sensitive to decreases in their wealth than to increases.

Mental Accounting
It describes the tendency of people to place particular events into different mental accounts based on superficial attributes (Shiller, 1998).

Regret
There is a human tendency to feel the pain of regret for having made errors, even small errors. Its a feeling of ex post remorse about a decision that led to a bad outcome. If one wishes to avoid the pain of regret, one may alter ones behavior in ways that would in some cases be irrational.

Heuristics
The dictionary definition for heuristics refers to the process by which people find things out for themselves, usually by trial and error. Trial and error often leads people to develop rules of thumb, but this process often leads to other errors (Shefrin, 2000). Heuristics can also be defined as the use of experience and practical efforts to answer questions or to improve performance. Due to the fact that more and more information is spread faster and faster, life for decision-makers in financial markets has become more complicated.

Herd Behavior
A fundamental observation about the human society is that people who communicate regularly with one another think similarly. The social influence has an immense power on individual judgment.

Overconfidence and Over & Under reaction

The combination of overconfidence and optimism causes people to overestimate the reliability of their knowledge, underestimate risks and exaggerate their ability to control events, which leads to excessive trading volume and speculative bubbles.

Anchoring
People have in their mind some reference points (anchors), for example of previous stock prices. When they get new information they adjust this past reference insufficiently (under reaction) to the new information acquired.

Profile of respondents
Gender

80% of the private investors who responded to the questionnaire were male. 20% of the private investors were female.

20% Male Female 80%

Profile of respondents
Age
30
20 10 0 10% 16-25 26-35 60%

20%
36-50

10% 51 above

60% of the private investors were in between the age of 26 to 35 years of age while 20% were in between the age of 36 to 50 years, 10% of investors were over 51 and 10% were in between the age of 16 to 25 years.

Do you have practical knowledge about Finance/Investment?

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Financial literacy and financial decision making

Practical Knowledge of Finance

Practical Knowledge of Number Percentage Finance Yes 28 70% No 12 30% Total 40 100%

No 30%

Yes 70%

From how many years you are trading or investing in Stock Market?

Financial literacy and financial decision making

Association with stock market Less than 1 year 1-3 years

Association with stock market

Number
Percentag e
16 14 12 Axis Title

6 11 14

15% 28% 35% 23% 100%

10 8 6 4 2 0

3-5 years 5 years above

Total

9 40

Series2 Series1

Less than 1 year 15% 6

1-3 years 28% 11

3-5 years 35% 14

5 years above 23% 9

Presently which factor do you consider at the time of choosing stocks?

P/E RATIO
Factors analyzed for choosing stock Number Percentage

P/E ratio

18
28 29 12 5 40

45%
70% 73% 30% 13%

Past Dividend Earning per Share Market Capitalization NAV per Share Total

Factors analyzed for choosing stock

35 30 25 20 15 10 18 12 5 P/E ratio Past Dividend Earning per Share Market Capitalization NAV per Share 28 29

5
0

Findings
73% of private investors believe that earning per share of stocks is the most contributing factor before making investment decision. 70% investors think of past dividend, 45% investor reported P/E ratio is also an indicator to estimate future performance for any companies, 30% think of market capitalization and only 13% think NAV per share before choosing stocks.

This research indicates that most of private investors are considered as short term investors. They want windfall gain within shortest possible time, so they care less about NAV per share and market capitalization. Moreover, to understand future performance and forecast future price of any stock, P/E ratio is undoubtedly a crucial factor. After the stock market debacle in 2010, investors became more concerned about P/E ratio.

In your opinion, which of the following factor is important before choosing stocks?

Which of the following factor is important before choosing stocks?

Stocks with high P/E ratio Stocks with low P/E ratio

20%

80%

Presently which factor do you consider at the time of taking investment decision?

