Conventional finance theories suggest that emotions and other external factors do not influence people when it comes to making economic decisions. However, there are numerous instances of emotions and psychology of the investors influencing their decisions, causing them to behave in an erratic or irrational way. With the passage of time, academics in both finance and economics realized that some investment anomalies and behaviors exist, which could not be explained by these conventional finance models. They realized that the real world is very chaotic, in which market participants often behave in a very unpredictable way. This irrationality of the market participants encouraged the researchers to look to cognitive psychology to account for the unreasonable and illogical behaviors which the conventional finance theories had failed to explain. The papers included in the current issue of the journal address some of the issues relating to irrational behavior of investors so as to facilitate a more correct asset valuation.

The first paper, "Generalized Behavioral Asset Pricing Model", by Adam Szyszka, examines how asset prices are influenced by various behavioral heuristics. The study develops a Generalized Behavioral Model (GBM) that presumes that the price of an asset is affected by three behavioral variables—errors in the processing of the information signals, representativeness errors and unstable preferences. The study reveals that the errors committed by the investors result in significant deviations from the fundamental value of the asset in the market, which can lead to temporary over- or underpricing of assets. The results of the study suggest that the ultimate scale of mispricing depends on the ability of the market to self-correct. This ability is measured by the `measure A' introduced in the model.

The proponents of behavioral finance believe that investors' decisions are influenced by factors, such as prejudices, emotion, gender, age, educational qualification, marital status, desire, goal and income. The paper, "Does Irrationality in Investment Decisions Vary with Income?", by Manish Mittal and R K Vyas, examines how the income levels of individuals affect their decision making. The study, using primary data, finds that income is the most significant factor responsible for the investors' overconfidence level and their tendency to overreact. This irrationality of the investors generally increases with the rise in their income levels. The results of the study suggest that investors belonging to the high income group are more likely to exhibit behavioral bias in their investment decision making. They are susceptible to make potentially costly mistakes in managing their investment portfolio which, in turn, affect their savings and asset allocation decisions.

In a general equilibrium framework, belief-driven variations in demand are necessary conditions for crashes to occur in the market. The origins of market crashes stem from both psychological and economic factors, and not from variations in fundamentals alone. The paper, "Psychological Aspects of Market Crashes", by Patrick Leoni, contends that an endowment fall may not trigger a market crash if the anticipation level is not high enough. The argument put forth is that when there is an expected low future endowment, agents will increase their demand for securities to hedge against this event. This results in raising the purchase price of those securities and, therefore, will lower their returns.

Competency of investors and their stock market trading behavior is an interesting area of research in behavioral finance. The last paper, "Individual Investors' Trading Behavior and the Competence Effect", by Abhijeet Chandra, establishes that while some investors trade very frequently, others leave their portfolios untouched for a longer period of time. This attitude of investors is influenced either by investors' background or the market environment. The study concludes that investors belonging to moderate to high-income groups and with high professional qualifications are more confident about their competency in stock market trading. These competent investors tend to trade more frequently in the stock market, as compared to other investors.

-- K K Ray
Consulting Editor