It is sometimes quoted that market movements seem mysterious in terms of the conventional theories of stock price determination. This perception seems to give credibility to the impact of individual biases or psychology on market conditions. A growing field of research on behavioral finance, studies on cognitive or emotional biases which are individual or collective create anomalies in market prices and returns. Behavioral models usually integrate insights from psychology with neoclassical economic theories. However, efficient market hypothesis proponents opine that any observed anomalies will eventually be priced out of the market or explained by appeal to microstructure. They further specify the necessity to distinguish between individual biases and social biases. The former can be averaged out by the market, while the other produce feedback loops that drive the market further away from the equilibrium of fair price.

In view of the above background, the first paper of this issue, "Investment Management by Individual Investors: A Behavioral Approach", by Abhijeet Chandra and Dinesh Sharma, focuses on how to identify the psychological biases that may drive the momentum effect in the Indian stock market. The authors mention that five main cognitive biases namely, overconfidence, conservatism, representativeness, under/over opportunitism and excess sensitivity to rumors are associated with stock market investments. To verify and make sure that these five psychological biases considered by the financial behavioral literature influence the investors' behavior, especially in the Indian stock market, a questionnaire survey technique is adopted in the study and the stock brokers were asked questions based on these five psychological biases. The results reveal that two of the five listed psychological biases were not found to be influential in case of the Indian investors. At the same time, some cognitive errors such as excess sensitivity to rumors, conservatism bias and representativeness bias are those contextual psychological biases which are pertinent in influencing the investors' behavior in the Indian stock market.

The second paper, "Behavioral Finance and Efficient Markets: Is the Joint Hypothesis Really the Problem?", by Mamadou A Konté, considers two identical assets A and B which do not have the same price. The asset A always reflects its fundamental value while asset B may be mispriced. The author argues that asset price B reflects its fundamental value and the mispricing is by chance. If anomalies are large and cannot be attributed to chance, the equal probability to have overvaluation and undervaluation is used to comfort efficient market theory. There is a long debate between proponents of efficient markets and behavioral finance on what is behind anomalies found on financial time series. In the model used in the paper, the author gives two explanations. For efficient market proponents, noise traders cannot be influenced by the presence of arbitrageurs. So, it is only by chance that an asset with a substitute is undervalued or overvalued. For behavioral finance proponents, noise traders are responsible for the deviation of asset prices from their fundamental value and there is no correction due to limits to arbitrage.

The third paper, "Bank Herding Incentive Systems as Catalysts for the Financial Crisis", Peter Haiss offers a classification of effects that narrows the scope of the banks' decision making into a funnel-shape and thus, prepares the ground for the financial crisis. The author conceptualizes a broader model to interpret why banks at times respond unanimously with the same disastrous strategies. To explain the narrowing of banks frame of action and resulting banking failures, the author develops the "bankers' strategy funnel". The author opines that inconsistent decision rules, too rigid bank regulation, stakeholder-focused incentive structures within banks and uncritical adoption of innovations may force banks into decisions that are micro-functional, but macro-dysfunctional. The author suggests remedies on the regulatory side (macro-prudential regulation, supervision of incentives) and on the banking side (proper reward systems and structured decision making) to re-establish prudent banking.

The next paper considered in this issue, "Foreign Institutional Investment and Stock Market Returns in India: Before and During Global Financial Crisis", by P Srinivasan, M Kalaivani and K Sham Bhat, uses ADF and PP tests to examine the stationarity of both net foreign institutional investment and NSE market return series. Instantaneous Granger Causality test is also employed to examine the contemporaneous relationship between net foreign institutional investment flow and equity market returns in India for the pre-global financial crisis and during the crisis periods. The authors reveal that there is evidence of negative feedback trading hypothesis and positive feedback trading hypothesis by foreign investors before the global financial crisis period and during the crisis period, respectively. The authors conclude that the foreign institutional investment acts as a smoothening effect and as a destabilizing force before and during the crisis period, respectively. However, such positive feedback trading strategies from foreign institutional investors seem to be the rationale during the period of global financial crisis.

The fifth paper, "Segmentation of Investors Based on Choice Criteria", by R Kasilingam and G Jayabal, examines the criteria used by investors to evaluate any investment instrument. It is important for the marketers to evaluate the investors and they should also segment the investors based on their choice and know the characteristics of each segment of investors. The study identifies four commonly used criteria namely convenience, risk protection, return and liquidity. The authors argue that by using these criteria, investors can be segmented into three categories namely, rational, normal and irrational based on the extent to which they consider each criterion.

The last paper, "Working of Credit Rating Agencies in India: An Analysis of Investors' Perception", by Bheemanagouda and J Madegowda, highlights the role and criticism of credit agencies in India. The paper makes an attempt to elicit and analyze the opinion of investors on the working of credit rating agencies in India. The study is mainly based on primary data and analyzes the investors' perception about various aspects of working of the credit rating services in India. The authors view that there is a lot of scope for the improvement of performance of the rating agencies in India. The genuine interest of the regulator to protect the interest of the investors and the credibility of the system as a whole should be the mantra of the rating process.

-- K K Ray
Consulting Editor