Stock Market Efficiency: Behavioral or Traditional Paradigm?

Topics: Stock market, Investment, Stock Pages: 37 (9671 words) Published: November 9, 2013
ijcrb.webs.com

FEBRUARY 2013

INTERDISCIPLINARY JOURNAL OF CONTEMPORARY RESEARCH IN BUSINESS

VOL 4, NO 10

STOCK MARKET EFFICIENCY: BEHAVIORAL OR TRADITIONAL
PARADIGM? EVIDENCE FROM KARACHI STOCK EXCHANGE (KSE)
AND INVESTOR COMMUNITY OF PAKISTAN
Author names and affiliations
Syed Jawad Hussain Shahzad (Corresponding Author)
MS Student - COMSATS Institute of Information Technology
Park Road, Chak Shahzad, Islamabad – Pakistan
Paeman Ali
MS Student - COMSATS Institute of Information Technology
Park Road, Chak Shahzad, Islamabad – Pakistan
Fawad Saleem
MS Student - COMSATS Institute of Information Technology
Park Road, Chak Shahzad, Islamabad – Pakistan
Sajid Ali
MS Student - COMSATS Institute of Information Technology
Park Road, Chak Shahzad, Islamabad – Pakistan
Sehrish Akram
MS Student - COMSATS Institute of Information Technology
Park Road, Chak Shahzad, Islamabad – Pakistan

Corresponding author
Syed Jawad Hussain Shahzad (Corresponding Author)
MS Student - COMSATS Institute of Information Technology
Park Road, Chak Shahzad, Islamabad – Pakistan
Abstract
Traditional finance explains the investment process on rational and logical grounds based on the assumption of rationality of average investor. This paper attempts to understand why traditional finance models fail to capture stock market movements and how behavioral finance explains that failure in the context of Pakistan’s financial market. Beginning with the basics of behavioral finance, the discussion unfolds to explain any association that investor’s decision making process has with the behavioral biases like overconfidence, regret, pyramid and risk. Primary data based on questionnaire and interviews of investors trading at Karachi Stock Exchange of Pakistan was used. The study concluded that behavioral traits have significant association with investment decision. The study will also open up the doors to further analyze the deviated scenarios which cause the market to create the loss spiral for one group and unbounded gain for the other.

Keywords: Behavioral finance, Regret, Pyramid, Overconfidence 1. Introduction
Traditional finance has developed different models to understand the pricing and market behavior and has developed different strategies to justify their very existence in the stock market. It proposes that markets are efficient in a sense that whenever there is a deviation from normality, some abnormal profit making

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INTERDISCIPLINARY JOURNAL OF CONTEMPORARY RESEARCH IN BUSINESS

FEBRUARY 2013
VOL 4, NO 10

scenarios are developed to capture excess returns, and the ensuing activity then leads to a pricing behavior which eliminates the opportunities for abnormal returns. In traditional finance, investors develop expectations based on the mean-variance optimization or stock valuation based on a firm’s financial aspects like sales, dividend, and cash flows. Investors evaluate all these intrinsic measures and then calculate the expected price of a security. This leads to an interesting question: If all values are derived from the firm’s financial indicators, then why do investors act as opposed to that suggested by the model driven results? Interestingly, traditional finance cannot answer this question since it is the domain of behavioral finance. There are certain anomalies or biases responsible for deviations in the market or price behavior. Behavioral finance explores the investors’ behavioral aspects and personality traits which render the traditional finance models less accurate and influence their decision making process. Traditional finance assumes that investors are rational and will keep behaving rationally where risk and return are defined through mean-variance analysis. But it is also important to understand how and why investors behave irrationally when they are faced with various psychological challenges. While...

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