(c) (i) Sewell defines behavioural finance as the influence of psychology on the behaviour of financial practitioners and the subsequent effect on markets. Behavioural finance suggests that individual decision-making is complex and will deviate from rational decision-making. Under rational decision-making, individual preferences will be clear and remain stable.
Individuals will make choices with the aim of maximising utility, and adopt a rational approach for assessing outcomes.
Under behavioural finance, individuals may be more optimistic or conservative than appears to be warranted by rational analysis. They will try to simplify complex decisions and may make different decisions based on the same facts at different times.
(ii) Bournelorth Co’s share price may be significantly influenced by the impact of behavioural factors, as it is a newly listed company operating in a sector where returns have traditionally been variable and unpredictable. The impact of behavioural factors may be complex, and they may exert both upward and downward pressures on Bournelorth Co’s share price.
Investors may, for example, compensate for not knowing much about Bournelorth Co by anchoring, which means using information which is irrelevant, but which they do have, to judge investment in Bournelorth Co.
The possibility of very high returns may add to the appeal of Bournelorth Co’s shares. Some investors may want the opportunity of obtaining high returns even if it is not very likely that they will. The IT sector has also been subject to herd behaviour, notably in the dotcom boom. The herd effect is when a large number of investors have taken the same decision, for example to invest in a particular sector, and this influences others to conform and take the same decision.
However, even if Bournelorth Co produces high returns for some time, the fact that it is in a volatile sector may lead to investors selling shares before it appears to be warranted on the evidence, on the grounds that by the laws of chance
Bournelorth Co will make a loss eventually (known as the gambler’s fallacy).
Under behavioural finance, the possible volatility of Bournelorth Co’s results may lead to downward pressure on its share price for various reasons. First some investors have regret aversion, a general bias against making a loss anyway. This, it is claimed, means that the level of returns on equity is rather higher than the returns on debt than is warranted by a rational view of the risk of equity.
Similarly under prospect theory, investors are more likely to choose a net outcome which consists entirely of small gains, rather than an identical net outcome which consists of a combination of larger gains and some losses. At present also,
Bournelorth Co does not have much of a history of results for the market to analyse. Even when it has been listed for some time, however, another aspect of behavioural finance is investors placing excessive weight on the most recent results.
If the market reacts very well or badly to news about Bournelorth Co, the large rise or fall in the share price which results may also not be sustainable, but may revert back over time.
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