Chapter 1

Introduction

1.1 Background

In today’s economy, money holds a significant role in one’s life as in order to trounce

the difficulties in future it is necessary to invest money. Investment is referred to as

the sacrifice of present consumption and investing that saved money in some financial

product with an expectation of earning higher returns in the future. But the

accessibility to large amount of information creates a lot of confusion among the

individuals, moreover it is very time consuming as well since the investors are many a

times not capable of processing the available information. In addition to that, it is also

necessary to have a sound knowledge of the existing investment options so as to

arrive at good investment decision. Nowadays, numerous investment avenues are

available with differing risk-return levels, differing liquidity and marketability. An

investor has to pick an appropriate investment avenue that satisfies his particular need

and risk taking appetite. The selection of an investment avenue is influenced by

numerous factors. For example, while taking decision regarding investment in risky

assets factors like gender, age, income, marital status and educational differences

enacts a leading role as the person falling in one category might have different

viewpoint and inclinations from their counterparts. The budding investment situation

evidently uncovers that there is a transformation in the likings of investors regarding

financial instruments. During 80s and 90s variety of investment avenues have been

pioneered and embraced which was apparent from the fact that investors have shifted

their money from conventional investment options towards equity and debt linked

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schemes which helps in blooming Indian financial markets.

Financial markets are the pillar of every economy. The flourishing Indian

financial market contributes a lot in uplifting Indian economy. The capital market is a

mechanism which helps industries, government and financial institutions in raising

funds and plays an important role in the development of the economy. It carries out

critical job of transforming households and organizational savings into investment and

leads to the conception of numerous financial assets. Stock market - a segment of the

capital market, is a platform which provides opportunities for buying and selling of

shares, mutual funds and many more financial products. A healthy stock market is

necessary for providing favorable environment for the economic growth of the

country. The stock markets help in bridging the gap between savers and investors and

in generating the prospects to put the hard earned savings in resourceful avenues. It

apportions limited savings to the industries that helps them in improving their

performance, the proof of which can be seen in their rapidly rising stock prices.

Moreover, the availability of so many income generating securities encourages the

people to spend less and invest their money in highly liquid and profitable securities.

The stock market helps in integrating the worldwide economies through the incursion

of capital in the form of Foreign Portfolio Investment (FPI) and Foreign Institutional

Investment (FIIs). Financial markets worldwide are experiencing extreme, exceptional

and expeditious changes. Besides, technology has also transformed the system and the

availability of amass information has triggered incredible changes in the way the

worldwide markets has been functioning.

Indian capital market is one of the swiftest developing markets in the world. It has

matured remarkably during the recent past in sync with the changing global financial

markets. Indian stock market is one of the oldest stock markets which was established

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in 1875. The first share trading organization in India was Native Share and Stock

Broker Association which is now known as Bombay Stock Exchange (BSE).

SENSEX, BSE India benchmark index, is India’s first stock market index which is

traced globally. SENSEX comprises 30 most volatile stocks from 12 diversified

sectors. In the past during the initial years of trading investors used to gather at

trading floor to initiate a transaction. But, with the passage of time, numerous scams

and lack of innovative technology called for the urgent need of starting a new and

better exchange which led to the establishment of National Stock Exchange (NSE).

NSE is now counted as one of most advanced exchanges dealing in specific stock and

exchange futures and having more than 50000 trading stations. In 1996, National

Stock Exchange initiated S&P CNX Nifty comprising 50 volatile stocks from 25

diverse sectors and from year 2000 onwards, it has also opened its gate for online

trading in stocks. At present, with the advancement of information technology,

majority of the transactions are performed electronically which has resulted in

paperless stock markets.

Capital market encompasses two sectors - Primary and Secondary market.

Primary market deals with the issue of new securities (also called as initial public

offerings- IPO) and further trading of all these securities takes place in secondary

market. The primary market is the key medium which helps in mobilizing savings

from the households to the companies straightly for investment purposes. It provides a

platform that enhances industrial and financial activities by supplying scarce funds to

the industries and the government. It introduces fresh securities in the market which

help in increasing the volatility and widening the base of secondary market.