Change in Factors Important for Investments

Factors considered before taking investment decision Number 18 24 11 5 16 74 Percentage 24% 32% 15% 7% 22% 100%

Information from the company Recommendations from professionals Past performance Information from media Own intuition of future performance

Total

24% of the private investors indicated information from companies as the most important factor considered when making investments after the speculative bubble. Furthermore, recommendations and forecasts from financial analysts played a significant part for private (32%) investors. Moreover, private investors (15%) did not focus much attention on the general development of the market from a historical point of view and information from media (7%).

During the increases in equity prices from January 2009 to October 2010, how did you react to announcements and other information from companies?

The Influence of Announcement on Decisions

Reaction to information Number 14 28 4 46 Percentage 30% 61% 9% 100%

First news Number of consequent news Not concerned about news Total

61% of the private investors made changes in their portfolio after several consequent news announcements pointing in the same direction. 30% of the private investors made changes in their portfolio after only one announcement and only 9% of the private investors were not concerned with news announcements from companies. The majority of investors indicated that they make changes in their portfolio after several consequent news announcements pointing in the same direction.

In your opinion, was the stock market overvalued at any point of time during the period from January 2009 to October 2010?

Possible Reasons for the Overvaluation & the Decline of the Market
Overvalue/Undervalue Yes No Number 33 7 Percentage 83% 18%

Total

40

100%

A clear majority of the respondents, 83% of the private investors considered the market to be overvalued during the period from January 2009 to October 2010. Only 18% of the private investors did not consider the market to be overvalued.

If yes, what do you think was the most important factor to the overvaluation of the market during January 2009 to October 2010?

Possible Reasons for the Overvaluation & the Decline of the Market
Reasons for market overvaluation Over confidence among investors in the stock market Earnings and profitability of the listed companies Loopholes in the regulatory system. Total Number
3 14 22 39

Percentage
8% 36% 56% 100%

56% of the private investors consider loopholes in the regulatory system as the most important factor that contributed to the overvaluation of the market. Commercial banks have been involved heavily in the stock market business during 2009 to 2010. The situation worsened when it was made mandatory for all banks to maintain their investment in the stock market equivalent to 10 percent of their total deposit and to comply by December, 2010, when in reality, the ratio was much higher than this level. Perhaps, Bangladesh Bank (BB) was not much aware about banks' exposure to the stock market.

What do you think was the most important contributing factor to the decline in the market from December 2010 until today?

Possible Reasons for the Overvaluation & the Decline of the Market
Reasons for market decline Number Percentage

Loss of confidence among investors in the stock market

10 22%

Earnings and profitability of the listed companies

4 9% 69% 0% 100%

Loopholes in the regulatory system. The forecasts of analysts. Total

31 0 45

69% of the private investors indicated that loopholes in the regulatory system were the most important factor that contributed to the market decline. As mentioned earlier that regulatory bodies were not concerned about such exposure of financial institutions in stock market. When Bangladesh Bank increased CRR (Cash Reserve Ratio) by issuing new monetary policy then, big players had to sell huge volumes of shares due to liquidity constraints, which caused share prices to decline. Withdrawal of banks' large investments from the stock market appears to be the main reason for the recent crash in the capital market in Bangladesh.

Choose two alternatives that best describe the investments you have been making since the market decline in December 2010 until today:

Behavioral characteristics Change in Investment Target Categories

Present investment Strategy
I invest mostly in companies with uncertain, but higher expected returns

Number
12 23 4

Percentage
23% 44% 8%

I invest mostly in companies with stable, but lower expected returns.

I invest mostly in large size companies. I invest mostly in small size companies.

13
52

25%
100%

Total

25 20 15 10 5 0 12 4 23 13 Series2 Series1

I invest mostly in companies with uncertain, but higher expected returns

I invest mostly in companies with stable, but lower expected returns.

I invest mostly in large size companies.

I invest mostly in small size companies.

