EFFECTS OF BEHAVIORAL FINANCE ON INVESTMENT

DECISIONS: A CASE OF PAKISTAN STOCK EXCHANGE

Mamoon ur Rehman
FA14-R04-007

Supervised By
Dr. Kashif Rashid
 FLOW OF THE PRESENTATION

1 • Introduction of the Topic

2 • Literature Review
3 • Statement of Problem
4 • Motivation of the Study

5 • Research Objectives

6 • Hypothesis and Research Models

7 • Results

8 • Conclusion
INTRODUCTION

• Behavioral finance is the merger of psychology with finance. Investors are

humans and their investment strategies are affected by social and
psychological factors inherent in human nature.
• Behavioral finance states that there are different anomalies in financial
markets and irrational investors are making above average risk adjusted
returns from capital markets. These anomalies could not be address
properly in financial literature and academic finance refuses to explain
them. Behavioral finance discusses the behavioral issues of investors and
analyze the investment decisions in behavioral perspective.
CONT’D

• People are not always rational in capital markets. Their financial decision
making influenced by behavioral biases, beliefs or preferences and do not
meet the traditional axioms of rational decision makers, then there are
effects of behavioral biases (Kim & Nofsinger 2008).
• Investors who act as irrational in their investments they are called as noise
traders. Behavioral finance anomalies are a challenge towards the Efficient
Market Hypothesis rational processors of information (Ramiah et al.
2015).
 CONT’D

• The irrational investment decisions showed behavioral errors and herding

effect of investors in investment strategies, it has noticed to adopt the
same investment strategies followed by most of investors in same period
(Chang & Lin 2015).
• In this study we have investigated the behavioral patterns of investors and
their respective impact on investment decision making. We have analyzed
the impact of confidence, optimism, pessimism, and rationalism on
investment decisions in Pakistan Stock Exchange (PSX).
• Traditional academic finance and economic theories are based on
rationality hypothesis. There are also investors in capital markets playing
role as irrational investors and earning the above average rate of returns..
Literature Review
Author (s) Methodology Findings

Boussaidi Causality Test Investors forecast future returns by past returns. Tunisian stock market
(2013) represented weak evidence that investors overreact on the earning information
and loss leads to the rational behavior in trading.

Bakar & Yi Multiple Overconfidence and availability bias have positive significant role in investment
(2016) Regression decisions. Conservatism has negative significant impact on investors’ decision.
Herding behavior is not having significant impact on investment decision making

Kapeliushnikov Explanatory Behavioral economics changed rationality concept of traditional economics and
(2015) Research added human behavioral impact. Behavioral economics is supported by
irrationalities and anomalies. It opposed the traditional welfare economics and
focus on individual preferences and their impact on decision making

Tuyon & Multiple Malaysian stock market influenced by behavioral factors. Empirical studies also
Ahmad (2016) Regression showed the investors adopted irrationality in investment decisions. It determines
the prices and makes market stable ultimately leads to adopted and bounded
market efficiency. The multifactor behavioral and fundamental risks also affect the
Dhaoui & Khraief Multiple Regression Pessimism exceeds optimism in French stock market. psychological
(2014) factors explain the market trading behavior. Investor judge and
incorporate the feelings and beliefs of other investors

Oprean (2014) Multiple Regression Pessimism, optimism, anxiety and the depression are against the rational
behavior. Anomalies exist and investors earn due to irrational behavior
which is an opportunity for sharp investors. Investors also behave like
animals and showed herding behavior (crowed behavior) to feel safe

Oprean & Tanasescu Multiple Regression Behavioral factors effecting the investment decisions in Romania and
(2014) Brazil. Romania showed pessimist behavior while Brazil showed optimist
behavior in market. Investors also behave like animals and showed
herding behavior (crowed behavior) to feel safe
Jlassi et al. (2014) E-GARCH Test Significant impact of over confidence on market volatility. Over
confidence exists with different intensities in global financial markets. It
is the main factor behind market disturbance.
Author (s) Methodology Findings

Guzavicius et al. Two-dimensional Investment decisions under uncertainty and risk circumstances, human
(2014) Gaussian function also have effect of emotions, illusions, false perception of the
information and some other irrational factors. Investors are exposed to
social factors. Existence of the irrational investors do not contradict
EMH.
Boussaidi (2013) Granger Causality In some conditions there is a positive and unidirectional causality in
Test trading volume and the return volatility which is confirming
overconfidence theory.