On the other hand, secondary market provides liquidity in stocks investment and

mirrors the overall health of the economy. Industries generally raise two types of

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funds from capital market in the form of either Equity or Debt. Equity capital is

considered as a part of net worth whereas Debt reflects the liability of the business

towards outside party. Moreover, the fund borrowed by way of equity is more

preferred by investors as well as businesses as compared to that of Debt. This is

because of the reason that if business firms manage to raise considerable amount of

equity capital through IPO, it helps them in approaching banks for long term funding.

The Indian stock market has seen extraordinary jubilation from the early 90s and

has too witnessed precarious admiration from many years. Presently, there are 19

stock exchanges in India wherein NSE (National Stock Exchange) and BSE (Bombay

Stock Exchange), having approximately 9600 companies listed, jointly contributes

more than 99% of the total turnover of Indian Stock market. Victory of equity market

entirely rest upon the trust of the investors as investors will invest in equities only if

they observe that it has excessive profitability potentials. In stock market, two types

of investors are seen, namely, retail investors (individual investors) and institutional

investors. Institutional investors are big investors who invest with the help of

Portfolio Managers. Portfolio Managers simply rearrange the financial assets in their

portfolio, depending on their personal valuation of numerous stocks but they do not

infuse the most desirable risky capital by forthcoming organizations for carrying out

new business activities. Moreover, Foreign Institutional investors (FIIs) usually invest

their money in any country just to purchase shares of the extremely profitable

companies but they do not cater risk capital to the organizations rather it is the retail

investors who caters risky capital. They offer risk capital, either in the form of

investment in equity shares or by the way of investing in mutual funds and are

accountable for market fluctuations for many decades.

An event that is described by various traditional finance theories as

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“abnormality”, the base of the global economy were stirred by Sub-prime mortgage

crisis 2008 that was initiated in USA and eventually resulted in slow down of

worldwide economies. Numerous economists, prognosticators oppressing powerful

positions in various government organizations and financial institutions were trapped

unprepared by this and subsequent events like insolvencies and defaults occurred.

Even with the crisis gaining pace, many of them were not competent to examine the

intensity or degree of the same. Downfall of economists, and subsequently the

theories they rely upon, on various incidents has brought forward the question: Do

investors actually behave rationally? Or are they prone to various behavioral biases

that lead to irrational decisions? The main concept that has governed finance was

Efficient Market Hypothesis (EMH) which tells that investors behave rationally while

taking investment decision. In other words, an investor is said to be rational when he

reframes his views immediately as soon as the new information comes in the market

and makes preferences that are up to the standards. But there are some investors who

overlook the fundamental or do not have the appropriate knowledge to implement the

available information and tend to take irrational decisions. They took a decision

which is in tone with their risk taking capacity. Moreover, majority of the investors

feel insecure in handling their stock market investment as it is very complex for an

individual to identify the companies having good future prospects.

1.2 Theoretical Framework of the Study

The earlier days of the stock market indicates that investor’s park their money in

company’s shares or mutual funds for probably healthy motives but walk out of their

holdings as soon as the market goes against them. They tend to sell the shares as and

when they hear some bad news related to the stock and also become ready to pay high

prices based on market rumors. This type of behavior is known as herd behavior

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which was seen in the case of Dot com bubble. Additionally, investors also believe on

word of mouth and feedbacks of their neighbors, friends and colleagues regarding

which stocks to buy or sell. They also take recommendation from financial advisors

and analysts. Henceforth, the decision making process of investors can be

hypothesized as a complicated behavior which is affected by several rational as well

as irrational factors leading to ineffective stock movement.

