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Introduction

The purpose of any investment is to make a profit and create wealth. While the financial goals may vary – from funding a foreign vacation to building a nest egg – the main motive is to get more returns than those possible with traditional banking products. While some investors may be more willing than others in terms of taking a higher level of risk, one thing is certain – nobody wants to lose money. However, many investors often react in an irrational, reckless or hasty manner to market changes. But why do investors make such knee-jerk decisions?

Behavioral finance is a discipline that focuses on finding out how human psychology affects the decision-making process of investors and the financial markets. It explains why investors make decisions based on their biases, emotions, and personal experiences instead of rational decisions backed by data and research.

The concept of behavioral finance dates to 1912 when George Seldon published “Psychology of the Stock Market.” However, the theory gained popularity and momentum in 1979 when Daniel Kahneman and Amos Tversky proposed that most investors tend to make decisions based on subjective reference points rather than objectively choosing the best option.

Market Efficiency and Behavioural Finance

In the world of finance, market efficiency is a concept that has been debated for decades. The efficient market hypothesis (EMH) suggests that stock prices always reflect all available information, making it impossible to consistently achieve returns that are higher than average. However, behavioral finance challenges this idea by suggesting that investors are not always rational and that their emotions and biases can impact their investment decisions. This is due to a variety of psychological biases and tendencies which are discussed in detail in the later portion.

The FOMO Phenomenon of Investing

FOMO, or Fear Of Missing Out, reflects the psychological aspect of investing where individuals are influenced more by emotions and the fear of missing out on market opportunities than by objective numerical analysis.

When it comes to investments, the fear of missing out or FOMO can strike when there is a big rally or newly surfaced exciting opportunity that has a lot of buzz. If an investor is feeling anxious or regretful because others are making money on an investment’s price movement and they’re not, it’s a sign of FOMO.

Ultimately, the desire to be part of the bandwagon and make money off the same trading vehicle others are profiting from could result in an investor entering a position at an inopportune time, or without appropriately vetting the idea and risks.

The FOMO syndrome is one of the primary reasons for the continual cycle of rise and fall in the price of financial securities. Some investors decide to buy or sell a financial instrument based on market sentiment (what everyone else feels). When prices are booming, they pile in, stoking demand and increasing prices further. Then, when prices are heading the other way, they sell or sit on their hands. This change in demand and supply is based on feelings rather than fundamental economic shifts and this can cause market booms to be frothier and slumps to be deeper and more prolonged.

Let’s analyse the four main parts of the Financial Markets cycle and dig into the Psychology

Boom

The first stage of the cycle is the boom. Here, securities prices are rising, and investors feel it’s a great time to be in the market. In the hope of making quick returns, others join in or they bring forward their purchasing decision i.e. they buy securities today that, in other circumstances, they would have purchased a few years into the future. This increases demand in today’s market, causing prices to rise further.

This creates FOMO (fear of missing out) and causes some investors to overpay for the securities. Investors who get into the market early in the boom will do well. Investors who get in too late risk paying higher prices than if they had waited.

Peak

At the peak of the market, most investors are elated. They can’t believe how well they have done. And a good number of people are still buying, which helps prices to remain high. But then FOMO begins to be replaced with FOOP (the fear of overpaying) – and investors worry that prices are too high and will fall in the future. This causes some buyers to pull back from the market and the people who pulled their purchases forward have now satisfied their demand. They don’t need to buy again.

The worry of falling prices causes a self-fulfilling prophecy. People are worried about falling prices, so they hold back from the market, this decreases demand, and prices start to fall.

Downturn

In the downturn phase, prices fall firmly. FOMO has gone, and FOOP is entrenched. The herd mentality comes back where some investors panic and sell. Then others follow, thinking that they need to get out, too. This decrease in demand and increase in supply causes prices to fall, and the self-fulfilling prophecy is proved true again.

At this point, sophisticated investors enter the market searching for financial securities at a bargain. They’ll negotiate hard, especially with panic sellers who are more emotionally driven.

Trough

Once in the trough, prices have bottomed out. Despite it being one of the best times to buy – since prices are at their lowest – however there is a large proportion of investors who are highly hesitant to invest at this time because they believe that the market/securities of a company is never going to rise again.

