You are here: UK Essays » Essays » Finance » Behavioural Finance

Free Essays - Finance Essays

Behavioural Finance.

I will focus upon the theory of behavioural finance in trying to explain the dot.com bubble.  To do this I will first explain what behavioural finance is.  Behavioural finance attempts to incorporate elements of psychology into finance to better understand investor behaviour.  Essentially, behavioural finance operates under the assumption that all investors are not rational.  As observed by Shleifer (2000) ‘At the most general level, behavioural finance is the study of human fallibility in competitive markets.’  Behavioural finance incorporates elements of cognitive psychology into finance in an effort to better understand how individuals and entire markets respond to different circumstances.  Some investors can be over-confident, while other less knowledgeable investors might be prone to herding effects.  Shefrin (1999) was one such author to talk about behavioural finance.  He is one author who argues that ‘a few psychological phenomena pervade the entire landscape of finance.’ 

Dot.com Bubble

In this section I will briefly explain what the dot.com bubble was.  The dot.com industry was comprised of companies that have started up to sell goods and services over the Internet.  They were given the name dot.com due to the fact that many website addresses ended with a ‘dot’ and the word com.  At first, these companies were very successful and when floated on the stock market did very well financially.  However, in 2000 this industry suffered a massive collapse.  Many of these companies subsequently did not survive.

Explanation of Bubble

In this section I will attempt to see if behavioural finance can explain this bubble.  Many authors have argued that the new communication technology of the 1990’s was exaggerated.  By this I mean that the new innovation is by some corners, i.e. the media and governments, over triumphed.  This can lead to irrational behaviour of investors.  This can lead to investors becoming over confident in the technology or industry.

Another factor of this over enthusiasm is that it could attract herding behaviour.  The irrational investor will be more likely to invest in something that is being hyped up as they feel that others are doing the same thing.  They will feel that if others are doing it then it must be a good idea for them to do it as well.

A factor that will have led to the dot.com bubble is that of speculation.  One such author that observed the speculation effect on the dot.com boom was Giombetti (2000).  Many informed investors would have probably over invested in the technology industry going against market theory.  They will have done this on the hope that their investment will pay off.  Even if their investment were initially at a loss they would have stayed with it.  Authors of behavioural finance outline this behaviour.  This behaviour of these investors would have distorted the market conditions for other investors.  Also, the herding effect would have been greater due to this.

These factors would have led to the stock prices of the dot.coms being vastly over priced.  This would, therefore, cause the bubble.  This bubble that has been created will, in turn, attract other investors.  These investors will invest as they feel they are missing out on a good thing.  This is another example of herding.  This meant that when the bubble burst stock prices would have fell rapidly, causing investors to lose vast sums of money.  This would cause them to pull out of the industry, which, in turn, causes the companies themselves to collapse.  If it were not for irrational investment then investors might have pulled out earlier, before the collapse.  This might have even meant that the collapse would not have happened.

Conclusion

To conclude I can say that behavioural finance is an alternative theory to the more traditional theories of investment such as the efficient market hypothesis (EMH).  Behavioural finance tries to incorporate areas of psychology into finance to try to better explain individual investment behaviour.  Essentially, behavioural finance states that the assumption of rationality does not occur.  As observed by Shleifer (2000) ‘At the most general level, behavioural finance is the study of human fallibility in competitive markets.’  This theory can be used to try to explain the emergence and subsequence of the dot.com bubble of 2000.  The dot.com bubble was created by the over investment into the companies that sell goods or services over the Internet.

As I discussed earlier, I found that the theory of behavioural finance does go a long way to explaining as to why the bubble was created and why it collapsed.  The main reasons behind the rapid growth of the bubble can be explained by the fact that investors were not acting rationally.  This lack of rationality is the underpinning of the theory of behavioural finance.  There were many reasons for the lack of rationality.  These included the fact that various influential bodies were over enthusiastic about the dot.com businesses.  These bodies included governments and the media.  These are bodies that have a wide target audience.  This meant that they could influence a lot of people, which would cause and increase the ‘herding’ behaviour of some investors.  This herding behaviour would over inflate the share price of these companies.

Another factor, that I discussed, was that of speculation.  The speculation of some investors would have increased the price even further than it should have been.  This speculation would have paid off in the short run; however, it could never have been sustainable in the long run.  Informed investors would have probably seen this, however, many of the investors that had invested would have done irrationally and, therefore, they would have ignored or not seen financial indicators suggesting that the prices were over valued.

These factors would have pushed the price up and up until eventually underlying financial theory would have brought the price down to its true level.  The bubble inevitably burst.  The rational investor would have foresaw this, however, the irrational investor would have not.  As many people lost out when the bubble burst, one can only conclude that many of the investors had done so irrationally.  This, therefore, leads me to conclude that traditionally financial theory cannot explain the dot.com bubble.  Only behavioural finance can.

References

Giombetti R.  (2000)  The Dot.com Bubble.  www.EatTheState.org  Vol 4, Issue 23

Shefrin H.  Beyond Greed and Fear.  (1999)  Understanding Behavioral Finance and the Psychology of Investing.  Harvard Business School Press

Shleifer A.  (2000)  Inefficient Markets. An introduction to behavioural finance.  Oxford university Press

All of the essays in this section were written by students and then submitted to us to publish and help others. Thanks to all of the students who have submitted their essays to us. You should not hand in our essays as your own. We do not condone plagiarism! If you need custom essays on your exact essay questions, then have a look at our essay writing service.

Sign up and be the first to receive our latest offers: