Rapp, H. (2000). Behavioral Finance: Paradgimenwechsel in der Kapitalmarktforschung (S. 87-116).

1 Introduction
There is no doubt about the fact that a big part of the daily happenings at exchanges is influenced by
psychologically factors. Spectacular and partly unexplained developments in stock exchange, such as
the worldwide stock market crash in October 1987 or the so-called “East euphoria” of 1990 in
Germany, mark at the end clear visible signs. Despite of the readiness of taking the factor
“psychology” at exchanges seriously in such phases, there is a widely uncertainty regarding the cause,
the extent and the importance of psychological phenomenon at stock exchanges. This deficit is also
attributed to the hesitant scientific confrontations between new theories and explanation models.

Starting from the “grey theory” that is the prevalent opinion of the textbooks with the subject on
capital markets, there should be following tried to bring more light in the widespread Darkness of
human behaviour at stock markets. In the foreground there is the question if individuals are
succumbing by systematic anomalies in behaviour, which are caused or strengthened by certain market
situations or environmental impacts. In this case models to explore the behavioural psychology of the
exchange participants could provide useful references for actual and future market behaviour. This
question will be pursued later in a practically oriented contemplation.

Hereby it is clear that in speculative markets (especially in stock exchanges) there can be identified
indeed characteristic market phases, which are resulting from psychological factors and define in
particular cyclic market turning points. Such market phases are marked regularly by external
behaviour patterns, so as collective greed or panic. They can be determined with special indicators
very precisely and represent important “Flood marks”, based on these portfolio managers can estimate
future chances and risks at the investment markets.
As a summary ones can say that psychological factors have (at least during some phases) a significant
and well predictable influence on stock markets. Furthermore, the “daily mania at stock markets” has a
system.

2 the grey theory: modern capital market theory and its deficit
Since more than 20 years, the so called “modern capital market theory” is part of both, the credo of
fiscal academics as well as a daily tool for portfolio managers around the world. As “modern capital
market theory” we denote the unsharp defined characteristic of theoretical structure with risk
minimizing (diversification) and general information about the information-processing as well as the
behaviour of the participants of speculative markets. The risk minimizing by diversification (based on
Harry Markovitz) is empirically proved and generally accepted. The others, more speculative
assumptions of the “modern capital market theory” are more in case of doubt.

The elements of the “modern capital market theory” are based on the so called “market efficiency
hypothesis” which was formulated by a group of professors from the USA by the end of 1960.
Especially the Nobel Prize winners James Tobin and William E. Sharpe as well was Professor Eugene
F. Fama from Chicago made great effort to arise and spread the theory. Essentially, the market
efficiency hypothesis is based on the assumption that capital markets be in conformity with the ideal
imagine of efficient markets. A market is deemed to be efficient if multiple participants and quick
information-processing lead to perfect competition.

Therefore, efficient markets should not allow generating additional value through individual
consideration of investments, as all information of relevance should already be included in the market
prices. In the 70s, Eugene F. Fama formulated this hypothesis of the so-called information efficiency
of the capital markets and since then it serves as a benchmark for the description of real capital
markets.
The central problem of the market efficiency hypothesis – and therewith of the modern capital market
theory – lies in a simplifying, but extremely important hypothesis: the assumption that all market
participants act strictly rational and according to the axioms of the so-called expected utility theory. It
is implied that participants at speculative capital markets take transaction decisions that are based on a
complete processing of all relevant information as well as in pursuance of an economic balanced
assessment of the utility. In total, this leads to the assumption that a great number of market
participants reacts identically towards new information and thus creates homogenous expectations.
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Rapp, H. (2000). Behavioral Finance: Paradgimenwechsel in der Kapitalmarktforschung (S. 87-116).

Only through this degradation of the real market participants toward the abstract model of the Homo
Oeconomicus, the representatives of the efficient market hypothesis are allowed to apply the
mathematically elegant models that are underlain and to defend it within professional discourses.

3 Too many anomalies: the overdue change of paradigm in capital market theory

The deeply ingrained notion of the behaviour of real market participants within modern portfolio
theory has been criticised for several years. Therefore, within a great number of scientific studies,
contradictions, deficiencies and poor empirical explanatory power of the efficient market hypothesis
have been pointed out. From a mathematical point of view, it is important that the modern capital
market theory is completely based on the so-called Gaussian statistics and the normal distribution
hypothesis that is derived from it.

Significant mathematically is in particular the fact that the modern capital market theory completely
based on the principles of the so-called Gaussian statistics and the derived normal distribution
hypothesis.
This assumes that numerous scientific phenomena to detect in their real forms by the static properties
of a so-called normal distribution and can be represented mathematically.
Most outstanding characteristic of a normal distribution, the symmetry of the distribution curve:
Positive and negative deviations from the average are uniformly distributed, so that likelihood and
degree of positive or negative fluctuations about the mean by statistical measures such as variance or
standard deviation can be calculated reliably.
This mathematical digression is necessary to reveal the dimension of a potential problem: Almost all
of today highly popular (mostly computer based) models for optimizing investment portfolios, risk
management in securities trading and option pricing - thus ultimately the entire institutional
investment management - based on the fundamentals of the Gaussian statistic.