At some point, an economic event will kick-start a new boom, and the whole cycle will begin again. However, usually true at a macro level, it is not necessary for the cycle to repeat in case of every security throughout the financial market. There are possibilities where the fundamentals or operations of a specific organisation are beyond recoverable and the boom phase doesn’t occur again for its securities due to no demand and no expectation of price rise in the future.

Concepts of Behavioral Finance

Mental Accounting

People partake in mental accounting when they assign money to different spending categories or “accounts.” They refuse to move money between accounts because they categorize their funds so that only specific sums can belong in each account. This way of thinking stems from the disbelief that money is fungible, meaning that its value remains the same no matter where you store it.

Herd Mentality

It refers to the tendency for individuals to follow others’ financial decisions, instead of doing their own research and analysis. For example, if a person notices others are investing in a certain stock, it may motivate them to do the same. To avoid herd behavior, individuals could do their own research to make financial decisions and measure their risk. Historically, herd behavior can start large sell-offs and market rallies in the stock market.

Emotional Gap

It describes when an extreme emotion motivates an individual’s financial decisions. In finance, the emotions that often comprise an emotional gap are anxiety, greed, enthusiasm and fear. These are the key reasons people make irrational decisions. Fear and greed can harm portfolios, affecting the stability of the stock market and the economy. Finance professionals often strive to advise individuals against these trends, offering long-term plans based on firm fundamentals and rational advice.

Self-attribution

It is the tendency for someone to make decisions based on an overestimation of their skill. This can mean someone considers their knowledge above the level of other professionals. This bias could lead to incorrect decision-making because it doesn’t factor in outside influences and expertise. People can avoid self-attribution by listening to the advice of financial professionals and researching the possible outcomes of a decision before committing to it.

Anchoring

It is the common inclination that you have to make decisions based on previously accepted information or the first piece of information you learn about a topic. Sometimes, this can lead to more informed decision-making. Other times, bias skews your abilities to come to logical conclusions, make accurate estimates or select suitable choices. Rather than viewing new information objectively, victims of bias compare any new information they receive to their reference point, which may not always be an accurate representation of a topic.

Cognitive Biases associated with Behavioral Finance

Overconfidence Bias

Overconfidence is an emotional bias. Overconfident investors believe they have more control over their investments than they truly do. Since investing involves complex forecasts of the future, overconfident investors may overestimate their abilities to identify successful investments. In fact, experts often overestimate their own abilities more than the average person does.

The table clearly indicates that traders who trade excessively (active traders) actually underperform the market indicating how overconfidence bias can lead to lower returns.

Loss Aversion Bias

According to the loss aversion bias, investors are more sensitive to loss than to risk and possible return. In short, people prefer to avoid loss over acquiring an equivalent gain. Experiencing a loss or facing the possibility of a loss might even induce risk-taking behaviour that could make losses even more likely or more severe. Many investors don’t acknowledge a loss until it is realised. Therefore, to avoid experiencing the pain of a “real” loss, they continue to hold onto an investment even as their losses from it increase.

For example- When asked to choose between receiving $900 or taking a 90% chance of winning $1000 (and a 10% chance of winning nothing), most people avoid the risk and take the $900. This is despite the fact that the expected outcome is the same in both cases. However, if choosing between losing $900 and take a 90% chance of losing $1000, most people would prefer the second option (with the 90% chance of losing $1000) and thus engage in risk-seeking behavior in hopes of avoiding the loss.

Confirmation Bias

Confirmation bias occurs when an investor quickly accepts any information that aligns with their own personal beliefs as a fact. Due to this type of bias, investors are more likely to believe that this type of information is correct without any facts or data to support it. Confirmation bias can also make investors less likely to accept facts that go against their already-held beliefs. This bias could entice you to select underperforming investment options or fail to determine when the right time to sell is.

Availability Bias

Some people rely too much on information that is easily available. Availability bias can be considered as a reluctance to undertake thorough research, which can be due to the huge choice of stocks and funds available: investors often only consider assets that are brought to their attention.

Endowment Bias

Also called the status quo bias or mere ownership effect, endowment bias describes how people overvalue something they already own. Research has shown how owners value their possessions far more than potential purchasers. Every security in a portfolio should be re-evaluated on a regular basis with your advisor, but this can become difficult because of choice supportive bias (the tendency to feel positive about something because you chose it). This behavioural finance bias is stronger with investors and advisors who built their own portfolios.

