Patterns of behaviour

Are all financial decisions rational? The assumption that they are underpins theories of economic behaviour and stock market models, such as the efficient market hypothesis.

Why then do stock market booms and busts occur if investors are acting rationally? Rational behaviour surely implies no shocks, with stock markets showing steady movements in share prices, but not sudden spurts. However, unexpected and significant news could still result in sudden shocks.

Also, why are some mergers and acquisitions considered to be poor deals? If a listed company is being acquired, surely the acquisition price should be based on the market value of its shares, if the markets are valuing it fairly. Why then is there uncertainty about the true value of many acquired companies? Why also do many acquisitions run into difficulties?

If proper due diligence has been done and decisions are made rationally, surely the directors of the acquiring company will only go ahead if the combination stands a very good chance of success.    

Behavioural finance attempts to explain how decision makers take financial decisions in real life, and why their decisions might not appear to be rational every time and, hence, have unpredictable consequences. Behavioural finance has been described as ‘the influence of psychology on the behaviour of financial practitioners’ (Sewell, 2005). Behavioural finance seeks to examine the following assumptions of rational decision making by investors and financial managers:

  1. Financial decision makers seek to maximise their utility and do so by trying to maximise portfolio or company value.
  2. They take financial decisions based on analysis of relevant information.
  3. The analysis of financial information that they undertake is rational, objective and risk-neutral.

Let’s look at how behavioural factors may influence decision making and, therefore, stock markets’ and companies’ financial strategies.


Maximisation of utility
Rational decision making by investors implies that their decisions about their investment portfolios will aim to maximise their long-term wealth and, hence, their utility. However, behavioural factors may influence investors to take decisions that are not the best ones for achieving maximum value from their portfolios. Investors may have preferences for particular stocks on non-financial grounds – for example, companies that they consider are acting with social responsibility. They may also avoid ’sin stocks’ – companies operating in sectors that they regard as unethical.

Investor utility may also be linked to the process of decision making. Some investors hold on to shares with prices that have fallen over time and are unlikely to recover. They may do this because it will cause them psychological hurt to admit, even only to themselves, that their decision to invest was wrong. This is known as cognitive dissonance.                  

Analysis of relevant information
Behavioural finance next looks at the basis that investors use to take decisions. It suggests that decisions may not be based on an assessment of relevant financial information, but on other grounds. Investors may use information that is not relevant but is readily available, possibly to simplify the decision making process (known as anchoring). For example, investors may buy shares that in the past have had high values, on the grounds that these represent their true potential values, even though rational analysis suggests that the prices of these shares will remain low in the future

Investors may also believe that the probability of a future outcome will be influenced by how often the same outcome has occurred in the past. A non-financial example of this idea would be the situation when a coin is flipped eight times, comes up as tails every time and it is said that heads is more likely the ninth time as, by the ‘law of averages’, heads must come up soon.

If the value of a company’s shares has risen for some time, investors will be using similar logic to the coin example if they sell those shares on the grounds that the shares have gained in value for ‘long enough’ and their price must therefore soon start to fall, even if rational analysis suggest that the rise in price will continue. This is known as the gambler’s fallacy.

Another deviation from rational analysis is the herd instinct, where investors buy or sell shares in a company or sector because many other investors have already done so. Explanations for investors following a herd instinct include social conformity, the desire not to act differently from others. Following a herd instinct may also be due to individual investors lacking the confidence to make their own judgements, believing that a large group of other investors cannot be wrong. If many investors follow a herd instinct to buy shares in a certain sector, for example the IT sector, this can result in significant price rises for shares in that sector and lead to a stock market bubble.

Investors may not therefore base their decisions on rational analysis, but there is also evidence to suggest that stock market ‘professionals’ often don’t do so either. Studies have shown that there are traders in stock markets who do not base their decisions on fundamental analysis of company performance and prospects. They are known as noise traders.

Characteristics associated with noise traders include making poorly timed decisions and following trends. Chartism, using analysis of past share prices as a basis for predicting the future, is an example of noise trading.

Fund managers may also be subject to behavioural influences. Fund managers who wish to give the impression that they are actively managing their investment portfolios, may periodically reposition their portfolios into new sectors, even though the old sectors continue to have good prospects. Some fund managers also ignore companies with low market capitalisation, with the result that their shares are not purchased and their value remains low (known as small capitalisation discount).  

Rational, objective and risk-neutral analysis
Investors may base their decision on an analysis of available information, but behavioural finance has highlighted that this analysis can be subjective. One aspect is confirmation bias, taking an approach or paying attention to evidence that confirms investors’ current beliefs about their investments and ignoring evidence that casts doubt on their beliefs. In the dotcom boom, some investors used a variety of methods to value high-tech companies at a large premium, but ignored models such as cash flow valuation models that indicated the worth of those companies was much lower.