At the same time, academic and experimental work of two researchers Daniel

Kahneman and Amos Tversky who provides their rich work to psychology in 1970s

acted as a base and gave birth to a new concept known as Behavioral Finance in

1980s, which examines how investors are affected by their emotions like greed and

fear while taking financial decisions. It primarily concentrates on how investors

deduce and take action on plentiful available information to take investment

decisions. One of the important reasons for the evolution of Behavioral Finance is the

problems confronted by traditional finance theories. The main objective of Behavioral

Finance is not to show that any of the traditional finance theory is outmoded, rather it

attempts to combine psychology biases with traditional finance theories in an effort to

establish a comprehensive model of human behavior. Behavioral finance pinpoints

that humans are vulnerable to several behavioral biases that can turn out to be the

major hurdle in their effort to get the best out of their wealth. Thus, it does not mean

that eminent investors are not susceptible to these faults; it is merely that they realize

the consequence of blending feelings in trading, and direct their intellect not to mingle

emotions with investment decisions.

Kent et al. (2001) found in their study that individual investors while taking

investment decision exhibit some common behavior and (a) they generally do not

involve themselves in all investment avenues (b) they show evidence of loss-averse

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behavior (c) they think that future performance of a share can be predicted by having

information of their past performance (d) they trade too violently (e) they place their

decisions by looking at the current state of affairs (status quo) (f) they do not create

effective portfolios at all times and (g) their decisions are affected by past high or low

of the respective shares. Behavioral models are looked as a new concept in share

markets and it is necessary to understand these models in order to become familiar

with the investment world.

Nowadays, it is very easy to invest in stock market as it does not require any

specialized knowledge to buy or sell a stock. Modern technology has resulted in

speedy trade between investors and it has become an upcoming trend to invest in

share market. Consequently, investors take irrational decisions ignoring the true

fundamental value of a stock. In present time, individual investors are doing trading

too frequently which is detrimental to their profit motive. Although excessive trading

might be beneficial for brokerage firm; but it is not lucrative for individual investors.

On the other side, the integration of worldwide markets has resulted in enlargement of

market size and the number of investors’ since past two decades by offering a wide-

ranging investment options. But it further complicates the investment decision making

process as a wide variety of investment options are available to investors to choose

from bonds to options. These financial products differ from each other in respect of

risk and return level associated with them and investors prefer those investment

options whose return and risk level is identical to their risk and return preference.

Apart from this, investor’s knowledge of share market and their prior experience adds

a lot to the evaluation of risk level in various investment options available. After

framing risk tolerance the investors frame their probable returns from that respective

investment option. Investor prefers to invest in those investment options which

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proposes the return in commensurate with the risk level of those investment options.

Shifting our attention to India in 2008, SENSEX- highly popular and oldest

benchmark index of Bombay Stock Exchange (BSE) signifying the free-float market

value of 30 well-founded companies stocks from different sectors- had seen an all-

time high of 20,873 in January 2008 even though the financial crisis was instigated in

USA. But after one year, during March 2009, the index has slipped to 8,160, as soon

as the financial crisis had extended to the global economies. Till November 2010,

although the waves of the crisis have not leveled out totally, in the meantime

SENSEX climbed on to a new high of 20,893. The whole investment environment

began to flourish again then but a new crisis abrupted this pace. This new crisis came

in form of Sovereign debt crisis instigated in Europe and SENSEX started tumbling

again.

1.3 Objectives of the Study

A single word that has governed the stock markets since 2008 has been “Volatility”

and Indian stock market is no exception. Intense movements in stock prices as a result

of anxiety and expectation have increased the complexity for a rational investor.

Financial markets movements are so outrageous that it is changing its side from

positive to negative returns and back just in the few weeks, days and months. Even,

the globalization of financial markets has resulted in enlarging investor’s population

since past two decades by catering to diverse investment options. Moreover,

individual investor takes into account their investment requirements, purpose and

limitation while taking investment decisions, but it is unlikely that decision proves to

be profitable every time. Their outlook is shaped by numerous factors such as how to

get rich instantly, dividend, past history of popular investors, online trading etc. A

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deep knowledge of how investors usually react to market movements can assist

financial companies in creating suitable strategies for their clients. Thus, it becomes

necessary to understand the irrational behavior of investors than it has ever had.