Role of Social Media and Technology to create FOMO

Scholars argue that social media is a successor to radio and television, but this claim lacks sufficient scientific evidence. The prevailing scientific literature supports the notion that FOMO and feelings of anxiety, discomfort, and fear of missing out on positive experiences are amplified with the emergence and omnipresence of social media. Social interaction and comparison between individuals, their lives, and achievements in the 21st century are no longer an analogue process, as they were in the 20th century.

The phenomenon of social media has given rise to thousands of subcultural vloggers and bloggers, who have become the subject of comparison, envy, and ultimately the detriment to the mental well-being of millions of social media users.

The FOMO effect is a phenomenon where individuals are drawn to the positive aspects of their peers, friends, and colleagues, leading to a distorted perception of their own lives. Social media users often present an idealized, optimistic picture of their lives, causing feelings of envy and jealousy. This can lead to disappointment and dissatisfaction, as they compare themselves to others. The increasing number of social media users, such as Facebook, has further amplified the influence of the FOMO effect, leading to frustration and dissatisfaction.

The Role of Social Media in Fueling Hype and FOMO

With billions of users each day, social media has become an essential aspect of our lives. It has changed how we exchange information, communicate, and even make decisions. Social media has contributed significantly to the cult stock excitement and FOMO (fear of missing out) in recent years. It has developed into an effective instrument for investors to generate excitement about a specific stock, raising its price and instilling a sense of urgency in prospective purchasers. This section will examine how social media contributes to FOMO and hype, as well as how it affects the stock market.

1. Social media as a means of sharing information– Social media has developed into a forum for exchanging news, information, and stock-related viewpoints. Due to the fact that they offer real-time stock market updates, platforms like Twitter, Reddit, and Stocktwits have gained popularity among investors. These platforms have made it possible for investors to communicate their stock-related insights, analyses, and projections, which may have an impact on other investors’ choices. A well-known investor tweeting about a certain stock, for instance, can generate talk about it, draw in more purchasers, and raise its price.

2. Using Social Media to Gather Market Sentiment– Additionally, social media is now a source of market sentiment. Social media platforms are used by investors to determine how other investors feel about a specific stock. To find out how popular a stock is with investors, they can look at how many mentions, likes, and shares it has received. Their choices to purchase or sell stocks may be influenced by this knowledge. Investors may feel pressured to purchase a stock if it is trending on Twitter, for instance, out of concern that they may lose out on possible profits.

3. Pump and dump strategies using social media- Pump and dump schemes, in which investors inflate the price of a company and then sell their shares at a profit, leaving other investors with worthless shares, have also been made possible via social media. Although pump and dump systems are against the law, they are hard to find and stop. Due of the ease with which investors can fabricate accounts and sway market sentiment, social media platforms have become a haven for these schemes.

4. How Social Media Affects the Stock Market- Social media has a big effect on the stock market. It has the ability to raise a stock’s price and draw in more purchasers by generating FOMO and hype around it. Social media can, however, also lead to stock market volatility because the excitement surrounding a given stock might fade rapidly, resulting in a sharp decline in price. Additionally, investors may make irrational judgements based on erroneous or incomplete information as a result of social media’s ability to generate fake market sentiments.

Research on Gen-Z and Investing: Social Media, Crypto, FOMO, and Family

Gen Z investors use a variety of resources to learn about investing and financial topics; online resources and personal connections dominate.

With many resources at their disposal, Gen Z investors learn about investing and finances primarily through social media (48 percent), internet searches (47 percent), parents/family (45 percent), and friends (40 percent).Taking a closer look at how Gen Z investors ages 18 and older use online resources, YouTube is the top source (60 percent of those who use online resources). Other key online sources include internet searches, Instagram, TikTok, Twitter, Reddit, and Facebook

Gen Z investors are more reliant on social media and family for financial information, while millennials and Gen X investors are more likely to leverage financial companies and professionals, along with internet searches.

When it comes to preferred information sources about investing and financial topics, each generation the study examined exhibits distinct characteristics : The top financial information sources for Gen Z investors are social media, internet searches, and parents/family. For millennial investors, the top three sources of information about investing and financial topics are internet searches, social media, and financial professionals. And for Gen X investors, the top three sources are internet searches, financial companies, and financial professionals.