Kannadhasan (2009) Explainatory Less experience investors showed representativeness bias in investment
Research decision making. Experienced investors gamble in trading.

Shiller (2003) Explainatory Anomalies in markets showed the excess volatility in stock markets.
Research Smart money (Rational investors) behave opposite than ordinary money
(irrational investors) and thus effect of irrationality in stock market is
offset.
Author (s) Methodology Findings

Ritter (2003) Explanatory Research Investors lost large amounts because of overvaluation. Most
short sellers, planned right for long run, were thrown out before
misevaluations. Forces of arbitrage, work well in high frequency,
work poor in low frequency events.
Studies et al. (2014) Multiple Regression Behavioral finance highlights the psychological edge of investment
analysis decision making process in strong contradiction to the Efficient
Markets Hypothesis.

Singh (2012) Explanatory Research It explains the financial anomalies in market in a confusing way.
Investors are not earning large profits from these market
anomalies.

Kiymaz & Berument OLS & Modified- Wednesday showed highest returns in week and lowest returns
(2003) GARCH observed on Monday. Highest stock volatility is find on Friday
while the lowest volatility is observed on Wednesday.
Author (s) Methodology Findings

Kafayat A, Investors in Pakistan who invested with respect of biases self-

Economics & Xxi attribution, overconfidence and over optimism have less returns
(2014) than investors made their investment decisions based on
rationalism.
 STATEMENT OF THE PROBLEM

• Behavioral finance is an attractive field of study and vast topic for research study. Analyzing and interpreting the
human behavior its impact on the investment decisions is not an easy task. There is a limited study done in
Pakistan to identify impact of behavioral factors such as, optimism, pessimism, confidence and rational expectations
on investment decisions.
• This study is aimed at identifying and comparing the impact of above mentioned behavioral factors on the
investment decisions. Most of the researchers have worked on it to explore the behavioral patterns and trends of
investors. To examine the impact of behavioral factors in a capital market is a lucrative job in behavioral finance
domain. Behavioral patterns are in human nature and it is difficult to avoid them in trade and making investment
decisions in financial markets.
MOTIVATION FOR THE STUDY

• In conventional and academic finance investments are based on the rationalism. These
investment analyses are based on risk and return tradeoff but neglect the human behavior
which cannot be ignored in investment decision making.
• This study will focus on the investor behavior and rationalism of investor. The aim of this
study is to find the human behavior effects on investment decisions in Pakistan Stock
Exchange (PSX).
• In Pakistan, it is proved from various studies that investment decisions are effected by human
behavioral patterns which cause volatility of returns and earning above average risk adjusted
returns.
CONT’D

• The behavioral errors mainly the pessimism, optimism, anxiety and the depression are
against the rational behavior. In stock markets anomalies exist and investors earn due to
irrational behavior. This is an opportunity for the sharp investors. In stock markets, human
behave like the animals and showed herding behavior (crowed behavior) to feel safe in
market. If the lots of people do same it confirms that their decision was wise (Oprean
2014).
• Behavioral finance argues that participants of financial markets not always have rational
decisions and their decisions have limitations. Behavioral patterns of non-professional
investors better explain the importance of behavioral finance (Bikas et al. 2013).
RESEARCH OBJECTIVES:

The purpose of this study is;

• To examine the impact of confidence on investment decisions in Pakistan Stock Exchange
(PSX).
• To examine the impact of optimism on investment decisions in Pakistan Stock Exchange
(PSX).
• To examine the impact of pessimism on investment decisions in Pakistan Stock Exchange
(PSX).
• To examine the impact of rational expectations on investment decisions in Pakistan Stock
Exchange (PSX).
 MODEL

• Econometric models are used to test the effects of behavioral errors and
rationalism variables on investment decisions.
• ln(volume) = β0 + β1 confidence + β2 optimism + β3 pessimism + β4 rationalism + €
(Oprean & Tanasescu 2014).
• DM = Σ βi SAi + Σ βi OCi + Σ βi OOi (Kafayat A. Economics & Xxi 2014).
• ln(volume) = β0 + β1 confidence + β2 optimism + €
• ln(volume) = β0 + β1 confidence + β2 rational + €
• ln(volume) = β0 + β1 optimism + β2 rational + €
• ln(volume) = β0 + β1 confidence + β2 pessimism + €
• ln(volume) = β0 + β1 optimism + β2 pessimism + €
CONFIDENCE

