Alternative prescriptions about the behaviour of markets are widely discussed these days. Most of these prescriptions are based on the irrationality of the markets in, either processing the information related to an event or based on biased investor preferences.

The Behavioural Aspect

Behavioural Finance is a field of finance that proposes psychology-based theories to explain stock market anomalies. Within behavioural finance, it is assumed that information structure and the characteristics of market participants systematically influence individuals’ investment decisions as well as market outcomes.

In a market consisting of human beings, it seems logical that explanations rooted in human and social psychology would hold great promise in advancing our understanding of stock market behaviour. More recent research has attempted to explain the persistence of anomalies by adopting a psychological perspective. Evidence in the psychology literature reveals that individuals have limited information processing capabilities, exhibit systematic bias in processing information, are prone to making mistakes, and often tend to rely on the opinion of others.

The literature on cognitive psychology provides a promising framework for analysing investors’ behaviour in the stock market. By dropping the stringent assumption of rationality in conventional models, it might be possible to explain some of the persistent anomalous findings. For example, the observation of overreaction of the markets to news is consistent with the finding that people, in general, tend to overreact to new information. Also, people often allow their decision to be guided by irrelevant points of reference, a phenomenon called “anchoring and adjustment”. Experts propose an alternate model of stock prices that recognizes the influence of social psychology. They attribute the movements in stock prices to social movements. Since there is no objective evidence on which to base their predictions of stock prices, it is suggested that the final opinion of individual investors may largely reflect the opinion of a larger group. Thus, excessive volatility in the stock market is often caused by social “fads” which may have very little rational or logical explanation.

There have been many studies that have documented long-term historical phenomena in securities markets that contradict the efficient market hypothesis and cannot be captured plausibly in models based on perfect investor rationality. Behavioural finance attempts to fill that void.

Regulatory Hindrances

In the real world, many a times there are regulatory distortions on the trading activity of the stocks such as restrictions on short-selling or on the foreign ownership of a stock etc. causing inefficiencies in the fair price discovery mechanism. Such restrictions hinder the process of fair price discovery in the markets and thus represent deviation from the fair value of the stock. Then there may be some restrictions on the price movement itself (such as price bands and circuit filters which prevent prices of stocks moving more than a certain percentage during the day) that may prevent or delay the efficient price discovery mechanism. Also, many institutional investors and strategic investors hold stocks despite deviation from the fair value due to lack of trading interest in the stock in the short term and that may cause some inefficiencies in the price discovery mechanism of the market.