Role of FOMO in creating Asset bubbles

Bubbles are defined as an asset’s market price exceeding its underlying value, indicating mispricing. However, not all temporary mispricing corresponds to a bubble, as they represent a rapid and continuous price increase. Bubbles occur due to successive price increases, creating an expectation of future price increases and attracting new market investors. This increase causes prices to rise further, but this increase ends with high expectations being reversed, causing the bubble to burst. Hyman Minsky developed a more detailed distinction for bubble formation, addressing five stages: displacement, boom, euphoria, profit-taking, and panic. The first stage is displacement, where financial innovations increase expectations of future profits, leading to a boom stage where asset prices increase exponentially, exceeding their fundamental value.

The euphoria stage is euphoria, where investors believe they can sell assets to unsophisticated investors, maintaining asset trading. The fourth stage is profit-taking, where experienced investors reduce their investments by taking profit.

Bubbles can arise due to various dynamics, with four models proposed by Brunnermeier (2016). The rational bubble model assumes investors are rational and share identical information, leading to bubbles when trading opportunities are available. The asymmetric information bubble model suggests traders hold overvalued assets with the expectation of reselling them to unsophisticated investors or those with divergent expectations. The heterogeneous belief bubble model suggests investors’ divergent prior experiences, leading to different investment decisions and psychological bias. The fourth model suggests bubbles can emerge due to limited arbitrage, which offsets mispricing by irrational investors. However, fundamental, noise trader, and synchronization risks prevent rational investors from opposing irrational transactions, causing bubble behavior to prevail. Overall, bubbles can occur due to various factors, including irrational traders, short-selling restrictions, and limited arbitrage.

Markets + FOMO = Bubble Trouble: Example of Asset Bubbles in the past

2021 NFT Bubble: NFTs– digital pieces of art were sold for millions of dollars driven by the belief that these will have a long-term value. Well, look at how that turned out. By the end of 2022, the market value of these assets will be reduced by 98%. Just like you need the right soap solution and technique to blow bubbles, certain conditions need to be present for an economic bubble to form. The combination of speculation, low interest rates, positive feedback loops and the belief that the prices will keep rising make the perfect bubble in the economy: promising a lot of profit but quite delicate.

The Internet Boom and the Dot-Com Bubble: in the late 1990s the dot- com bubble grew due to the rapid growth of internet related companies. Investors bought shares of companies with little to no profit history. The bubble inflated and so did the stock prices. When these companies failed to deliver profits, the bubble burst, leading to collapse of many tech companies and steep decline in the stock market.

The South Sea Bubble of 1720: The South Sea Company, granted a monopoly to trade with South America, became the focus of speculation in England. Investors bought shares in the company at inflated prices, driven by rumors of untold riches. When the company’s value was revealed to be vastly inflated, the bubble burst, causing significant financial losses.

The Crypto Craze of 2017: The rise of cryptocurrencies, particularly Bitcoin, has sparked a speculative frenzy reminiscent of past bubbles. In 2017, Bitcoin’s price skyrocketed, drawing investors and media attention. However, its value subsequently experienced significant fluctuations, underlining the volatile nature of the cryptocurrency market. It’s hard to say if cryptocurrencies were actually a bubble or not. The volatility of the market and speculation sent the prices through the roof and also resulted in some losses. Instead of bringing the economy down, crypto did prove to be beneficial, promoting innovation and investment into a decentralized financial system. Although sometimes bubbles can have such benefits, the risks definitely outweigh them.

Causes of market bubbles

Now that you know about the stock market bubbles, the obvious question you will have is – why do market bubbles form? To be honest, it is different to tell a reason because if you look at history, every time, there is a different reason, and the causes are complex. Easier to understand once they have burst but difficult to see as they form. However, let us look at some common factors which lead to it:

• Speculation and Herd Mentality: As the stock prices begin to rise, some investors jump in not because of the asset’s underlying value, but because they expect prices to keep climbing. It can create a self-fulfilling prophecy, as more and more people buy in, pushing prices even higher.
• Irrational Exuberance: Sometimes, a sense of euphoria takes hold of the market, fueled by positive news stories and a belief that prices can only go up. It can lead to investors making illogical decisions based on emotions rather than a careful evaluation of the asset’s value.
• Lack of Regulation: A lack of regulations can create an environment where risky behavior is encouraged. It can contribute to the formation of bubbles, as investors may be less likely to be concerned about the potential for a crash.
• New Technologies or Industries: The emergence of new technologies or industries can sometimes lead to bubbles, as investors get caught up in the hype and excitement surrounding the potential for future growth.