• if: Rt-1 ≥ 0 → there_ will_ be_ transaction

• if: Rt-1 < 0→ there_ will_ be_ no_ transaction
The security price above from previous day/week or remaining same as previous day/week
give confidence of investment to investor.
(Oprean & Tanasescu 2014).
OPTIMISM

• if: Rt-1 ≥ Ṝ + σ → there_ will_ be_ transaction

• if: Rt-1 < Ṝ + σ → there_ will_ be_ no_ transaction
Investor earned some profit at previous day/week and investor set a minimum profit level
and if he foresees the next day returns greater than previous only he will invest otherwise
he will refrain from trading.
(Oprean & Tanasescu 2014).
PESSIMISM

• if: Rt-1 ≥ Ṝ - σ → there_ will_ be_ transaction

• if: Rt-1 < Ṝ - σ → there_ will_ be_ no_ transaction
Investor incurs loss in investment he limits the trading by setting a maximum amount of
risk tolerance. Pessimist investors refrain from trading and set a limit of loss when loss
reaches at a certain preset level.
(Oprean & Tanasescu 2014).
RATIONALISM

• Pt+1 = Et Pt+1 + ε t+1

Based on Theory of Price Movements
• E(R) = Rt-1 + ε t-1
• Expected Return of a security
(Oprean & Tanasescu 2014).
TRADING VOLUME

• Natural log has been taken of the trading volume of KSE 100 index in each of the Daily,
Monday and Friday samples.
(Oprean & Tanasescu 2014).
HYPOTHESES

•H1: Confidence Effect the Investment Decisions

•H2: Optimism Effect the Investment Decisions
•H3: Pessimism Effect the Investment Decisions
•H4: Rational Expectations Effect the Investment Decisions
RESEARCH METHODOLOGY:

Population
• The indices in Pakistan Stock Exchange (PSX) is the population of the study.

Sample
• The study sample is KSE 100 index. It is the most important and popular index of Pakistan
Stock Exchange (PSX)
• We have taken three samples in this study, the daily values, Monday values (start of the week)
and Friday values (end of the week). Through daily sample we can examine the overall
behavior of investors, while Monday and Friday samples tell the start of the week and end of
the week behavior of investors.
CONT’D

Data Collection
The data of KSE 100 index daily values and trading volume is collected from the Standard
Capital Securities Pvt Ltd website.The data therefore is secondary in nature.

Study period
• The study covers the duration of four (04) years, January, 2012 to December, 2015.
ESTIMATION TECHNIQUES

• The aim of this study is to examine the effects of investor behavior

(behavioral errors & rationalism) on investment decision making. It was
done in two steps.
• In the first stage, we checked the data stationarity through Augmented
Dicky Fuller Stationarity Test
• In the second stage the OLS Regression technique is applied to examine
the behavior effects on investment decisions (trading volume).
STEP 1: STATIONARITY TESTS

• Stationarity tests are used to find the data stationarity, either the variables are
stationarity at level or not.
• Augmented Dicky Fuller Test is typically used to measure data stationarity of all
variables
• All the variables found stationary at level so we applied OLS (Ordinary Least
square) technique of Regression
STEP 2: ECONOMETRIC MODEL

• Econometric models are used to test the effects of investor behavior (behavioral
errors and rationalism). Econometric models are tested by econometric
technique for time series data.
• ln(volume) = β0 + β1 confidence + β2 optimism + β3 pessimism + β4 rationalism + €
(Oprean & Tanasescu 2014).
lnVolume = Natural Log of Trading volume of KSE 100 index, β0 = Constant or
Intercept, Confidence = Confidence behavior of investor, Optimism = Optimism
behavior of investor, Pessimism = Pessimism behavior of investor, Rationalism =
Rational behavior of investor, € = Error term or residuals in model
 DESCRIPTIVE STATISTICS DAILY

LnVolume Confidence Optimism Pessimism Rational

Expectations
Mean 8.076 0.001 -0.008 0.008 -1.401
Median 8.105 0.001 -0.008 0.008 1.991
Maximum 8.571 0.045 0.035 0.052 0.045
Minimum 7.051 -0.044 -0.054 -0.037 -0.044
S.D. 0.218 0.008 0.008 0.008 0.008
Observations 990 990 990 990 990
 DESCRIPTIVE STATISTICS MONDAY