In this context the immediate questions that come to our mind are: Are individual

investor’s trading in Indian stock market are rational? If no, what are the factors that

affect the decision making process of individual investors? Does the impact of various

biases differ between the investors group having different characteristics? Do

demographic factors have an effect on the financial decision making of investors? Do

demographic factors play any role in determining which investor is more influenced

by a particular bias?

1.3.1 Objectives

The present research first makes an attempt to understand various traditional finance

theories that has been the base of Indian stock market for decades. At the outset, it

explores how Indian stock market has evolved over a period of time and how it has

shifted from a paper based stock market to a digital stock market. Then it explains

how the availability of numerous financial products creates confusion in investor’s

minds due to which they sometimes tend to ignore the fundamentals of the company

and are likely to take faulty decisions. The objectives of the study are to examine

whether the individual investor’s trading in Indian stock market are rational or not.

The study also examines the impact of various behavioral biases on decision making

process of investors. It focuses on seven behavioral biases: Loss Aversion, Regret

Aversion, Overconfidence Bias, Herd Behavior, Representativeness Bias, Anchoring

Bias and Cognitive Dissonance Bias. Another aspect of the research is to study the

impact of these biases on different investor’s group. It also attempts to investigate the

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impact of demographic factors in determining which investor group is more

influenced by a particular bias.

With the above background, the specific objectives of the present research work are to

examine the impact of various behavioral biases on investor’s group of differing

characteristics, and to analyze which demographic factor is playing a major role in

influencing an investor with a particular bias. The specific objectives are listed as

follows:

1. To discuss the evolution of Indian share market;

2. To examine whether behavioral biases persists among investors.

3. To analyze which investor’s group (with different characteristics) is affected or

unaffected by the behavioral biases.

4. To find out the level of association between various demographic variables and the

factors influencing the investment decision making process.

Investor’s behavior and its impact on stock market have been studied by many

researchers worldwide. Prominent studies include the work of Shiller (1990);

Lakonishok et.al (1992); Kiyilar and Acar (2009); Thaler and Johnson (1990);

Hirshleifer et.al (1998) and Barber and Odean (2000). The present study is an

improvement over the existing studies. The study tries to investigate investor’s

behavior in Indian context and our time frame includes those investors who have

experienced speculative bubble 2008 which helps in clearly understanding the

changes in their behavioral aspect.

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1.4 Methodology, Time Frame and Data

The methodological approach of this research is based on the Discriminant function

analysis and Binary Regression (Logit). Discriminant function analysis is a statistical

tool which is used when the total sample is to be segregated into two or more

mutually exclusive groups on the basis of some clearly defined independent variables

and establishing a linear combination among them. In other words, it helps in

determining which specific categorization or group variable associates on the basis of

its attributes or features and which variables are the perfect predictors that contribute

majorly in discriminating the groups. On the other hand, binary regression (Logistic

regression), is used to predict a discrete outcome, such as group membership, from a

set of variables that may be continuous, discrete, dichotomous, or a mix of any of

these. Generally, the dependent or response variable is dichotomous, such as

success/failure.

For the current research, primary data has been collected using structured

questionnaire (sample copy attached in annexure as annexure 1) which were

distributed in person to investors engaged in trading through brokerage houses and

also as an online survey to those who choose to trade online. For this purpose, the data

of 5,000 investors was collected from reputed brokerage houses and financial

websites (of those who have uploaded their portfolio for tracking purpose).

Questionnaires which were completely filled in all aspects were only taken for

analysis purpose. 10% investors were picked randomly to ensure that sample size

truly represents the whole population. The present research aims to collect data from

diversified investors of distinct age, educational qualification, years of investment

experience with differing attitudes in different market scenarios. Further, the

questionnaire was prepared and made accessible to respondents in July 2015 to March

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2016. Finally, 419 responses were received and amongst them 380 were chosen after

rejection of incomplete questionnaires.