Ways to identify a stock market bubble

It is not an easy task, but doable. There are a few things you can monitor to figure out if a bubble is forming in a stock, industry, or the overall market. Here are a few things to evaluate:

• High P/E Ratios: A high P/E ratio can indicate that the stock is overvalued relative to its current profitability. However, it is essential to consider the industry average P/E ratio as well, because some sectors naturally have higher P/E ratios than others.
• Low ROE: ROE measures how effectively a company uses shareholder equity to generate profits. A low ROE suggests that the company may not be generating enough return on its investments, which could be a red flag if stock prices are rising rapidly.
• Strong momentum in the prices: Rapidly rising stock prices can be a sign of a bubble, especially, if they are not supported by strong fundamentals such as earnings growth. This momentum is often fueled by speculation and FOMO (fear of missing out).

Effect of stock market bubbles

A market bubble is not good both for investors and businesses. However, in this section, we will focus on the two major effects the stock market bubble can have on investors:

• Loss of Wealth: The most immediate and widespread effect is significant financial losses for investors who hold stocks when the bubble bursts. It can range from retirees losing their nest eggs to young investors seeing their dreams of financial security evaporate.
• Erosion of Trust: Bubbles can erode trust in the financial system, leaving investors feeling burned and hesitant to participate in the market in the future.

How FOMO affects different niches of Investors

FOMO stems from the anxiety of potentially missing lucrative investment opportunities and often leads to impulsive decision-making. However, the way retail and institutional investors approach FOMO differs significantly due to variations in their resources, expertise, objectives, and risk management capabilities.

Retail investors, often characterized as individual or small-scale market participants, are significantly more susceptible to FOMO due to their limited access to resources and professional advice. Their investment decisions are often influenced by emotional triggers rather than in-depth analysis.

Social media platforms like Reddit, Twitter, and YouTube are particularly impactful in shaping retail investors’ behavior. These platforms frequently highlight stories of extraordinary gains, creating a sense of urgency and a herd mentality. Retail investors often enter markets during peak hype, driven by the belief that they might miss out on significant profits if they do not act quickly.

For example, during the cryptocurrency boom in 2020-2021, retail investors heavily flocked to assets like Bitcoin and Dogecoin. Many entered at the height of the frenzy, only to face losses when prices corrected. A survey by Charles Schwab revealed that over 50% of retail investors admitted to making decisions based on FOMO, with most of these decisions leading to suboptimal outcomes due to a lack of proper analysis and risk assessment.

Another defining trait of retail investors influenced by FOMO is their inclination toward short-term gains. The promise of rapid returns often leads them to over-concentrate their investments in trending assets, neglecting diversification. This lack of a long-term perspective and insufficient diversification increases their exposure to volatility and market downturns.

Institutional Investors’ Approach to FOMO

Institutional investors, which include hedge funds, mutual funds, pension funds, and investment banks, operate with a far more structured and data-driven approach. Their decisions are guided by robust research, financial models, and risk management frameworks. While institutional investors are generally more rational, they are not entirely immune to FOMO, especially in highly competitive or rapidly evolving sectors.

FOMO among institutional investors often arises from peer performance pressure. In an industry where success is measured against benchmarks or competitors, institutions may feel compelled to align with market trends to avoid underperformance. For example, during the rise of artificial intelligence (AI) in 2023, many institutional investors increased their exposure to AI-related stocks, driven not only by growth potential but also by the fear of lagging behind their peers.

Unlike retail investors, institutional investors mitigate FOMO-induced risks through diversification and hedging strategies. Even when they enter trending markets, their portfolios are well-balanced to absorb potential downturns.