In particular, the well-known, developed by later Nobel laureate William F. Sharpe and today in
practice widespread capital asset pricing model (CAPM), but also the so-called Black / Scholes model
for valuing options follow the simple logic of the normal distribution hypothesis.

The mathematical elegance, but also the explanatory power of modern capital market theory and all
the accompanying explanatory models stands and falls with the assumption that this hypothesis can
also be transferred easily to the price formation on real securities markets.

It is interesting to know that some of the "fathers" of the modern capital market theory exactly
originally doubted strongly that condition: It has already been observed in early studies on price
formation on the US stock market that stock prices did not follow the later imputed random walk and
that equity returns were not normally distributed, but seem to follow other statistical regularities.
Eugene F. Fama, who later became famous as an opponent of the market efficiency hypothesis, had
1963 the result, that equity returns do no follow normal distribution, but a clear unsymmetrical
distribution (known as Pareto-distribution). Even Harry Markowith, father of portfolio theory, made at
the very beginning a similar assumption of possible inapplicability of the normal distribution
hypothesis.

This short review of the history of modern capital market theory is quite ironical. Nowadays academic
studies had been published who do not base on modern capital market theory. Behavioral scientist
point out, that individuals do underlay on an information and decision behavior which has systematic
rumors und wrong decisions, which deviates from a rational behavior. If you follow these statements,
several anomalies on security markets, like for example not having a clear relation between risk and
return on investments, existence of over- and undervaluation of securities or cyclical occurrence of
collective misinterpretation and market euphoria, become understandable. Even inapplicability of
normal distribution hypothesis can be solved by this, that nonlinearity (anomaly) and heavy oscillation
(up- and downs) in the behavior of market participants are allowed. In that case the earlier rejected
hypothesis unsymmetrical and nonlinear market behavior (statistically expressed: Existence of pareto
distribution of equity returns) gain strong evidence. By this, earlier results of empirical capital market
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Rapp, H. (2000). Behavioral Finance: Paradgimenwechsel in der Kapitalmarktforschung (S. 87-116).

research, but also new findings concerning human individual behavior as well as basic assumptions of
cyclical and unstable market behavior on securities market can be applied consistent in a
holistic/integral theory of capital market.
The here now indicated anomalies-discussion is at the moment indeed in professional circles in full
progress. Nevertheless a serious attempt is still missing, the statements of the Modern Capital Market
Theory to replace with new, realistic assumptions.
(the author try this exemplary in illustration 1).

„old“ „new“
+“
Postulates of the „Modern Capital Market Findings of „Behavioral Finance“
Theory“

- homogeneous investors
- perfect information
(completely, at the same time, corect,
free)
- independent « ratonally » behave
(individually / collectively)
- compensation individual error at
the market level
(validity of the « law of the large
number)
- functional ability of the arbitrage
principle
(reliable balance of lack ratings by
«rational» speculators and arbitrage)
- Heterogenous investors
- Incomplete information
(information asymmetry)
- dependent „irrationaly“ behavior
pattern
(systematic behavioral anomalies)
- aggregation of behavioral errors on
the market level
(social irritation / social infection)
- limited function of the arbitrage
principle
(ineffectiveness in collective
wrongdoing / « market fashion »

Illustraion 1: paradigm shift

The renowned science theorist Thomas S. Kuhn has studied this negative behaviour of established
science using numerous historical examples and described very aptly. Accordingly to that,
recognizable wrong, but generally believed scientific dogma can only by radical over ground throw
previous perspectives overcome what Kuhn has referred as paradigm shift. Nobody is seriously ready
for this paradigm shift in the world of the Modern Capital Market Theory. The reasons for this are
obvious: The currently active generation of economist, professors and portfolio managers has been
formed from the mid-seventies to the (a Nobel Prize honoured) model of efficient markets. The model
world of Modern Capital Market Theory has since for many academics – but also numerous plant
manager – the rank of a dogma which should not be given up lightly again.

The widely spread way of thinking that one can delegate complex investment decisions to
mathematical decision models based on the modern capital market theory, is obviously not an option
for several investors. The critical view on the drawdowns oft he modern capital market theory – as
well as ist implication of the portfolio management modell – remains systematically bad. Ironically,
Grange/Morgenstern (two of the smartest Scientist of the ongoing century) wanted to introduce a

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Rapp, H. (2000). Behavioral Finance: Paradgimenwechsel in der Kapitalmarktforschung (S. 87-116).

change of paradigma: they want a stronger focus on psychological analytical methods especially on
mass psychology.