You are faced with following situation: A stock that you bought one month ago for TK 50 is selling today at Tk 40. One month from now the stock price will have either increased in price by Tk 10 or decrease in price by TK 10. Both possibilities are equally likely; fifty-fifty chance. Choose from the following:

The Prospect Theory Susceptibility to Loss Aversion When Faced with Losses
Susceptibility to Loss Aversion Number 19 Percentage 48%

Sell the stock now, thereby realizing a TK 10 loss. Hold the stock for one more month, given 50-50 odds between losing as additional Tk 10 or breaking even.
Total

21 40

53% 100%

53% of the private investors chose to gamble and hold the stock in question for one more month in order to have the possibility to break-even, although they faced an equal risk to further increase their losses. 48% would sell the stock and realize a minor loss. The preference for the gamble proves that investors are risk lovers when confronted with losses.

If the DSE general index has increased consecutively during the past three days what is the probability that it will increase in value during tomorrow as well?

Probability for Continued Changes in Value

Probabilities with repeated events (Increase) 30% 40% 50% 60% Total Average Increase Number 9 8 16 7 40 Percentage 2.7 3.2 8 4.2 18.1 45%

If the DSE general index has decreased consecutively during the past three days what is the probability that it will decrease in value during tomorrow as well?

Probability for Continued Changes in Value

Probabilities with repeated events (Decrease) Number 30% 40% 50% 60% Total Average Decrease Percentage 28 7 5 0 40 8.4 2.8 2.5 0 13.7 34%

Patterns are easily thought to exist in data that is truly random and continuous price increases are categorized as improbable. This is consistent with the overconfidence hypothesis described in theoretical section. Conservatism can also help in explaining why people give too much weight to the prior probabilities of events in a given situation, as people are reluctant in changing their opinions.

If you look at the stock market today, in your opinion, it is:

Opinions & Estimates on Current & Future Market Values

0 8%

Overvalued

Undervalued 93% Valued at a fundamentally correct level

What do you think the value of DSE general index will be in 6 months?

Opinions & Estimates on Current & Future Market Values

16

14

12

10 Series2 8 15 Series1

11

4 6 6

2
2 0 0 Below 4000 4000-4500 4600-5000 5000-5500 5600-6000 Above 6000

Bangladesh stock market crisis: diagnosis, remedies

The Bangladesh capital market landscape showed a bubble and burst episode in 1996. The benchmark price barometer of DSE, General Price Index (DGEN), increased by 139.3 percent during 1991-1995 and stood at 834.7 at the end of 1995. To understand what caused such a plunge again this year, one has to turn a few pages back. From January 2010 to December 2010, the DGEN marked an increase of 80 percent, daily turnover rose by 60 percent and the number of B.O. account holders reached 3.21 million from 1.25 million i.e. an increase of 154 percent. On the other hand, in the FY2010 our GDP had grown only by a mere 5.5 percent.

Stock Market Blame Game

These include misuse of book building methods, placement shares, direct listing and problems in audit reports. In the secondary market, which deals with stocks bond options and futures, there were different toxic elements, like split shares, margin loans, serial trading and issue of right shares. Furthermore, over exposures of banks, omnibus accounts, insider trading, anomalies in BO account and the restricting nexus of big players like SEC, DSE/CSE & political leaders. Bangladesh capital market continues to witnessing unprecedented falls in stock prices. There are some reasons behind this downward trend to continue.

Current scenario of capital market in Bangladesh

After the steady fall in January, market seems to recover a bit in the second month of the year. DGEN landed higher than January, with a 541.45 points gain, at a volume level of BDT 5358.75 mn as on February 29, 2012. The month started with DGEN losing 537.72 points within first three trading days, breaking the 4000 psychological level and reaching a 27-month low of 3616.24, lowest since November 16, 2009.

Recommendations for stabilizing stock market

To survive a market crash it is helpful to have a sound investment strategy and a suitable back up plan. Stop loss orders Diversification Invest for the long term Invest in good companies Demutualization of the stock exchange