Differences in disposable income

Disposable income, defined as the amount of income left after deducting taxes and mandatory expenses, significantly influences investment behavior. Retail and institutional investors operate in vastly different financial landscapes, with disposable income being a critical factor in shaping their risk tolerance, investment strategies, and overall market impact.

Retail investors typically have limited disposable income compared to institutional investors. A report by Statista highlights that the average annual disposable income of middle-class households in the United States is approximately $65,000. However, only a fraction of this amount is available for investments after covering living expenses, loans, and savings.

This limitation forces retail investors to focus on smaller, often high-risk investments in hopes of achieving higher returns. Cryptocurrencies, penny stocks, and speculative assets tend to attract retail investors, as they perceive these options as opportunities to multiply their modest capital quickly. Unfortunately, this approach often leads to higher exposure to market volatility.

During the 2021 cryptocurrency surge, over 60% of retail investors allocated more than 20% of their disposable income to digital assets, according to a study by CoinDesk. When the market corrected, many of these investors faced significant financial setbacks, underscoring the vulnerability created by limited disposable income.

Institutional investors operate with significantly larger financial resources. These entities manage pooled funds from various sources, including pensions, endowments, and sovereign wealth funds. According to Preqin, the average institutional investor oversees $2 billion in assets under management (AUM), with a large portion allocated for investment purposes.

Unlike retail investors, institutional players have the advantage of accessing consistent cash flows and diversified funding sources, allowing them to invest substantial amounts without jeopardizing financial stability. This financial cushion enables institutions to pursue long-term investment strategies, focus on stable returns, and diversify portfolios across multiple asset classes and geographies. Institutional investors maintained their positions in blue-chip stocks and diversified their holdings into emerging markets, real estate, and renewable energy. Their higher disposable income allowed them to capitalize on market downturns, buying undervalued assets while retail investors struggled to maintain their portfolios.

Regulatory Environment and Government Laws

SEBI’s New Guidelines to Tackle Market Rumours

India’s financial markets are poised for significant changes as the Securities and Exchange Board of India (SEBI) introduces new regulations aimed at addressing the impact of market rumours on stock prices. These rumours often lead to speculative trading, creating unnecessary volatility that undermines investor confidence and market stability. SEBI’s new measures, outlined in a circular issued on May 21, 2024, seek to promote transparency, accountability, and fairness in the stock market. These guidelines, set to be implemented in phases, mark a significant step toward safeguarding the integrity of the Indian financial ecosystem.

The new regulations will be implemented in two stages. Beginning June 1, 2024, the top 100 listed companies will be required to comply with these guidelines. By December 1, 2024, the next 150 companies will also fall under the purview of these rules, bringing the total to 250 listed entities. This phased approach ensures that companies have sufficient time to adapt to the new requirements, making the transition smoother and more effective.

One of the core provisions of these guidelines is the mandatory verification of market rumours. Companies are now obligated to closely monitor significant movements in their stock prices that may be linked to unverified information circulating in the market. If such a movement occurs, the affected company must respond within 24 hours, either confirming or denying the rumour or providing necessary clarifications. This immediate response requirement is expected to reduce speculative trading and ensure that investors are not misled by unfounded claims.

A unique aspect of the guidelines is the introduction of the “unaffected price” concept, designed to provide a more accurate reflection of a stock’s value, free from the distortions caused by rumours. To determine this unaffected price, SEBI mandates the calculation of an adjusted volume-weighted average price (VWAP).

By incorporating this adjusted VWAP, SEBI aims to ensure that key transactions such as preferential share issues or open offers are fairly priced, reflecting the true market conditions rather than temporary fluctuations driven by speculation.

The delayed implementation of these guidelines, originally planned for February 2024, highlights SEBI’s commitment to ensuring that companies have adequate time to prepare for compliance. Starting with the top 100 companies in June and expanding to the next 150 by December, the market regulator aims to create a controlled and systematic rollout of these measures, allowing for efficient integration into the existing regulatory framework.

SEBI’s guidelines reflect its proactive stance in addressing the challenges posed by misinformation in the stock market. By enforcing stringent rules on market rumours and ensuring that stock prices are based on verified information, the regulator aims to protect investor interests while promoting a transparent and fair trading environment. These measures not only curb speculative trading but also lay the groundwork for a more resilient financial market, fostering long-term confidence among market participants.

 

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