LnVolume Confidence Optimism Pessimism Rational

Expectations

Mean 8.043 0.005 -0.024 0.024 2.271

Median 8.074 0.006 -0.023 0.025 -0.0009

Maximum 8.562 0.097 0.067 0.116 0.114

Minimum 7.051 -0.108 -0.138 -0.089 -0.092

S.D. 0.235 0.024 0.024 0.024 0.024

Observations 203 203 203 203 203

 DESCRIPTIVE STATISTICS FRIDAY

LnVolume Confidence Optimism Pessimism Rational

Expectations

Mean 8.088 0.006 -0.020 0.020 -7.531

Median 8.110 0.006 -0.019 0.021 -0.0006
Maximum 8.551 0.069 0.042 0.083 0.063
Minimum 7.343 -0.057 -0.084 -0.043 -0.063
S.D. 0.208 0.020 0.020 0.020 0.020
Observations 188 188 188 188 188
 STATIONARITY TESTS

Friday
Daily Monday
Conclusion
Constant plus trend Constant plus trend
Constant plus trend
Variables
Level Level
Level
Ln-Volume -5.804 -6.359 -8.085 I(0)
Confidence -27.265 -15.620 -12.217 I(0)
Optimism -27.266 -15.919 -12.217 I(0)
Pessimism -27.266 -15.599 -12.217 I(0)
Rational Expectations -27.266 -1.191 -12.217 I(0)
REGRESSION MODEL

• ln(volume) = β0 + β1 confidence + β2 optimism + β3 pessimism + β4 rational + €

(Oprean & Tanasescu 2014).
LN(VOLUME) = Β0 + Β1 CONFIDENCE + Β2 OPTIMISM + Β3
PESSIMISM + Β4 RATIONAL + €
DAILY SAMPLE RESULTS
Variablesaaaa Coefficient Standard Error T-Statistics Probability

Confidence 833.289 NA NA NA

Optimism -831.114 NA NA NA

Pessimism 0.00000 NA NA NA

Rational 0.00000 NA NA NA

R Squared 0.587 Adj R Squared 0.584

Durbin Watson 1.90 N 990

 LN(VOLUME) = Β0 + Β1 CONFIDENCE + Β2
OPTIMISM + Β3 PESSIMISM + Β4 RATIONAL + €
MONDAY SAMPLE RESULTS
Variables Coefficient Standard Error T-Statistics Probability

Confidence 1395.589 NA NA NA

Optimism -703.132 NA NA NA

Pessimism -691.290 NA NA NA

Rational 0.00000 NA NA NA

R Squared 0.291 Adj R Squared 0.270

Durbin Watson 2.076 N 230

 LN(VOLUME) = Β0 + Β1 CONFIDENCE + Β2
OPTIMISM + Β3 PESSIMISM + Β4 RATIONAL + €
FRIDAY SAMPLE RESULTS
Variables Coefficient Standard Error T-Statistics Probability

Confidence 306.7659 NA NA NA

Optimism -306.4a61 NA NA NA

Pessimism 0.00000 NA NA NA

Rational 0.00000 NA NA NA

R Squared 0.266 Adj R Squared 0.242

Durbin Watson 1.996 N 188

REGRESSION

• We quoted the regression results of daily, Monday and Friday samples, it showed the
overall behavior, start of the week behavior and end of the week behavior of investors in
KSE 100 index of Pakistan Stock Exchange (PSX). The regression model collapsed in case
of Pakistan Stock Exchange (PSX).
• We used an other regression model as:
• DM = Σ βi SAi + Σ βi OCi + Σ βi OOi (Kafayat A. Economics & Xxi 2014).
REGRESSION MATRIX

• ln(volume) = β0 + β1 confidence + β2 optimism + €

• ln(volume) = β0 + β1 confidence + β2 rational + €
• ln(volume) = β0 + β1 optimism + β2 rational + €
• ln(volume) = β0 + β1 confidence + β2 pessimism + €
• ln(volume) = β0 + β1 optimism + β2 pessimism + €
REGRESSION CONDITIONS

• An investor may be confident and optimist at same time but not pessimist and rational
• An investor may be confident and rational at same time but not optimist nor pessimist
• An investor may be optimist and rational at same time but not confident nor pessimist
• An investor may be confident and pessimist at same time but not optimist and rational
• An investor may be optimist and pessimist at same time but not confident and rational
• We have focused on the behavioral and rational conditions not on the parameters so all
the above regression equations estimated simultaneously.
LN(VOLUME) = Β0 + Β1 CONFIDENCE + Β2
OPTIMISM + €
Variables Daily Monday Friday

