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Behavioral Economics and the Effects of Psychology on the Stock Market Justin L State University of New York College at Buffalo - Buffalo State College Digital Commons at Buffalo State Applied Economics Theses Economics and Finance 5-2017 Behavioral Economics and the Effects of Psychology on the Stock Market Justin L. Nagy [email protected] Advisor Dr. Theodore Byrley First Reader Dr. Theodore Byrley Second Reader Dr. Frederick Floss Third Reader Dr. Xingwang Qian Department Chair Dr. Frederick Floss To learn more about the Economics and Finance Department and its educational programs, research, and resources, go to http://economics.buffalostate.edu/. Recommended Citation Nagy, Justin L., "Behavioral Economics and the Effects of Psychology on the Stock Market" (2017). Applied Economics Theses. 24. https://digitalcommons.buffalostate.edu/economics_theses/24 Follow this and additional works at: https://digitalcommons.buffalostate.edu/economics_theses Part of the Behavioral Economics Commons Behavioral Economics and the Effects of Psychology on the Stock Market By Justin L. Nagy An Abstract of a Thesis In Applied Economics and Finance Submitted in Partial Fulfillment of the Requirements for the Degree, of Master of Arts 2017 Buffalo State College State University of New York Department of Economics and Finance i Abstract of Thesis Behavioral Economics and the Effects of Psychology on the Stock Market The purpose of this thesis is to study the contributions behavioral economics and finance have had on the understanding on how the stock market works. The idea that psychology plays a role in influencing the stock market can be dated back to Adam Smith who wrote about individual’s behavior in his work Theory of Moral Sentiments. It wasn’t until the latter half of the 20th century that behavioral economics became accepted as a counter to Eugene Fama’s widely accepted theory of Efficient Market Hypothesis. This paper will analyze the development of behavioral economics, review the main contributors to the field and review main theories as it relates to the psychology of the human mind, and how it can influence the stock market. ii Dedication This thesis is dedicated to my amazing wife Kiersten, who never stopped encouraging me to finish this work. Thank you for always being supportive, and for tolerating me when I talk about the “sunk cost fallacy” and “opportunity costs”. iii State University of New York College at Buffalo Department of Economics and Finance Behavioral Economics and the Effects of Psychology on the Stock Market A Thesis in Economics and Finance By Justin L. Nagy Submitted in Partial Fulfillment of the Requirements for the Degree of Master of Arts May 2017: Theodore Byrley, Ph.D. Chairperson of Committee Frederick Floss, Ph.D. Chairperson of Department of Economics and Finance Kevin Miller, Ed.D. Interim Dean of the Graduate School iv THESIS COMMITTEE Dr. Theodore Byrley Associate Professor of Economics and Finance Dr. Frederick Floss Chairperson of Department of Economics and Finance and Professor Dr. Xingwang Qian Associate Professor of Economics and Finance v Table of Contents Abstract of Thesis ......................................................................................................................................... ii Dedication.................................................................................................................................................... iii THESIS COMMITTEE ...................................................................................................................................... v Table of Figures ......................................................................................................................................... viii Chapter One: ................................................................................................................................................ 1 Introduction: ............................................................................................................................................. 1 Chapter Two: ................................................................................................................................................ 3 Fundamental Theories of the stock market: ........................................................................................... 3 Technical Analysis: ............................................................................................................................... 3 Fundamental Analysis: ......................................................................................................................... 4 Chapter Three: The Efficient Market Hypothesis (EMH): ........................................................................... 6 Efficient Market Hypothesis .................................................................................................................... 6 Theoretical Background ....................................................................................................................... 8 Empirical Foundations of EMH........................................................................................................... 10 Limitations of EMH: ................................................................................................................................ 12 Chapter Four: Animal Spirits and Irrational Behavior: Keynes to the Present. ....................................... 13 Keynes view on efficient markets: ..................................................................................................... 13 Surge of Behavior Economics: ................................................................................................................ 16 Important Contributors to Behavioral Economics: ........................................................................... 16 Richard Thaler..................................................................................................................................... 16 Daniel Kahneman and Amos Tversky ................................................................................................ 17 Foundations of Behavioral Economics .................................................................................................. 18 Chapter Five: Fundamentals ideas of Behavioral Economics. .................................................................. 20 Major Theories of Behavioral Economics .............................................................................................. 20 Prospect Theory .................................................................................................................................. 20 Fear of Regret and Disposition Effect ................................................................................................ 29 Herd Behavior and Groupthink .............................................................................................................. 32 Groupthink .......................................................................................................................................... 33 Individual Herding .............................................................................................................................. 36 Bubbles ............................................................................................................................................... 39 Feedback Theory ................................................................................................................................ 43 Cognitive Biases and Heuristics ............................................................................................................. 44 vi Bayes’ Theorem .................................................................................................................................. 44 Anchoring ............................................................................................................................................ 48 Availability Bias .................................................................................................................................. 53 Framing ............................................................................................................................................... 54 Representativeness ................................................................................................................................ 55 Chapter Six: Empirical Evidence ................................................................................................................. 61 Overreaction in the Stock Market: Representativeness and Bayes’ Theorem .................................... 61 New Zealand Stock Exchange Study .................................................................................................. 61 De Bondt and Thaler Study ................................................................................................................ 63 Herding in the Swedish Markets ............................................................................................................ 66 Results ................................................................................................................................................. 69 Chapter Seven: Conclusions Working Notes ............................................................................................. 73 Concluding remarks: ..............................................................................................................................
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