The data collected with the help of questionnaires were segregating in respective

bias categories and evaluated using SPSS 21.0 in order to extract some relationship

amongst them. Additionally, the responses of all the behavioral biases questions were

combined and converted into binary variables and evaluated in response of

demographic variables using STATA 13.0 to extricate some relationship amongst

them. Chi-square test for independence was also used to test the various hypotheses

and various charts and tables were made using Microsoft excel to present the

demographic characteristics of the respondents like their age, gender, educational

qualification, risk taking capacity, etc.

1.5 Contribution of the Study

A number of researches have been carried out worldwide that capture the investor’s

behavior and its impact on their investment decision-making process. Same way,

Indian is an emanating market and is also naked to behavioral biases which can be

seen from various anomalous events experienced by it like dot.com bubble, financial

crisis 2008, and many more. This can be due to the indifferent attitude of the stock

market towards investor’s behavior that gave birth to these crises and washed away all

the money of investors. Thus, it becomes even more important as well as interesting

to study this irrational behavior of investors and that is why the present study is being

carried out to have an insight of the share market inefficiencies caused by it. The

present has been carried out to fill the following gaps:

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(a) Most of the researches focused only on one category of investor but the present

research studies the behavior of students, businessmen, housewives, salaried and

others in entirety and its impact on stock market.

(b) The present study has also formed different investor’s group on distinct

parameters to check which group is influenced by a respective bias.

(c) The present research also examines the impact of demographic factors in

determining which investor group is more influenced by a particular bias which has

been considered by other researchers.

1.6 Structure of the Research

The following research study is organized into eight chapters.

After introduction in the present chapter, Chapter 2 gives an overview on India’s

Capital market-development and performance. This chapter gives a quick look at the

development of Indian Capital market since liberalisation and globalisation. It also

mentions how share markets are twirled from a market where everything was done on

paper to paper free market. It cites the establishment of various Sectoral indexes in

NSE and BSE and the performance since their inception.

Chapter 3 gives a theoretical framework of seven behavioral biases considered

in the study. This chapter acquaints with various traditional financial theories and the

grounds for the emergence of behavioral finance. Further, it also mentions the

background and progression of behavioral finance and various popular theories based

on individual behavior. It moves on with the discussion of how different behavioral

biases, namely, loss aversion bias, regret aversion bias, overconfidence bias,

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representativeness bias, cognitive dissonance bias, herd behavior and anchoring bias,

affect the decision making process of individual investors.

A detailed review of existing literature is given in Chapter 4. It provides the

summary of literature on individual investor’s investment behavior that is used as a

starting point for primary research. This chapter also covers the work that has already

been done by the researchers previously as well as the results and findings extricated

from their study related to various behavioral biases. Recent literature has supported

that risk-taking capacity of an investor is affected by previous financial gains and

losses. Thus, after realizing financial gains, investors are ready to take more risk.

From literature review it is also found that males are more overconfident and risk

seeking as compared to females.

Chapter 5 features the data and research methodology used in empirical

analysis for simplifying data in order to get desired results. Further it mentions the

theoretical explanation of various statistical tools (discriminant analysis, chi-square)

which is then followed by concrete analysis and results are shown in detail in next

chapter.

Chapter 6 presents data analysis and evaluates the results of the study. This

chapter has dual objectives: Firstly, the whole sample is divided in two investor’s

group (less experienced and experienced investors) on the basis of their investment

experience in stock market. After that, various statistical tools are used to check

which investor group is more prone to which behavioral bias. And afterwards, the

responses of behavioral biases were converted into binary variables to examine the

impact of demographic factors in determining which investor group is more

influenced by a particular bias.

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 Finally, Chapter 7 encapsulates the thesis and deduces the conclusions and

recommendations of the present research. Additionally, it also presents the

contribution of the present study and suggests some areas for future research.

Behavioral finance is certainly an exposed opportunity and I contemplate that future

theories should be focused on this research issue. It was found in the present study

that both the investor’s group exhibit Herd behavior bias, overconfidence and

representativeness bias in an equally likely manner; whereas for other variables,

namely, loss aversion bias, regret aversion bias, anchoring bias and cognitive

dissonance bias are exhibited by experienced investors more as compared to less

experienced investors.

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