Behavioral Finance - And the Change of Investor Behavior during and After the Speculative Bubble At the End of the 1990s

Abstract: The apparent high valuations in the aggregate market and the high price earnings ratios, experienced in the equity markets at the end of the 1990s, can be characterized as a so-called speculative bubble. The existence of such a phenomenon can in part be attributed to less-than-rational aspects of investor behavior and human judgment. The purpose of this thesis is to conduct a research on how private as well as institutional investors have changed their investment behavior as a consequence of the speculative bubble during the period from fall 1998 to March 2000. Our purpose is to establish what factors lie behind the speculative bubble and further investigate whether the investment objectives and factors influencing investment decision-making are different today than during the speculative bubble. Behavioral finance provides the fundamental theoretical framework for this thesis. The empirical research is based on a questionnaire directed towards active private investors in Sweden, more specifically members of the Aktiespararna Association, and institutional investors mainly resident in southern Sweden. The results obtained suggest that the behavior of market participants during the speculative bubble was to some extent irrational and that the composition of investments has changed as a consequence of the speculative bubble. During the steep rise in value of the equity market, information from companies was the most important factor influencing investments among both private and institutional investors. However, it was considered as the least significant reason for the overvaluation of the market. When comparing the time period after the speculative bubble, information from companies gained importance for both groups of investors, especially institutional investors. This indicates an increase in the importance of fundamental data and valuations today than during the speculative bubble when intuition and other more vague valuation methods seemed to have influenced investments to a greater extent. Furthermore, the results indicate herd behavior as an important contributing factor to the overvaluation as well as the decline of the market. Both groups of investors also consider the forecasts of analysts as an important factor contributing to the overvaluation of the market but not as important when considering reasons for the market decline. The importance of analysts’ forecasts to the overvaluation of the market suggests that analysts do share some blame for the IT bubble. The results show that the fall in market values after March 2000 was mainly due to earnings and profitability of companies, or a lack thereof. Overconfidence is another concept in behavioral finance that seems to have influenced investment decision-making strongly during the speculative bubble and may help explain the observed irrational behavior of investors. The fact that the market today is considered undervalued by a majority of investors may also imply the existence of overconfidence. This contradicts the efficient market hypothesis and implies that investors believe they can beat the market and overestimate their talents while underestimating the likelihood of bad outcomes. This thesis supports, to some extent, the assumption that even though a majority of the investors during 1998 to 2000 seem to have realized the seriousness of the speculative bubble they nevertheless continued their investment activities knowing that the risk for a collapse was imminent. A more common understanding of factors underlying speculative bubbles and the way in which psychological factors affect our decision-making should help to avoid the occurrence of such phenomenon and enhance the efficiency of today’s global financial markets.