Confidence 833.289 269.097 306.765

Probability 0.000 0.000 0.000

Optimism -831.114 -266.207 -306.461

Probability 0.000 0.000 0.000

R-Squared 0.587 -14.395 0.266

Adj. R-Squared 0.585 -14.706 0.250

Durbin Watson 1.904 1.044 1.997

N 990 203 188

LN(VOLUME) = Β0 + Β1 CONFIDENCE + Β2
RATIONAL + €
Variables Daily Monday Friday

Confidence 7229.024 1446.444 1361.116

Probability 0.000 0.000 0.000

Rational Expectations 7226.849 1445.333 1360.811

Probability 0.000 0.000 0.000

R-Squared 0.587 0.259 0.266

Adj. R-Squared 0.585 0.244 0.250

Durbin Watson 1.90 2.00 1.99

N 990 203 188

LN(VOLUME) = Β0 + Β1 OPTIMISM + Β2 RATIONAL +
€
Variables Daily Monday Friday

Optimism -939.398 -326.190 -395.627

Probability 0.000 0.000 0.000

Rational Expectations -941.573 -327.975 -395.9317

Probability 0.000 0.000 0.000

R-Squared 0.587 -22.336 0.266

Adj. R-Squared 0.585 -22.807 0.250

Durbin Watson 1.90 1.03 1.99

N 990 203 188

LN(VOLUME) = Β0 + Β1 CONFIDENCE + Β2
PESSIMISM + €
Variables Daily Monday Friday

Confidence -1077.205 -10.219 -557.313

Probability 0.000 0.000 0.000

Pessimism 1079.380 11.559 557.618

Probability 0.000 0.000 0.000

R-Squared 0.587 0.240 0.266

Adj. R-Squared 0.585 0.225 0.250

Durbin Watson 1.904 1.977 1.99

N 990 203 188

LN(VOLUME) = Β0 + Β1 OPTIMISM + Β2 PESSIMISM +
€
Variables Daily Monday Friday

Optimism -468.612 -162.203 -197.661

Probability 0.000 0.000 0.000

Pessimism 470.786 163.987 197.965

Probability 0.000 0.000 0.000

R-Squared 0.587 -22.336 0.266

Adj. R-Squared 0.585 -22.807 0.250

Durbin Watson 1.904 1.032 1.99

N 990 203 188

REGRESSION ANALYSIS

• There is a mix trend of investor behavior effecting the investment decisions. The
investment decision making in Pakistan Stock Exchange (PSX) during 2012 to 2015
effected by confidence, optimism, pessimism and rationalism as well. So, all the hypotheses
are accepted that investment decisions are effected by behavioral errors investor
rationalism (rational expectations) of investors.
 RESULT’S SUMMARY
Hypothesis Daily Monday Friday Literature Support

H1: Confidence effects Trading Volume Accepted Accepted Accepted Bakar & Yi (2016) and Jlassi
et al. (2014).

H2: Optimism effects Trading Volume Accepted Accepted Accepted

Oprean & Tanasescu (2014).

H3: Pessimism effectssTrading Volume Accepted Accepted Accepted

(Oprean & Tanasescu (2014).

H4: Rationalism effects Trading Volume Accepted Accepted Accepted Kafayat P. Economics & Xxi
(2014).

a
RECOMMENDATION

• There is a need to train investors about rationalism. The technical and fundamental
analysis of stocks and overall market analysis is necessary for investment decision making.
• The proper training and development is the responsibility of stock exchange regulators.
There is need to create specialist’s posts in stock markets who can guide the investors to
trade in stock market. These measures will be helpful to avoid the behavioral errors made
by investors in Pakistan Stock Exchange (PSX).
CONTD…

• Government of Pakistan should take necessary decisions for stock exchange for the
betterment of economy. If investors think rational it is the ideal situation for economy
and it tells that investors have no other fear, greed and other behavioral factors in their
mind.
• The government should educate the population to invest in stock market and should give
them protection to some extent.
• There is a strong need of Foreign Portfolio Investment (FPI) in Pakistan Stock Exchange
to further boost the stock market and to reduce the anomalies of local investors.
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THANK YOU!