Another aspect of investor bias is attitudes towards risks. Rational theory suggests that risk-neutral investors will adopt a long-term approach based on expected values. However, behavioural finance has highlighted various attitudes towards the risks of making profits or losses. Some investors may be attracted by a company that offers the possibility of making very high returns, even if the possibility is not very great (again, the dotcom boom provides evidence of this).

Other investors may have regret aversion, avoiding investments that have the risk of making losses, even though expected value analysis suggests that, in the long-term, they will make significant capital gains. Investors with regret aversion may also prefer to invest in companies that look likely to make stable, but low, profits, rather than companies that may make higher profits in some years but possibly losses in others.

There is also evidence that many investors pay most attention to the last set of financial results and other recent information about a company, and take less notice of data that has been available for a while. Explanations for this have included recent information being more readily accessible and more immediate in investors’ minds than older information. A consequence of this may be over-reaction when companies release information, with share prices rising or falling quickly after information is released and then going back in the opposite direction to an equilibrium value over time.

Behavioural finance also suggests that there may be a momentum effect in stock markets. A period of rising share prices may result in a general feeling of optimism that price rises will continue and an increased willingness to invest in companies that show prospects for growth. If a momentum effect exists, then it is likely to lengthen periods of stock market boom or bust.

Finance managers          

Behavioural finance studies have also looked at decision making by managers of companies. They have identified factors that affect investment decisions of all types, but particularly focused on mergers and acquisitions, since many do not appear to fulfil the expectations of the acquiring company.  

Maximisation of utility
Companies can be regarded as maximising their utility by long-term maximisation of their shareholders’ wealth. However, it is not just behavioural finance that casts doubt on whether company managers are seeking this objective for their shareholders. Agency theory also highlights that managers may have different objectives from shareholders, such as maximising their own short-term rewards and expanding the company by acquisition or other means in order to enhance their own reputation. 

However, behavioural finance has highlighted that managers’ objectives may not be explainable rationally. Studies have looked at contested takeovers, where different companies bidding against each other has forced the acquisition price up to a level that was significantly greater than many outside the companies involved thought was reasonable. One theory for this is that once managers enter into competition, it makes acquiring a company that others have sought to buy as well, a source of satisfaction in itself. The acquirer’s managers are unwilling to let someone else have what they have been trying to acquire (known as loss aversion bias).                  

Analysis of relevant information
There is also evidence that when managers choose to bid for another company, the factor is sometimes not a rational assessment of the target’s potential, but their belief in their own abilities. Some managers of acquiring companies seem to believe that, however poor the outlook for the target seems, their own considerable management skills will improve its prospects after the merger takes place. A symptom of this belief could be managers arguing that the target should be valued not using its own price-earnings ratio, but using the (higher) price-earnings ratio of the acquirer.

Once an acquisition or any other strategy has been implemented, what influences managers may be the need to show that they have made the right decisions. Managers may feel that a failing strategy would damage their reputation, and possibly their future prospects. Therefore, they may decide to commit more funds trying to ensure that the strategy is successful, rather than admitting defeat and taking steps to mitigate losses (known as entrapment).               

Rational, objective and risk-neutral analysis
Managers may also be subjective when they analyse information. Also, they may have confirmation bias, paying attention to information that suggests that an acquisition will enhance value and ignoring evidence that indicates that the target will not be a good buy. They may also seek information that provides a simple yardstick for their own decision making, however flawed that information may be. The value put on the target company by its own directors may be subject to considerable bias, but the acquirer’s directors may regard it as a good indication of what the target’s fair value is.  

Limitations of behavioural finance

Critics of the behavioural finance approach have argued that even if individuals make irrational decisions when left by themselves, participating in finance markets helps discipline them to act rationally by giving them opportunities to learn from their experiences. The consequences of irrational decisions are short-term anomalies. In the longer-term general theories, such as the efficient market hypothesis, will apply.


Behavioural finance has identified a number of factors that may take individuals away from a process of taking decisions to maximise economic utility on the basis of rational analysis of all the information supplied. If these factors apply in practice, they can lead to movements from what would be considered a fair price for an individual company’s shares, and the market as a whole to a period where share prices are collectively very high or low. For an acquisition, it can lead to a purchase price that differs significantly from what appears to be a rational valuation.       

If you’re asked in the Advanced Financial Management exam to consider behavioural factors that may influence the decisions of investors or managers, you’ll need to read the question scenario very carefully. Look out for information about how investors or managers may be taking decisions, or factors in the situation that may trigger biases that the decision makers have.

You may not be able to come to a firm conclusion about what decision makers will do and why, but you should be looking to discuss various possibilities. Bringing real life into your answer has to mean questioning the assumption that all financial decisions are taken rationally, and at least admitting that behavioural factors may influence decision makers.     

Written by a member of the examining team for Advanced Financial Management