Ingeniería del Proyecto

In recent decades, financial and economic literature argues that investors’ trade is rational, even if they are engaged in trade irrationally (such as random trade). The deviation from equilibrium caused by the irrational trades can be offset by other irrational trades from other irrational investors. Hereby, it can be presumed that the market is effective, and all isolated rare events cannot significantly affect the price-making process, which may naturally reduce market return and trade volatility. The Efficient Markets Hypothesis has achieved a success in academia since the mid-1960s with impressive theory and been deemed as academic orthodoxy (Jensen, 1978). However, the Efficient Markets Hypothesis has been seriously challenged and criticized by the behavioral economics in the recent three decades.

The Effective Market Hypothesis argues that asset prices generally reflect all relevant basic information and provide appropriate resource allocation signals, but some researchers try to test if the actual mode of operation of the economy is affected by human psychology. Keynes

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realized the problem in 1936 for the first time and made a clear statement. He held that all investor decisions are deviated from rational assumptions and he attributed economic failure to psychological factors and irrational behaviors - animal spirits. Based on experiments, Tversky and Kahneman (1986) posed direct challenge on rationality assumptions of human behaviors, in which experimental subjects’ preferences were affected predictably by the framing of decision problems, or by the procedure used to elicit performance. That is to say, human sensitivity of framing violates the basic assumptions about the rationality of human behavior. Later, Keynes’s viewpoint was inherited and developed by Akerlof and Shiller (2009). Akerlof and Shiller (2009) replaced the rational hypothesis with investor’s behavior bias to explain the fluctuations in stock returns and trading volume. They argued that the concrete framework of behavioral economic explanation should inclusive of changing confidence, temptations, envy, resentment, and illusions, and all those sentiment had been witnessed in the financial crisis of 2008.

Animal spirits phenomenon can be understood as the investor-driven irrational behavior. Keynes (1936) held that for most cases, the full consequences of people’s decision is uncertain and is not the outcome of cool-headed calculation, which can only be deemed as the results of animal spirits. In this particular framework, Keynes defined the animal spirits as “a spontaneous urge to action rather than inaction”. However, Akerlof and Shiller (2009) extended this definition to include optimism and pessimism. Therefore, Animal Spirits include spontaneous behavior as well as optimistic and pessimistic beliefs.

Previous literature (De Bondt and Thaler, 1987; Barberis et al., 1998; Daniel et al., 2001) linked stock price volatility and price anomalies with underreaction and overreaction. Underreaction and overreaction are driven by the investors’ pessimism, optimism and overconfidence. On this line, early studies such as Ciccone (2003) show that investor sentiment and behavior plays a decisive role in the stock market. Investors’ optimism and pessimism are particularly reflected in the stock price. Haruvy et al. (1999) argued that optimistic investors are those who incline to choose the potential investment strategy with highest payoff. These authors define optimistic investors as “those who are motivated by worst-cases scenarios and hence tend to choose a secure action.” Wenstein (1980, 1986, 1989) and Otten (1989) argued that optimistic investors consider that positive events have greater probability of happening on them while negative events are unlikely to occur as compared to other investors. On the contrary, pessimistic

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investors hold that they are more likely to be exposed to negative events while are unlikely to have positive events. These beliefs have led to an increase in the trading of optimistic investors, while a decrease in the trading of pessimistic investors. In terms of trading strategy, Chen (2013) deemed that optimistic agents will be more positive in trading while pessimistic agents will be relatively conservative in trading.

King (2009) agreed with Akerlof and Shiller (2009) and discussed the key role of investors’ irrational behavior, such as optimism or pessimism, or more specifically, what they call animal spirits. His conclusion is that behavioral bias can explain the main part of the economic fluctuations. Optimistic and overconfident investors are more inclined to risky investment. They are engaged in the trades irrationally, and their irrational reaction will lead to abnormal fluctuations in trading volume, and then will affect the stock returns. Empirical studies show that irrational investor behavior not only exists in the international stock market, but also has a significant impact on price fluctuations (Chuang, 2010).

Another important psychological factor affecting the stock market is overconfidence. Overconfident investors will overemphasize the accuracy of the information they own, while ignoring public information (Daniel, et al., 1998). They also overestimate their ability of judgment while underestimating the ability of others. As a result, they have overreacted to private information and underreacted to public information (Odean, 1998). The asymmetric reaction of overconfident investors leads them to underestimate the risks and take positive actions to increase the trading volume (De Long et al., 1990; Kyle and Wang, 1997; Benos, 1998; Odean, 1998; Wang, 1998,2001; Daniel et al., 1998; Hirshleifer and Luo, 2001), and De Bondt and Thaler(1985) argued that overconfidence is a key behavior factor in unlocking the mystery of market transactions. In particular, Gervais and Odean (2001) have developed a model, which is used to predict that overconfident investors attribute market returns to the accuracy of their private information, their ability of judgment and their ability to choose the stock; and sustained wealth accumulation also leads them to overreact in the market.