4 We see land! Behavioral Finance as a new explanation model for capital markets
New psychological learnings about the habits of market participants need to be taken into account.
This is obviously a good evolution of the modern kapital market theory. Based on that, a new School
of Thinking has emerged: Behavioral Finance! Crucial fort hat new way of thinking was the finding
that human beings are only capable of a few rational actions, because of their physical, mental and
neurological limits („bounded rationality“). Main parts of Behavioral Finance are therefore all
processes of: Selection, Recording and Proceeding of all relevant information oft he expection
building as well as the ex post decission building of market participants. We also need to take
consequencies of interactions of the market participants into account. (see picture 2):

From a psychological point of view, it is well known, that individuals are subjected to a variety of
mental (systematic) behavioral anomalies. Therefore, their decision behavior diverges significantly
from the assumptions from the expectations and utility theory. Exemplary a reference to the work of
the psychologists Kahnemann and Tversky must be made. They found in extensive experiments
(experiments induced partially professional capital market participants) simple and partially simplified
decision-making patterns and rules of thumb (heuristics), which must be interpreted as irrationalities
and behavioral anomalies. What is very important is that these anomalies do not occur randomly and
independently of each other, but systematic and intersubjectively correlated. 17 On the basis of similar
observations Heiner developed a theory of the predictable decision behavior. Pursuant to this theory,
individuals fall back on naive and therefore partially predictable heuristics with increasing complexity
of a decision situation18. New simulation-experiments by Dörner show that behavior reason is
decreasing disproportionately with increasing complexity of decisions. As a whole this behavioral
anomaly can be simplified in three categories: The information perception, information processing and
the downstream decision-making process. Firstly, there is the phenomenon of selective perception. In
the process of numerous psychological experiments there was proven that within a large amount of
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Rapp, H. (2000). Behavioral Finance: Paradgimenwechsel in der Kapitalmarktforschung (S. 87-116).

information predominantly the information was notice which already complied with ones opinion or
belief. Because every individual is different, every human is going to react differently to new
information and interpret it subjectively. Thus new information on the capital markets is not – as in
theory - going to trigger a simple expectation, but various different reactions and trading behavior.
This behavior is strengthened if market participants have historic experience (conditioning). In this
case new information is not checked for its contents but – analog to earlier adopted behavior – newly
interpreted, falsified or even ignored. This mental manipulation leads to a decision behavior which is
based on pro-cyclical, historic driven behavior patterns and rules of thumb. As an example we take the
“buy on dips” mentality, which is when the purchase of a stock is profitable if one buys it after a
retreat of prices on the market (The reader can decide for himself if this rule of thumb is
reasonable).Other anomalies in the handling of information are the empirically proven fact that
individuals tend to opinion comparison with reference groups and alleged authorities. From this follow
typical behavior errors. Expression of politicians, experts, or similar groups is often uncritically
accepted contrary to their own convictions. Examples can be found in the general euphoria about
starting in 1990. For example during the German reunification, with a massive overestimation of
economic opportunities in Eastern Europe. It can be stated that individuals overweight the content of
new messages over existing data. This anomaly results in light of new information regularly to
overreact and hasty action, which is actually typical of the daily events in the capital market.
Comparable mental anomalies can also be observed when market participants forming their
expectations and their decision-making. To be seen in psychological experiments there is a strong
tendency of individuals to give uncertain events an unjustified highly probable or inappropriate
positive expression. The tendency to over-optimism is strongly correlated with the desire of joining
these events and therefore leads to uncritical decisions or exaggerated optimistic assessments of risky
projects.
The phenomenon of over-optimism has been demonstrated in numerous scientific studies and
featuring in particular the majority of forecasts of economic researchers and financial analysts. Such
misperceptions are additionally reinforced by the phenomenon of illusion of control. This
phenomenon is built up with persistent feelings of success in the psyche of a decision-maker. It
suggests him that the successes of the past is based solely on its own intervention and thus arbitrarily
extrapolate into the future.
So an average investor will interpret longstanding positive investment performance less as a
consequence of random favorable market conditions, but instead primarily as a result of our own
investment capacity. The longer then holding a series of positive events, the more the individual is
subject of the illusion of being able to control these events. By positive conditioning, this effect is
further enhanced. The investor will be increasingly insensitive to external factors, such as negative
news from the real economy or similar warning signals over time. In this environment, an individual
on the unexpected occurrence of negative environmental conditions, initially react with subjective
perception control. Here by they have the impression that they have unsafe situation under control.
Necessary adjustments will therefore be delayed or ignored. Only when the illusory nature of control
is evident effected, necessary decisions and behavioral changes. Delays may occur again because
individuals behave in situations of losses initially passive. It typically occurs a pronounced flight
scheme and avoid schema. Whereby the decision maker cannot see the perception of the problem. The
erroneous decision is displaced and instead is waiting for that solves the problem by itself. Even this
failure is known from psychological research, where it is referred to as "aversion to regret".
Individuals become to important decisions a strong mental connection. That is why it is very difficult
for them to review later or to make critically questions on them. Typical of the long-term effects of
such anomalies is thus the subsequent failure of decision-makers to perceive changes in environmental
operations and our own mistakes or wrong decisions to correct timely and consistent fashion. This
phenomenon seems to explain why stock market investors often sit out entering losses on newly
acquired title prefer instead to limit through quick sale of the title.

Depending on backward-looking experience patterns individuals may also be subjects to a very limited
risk perception. In particular, after long periods of generally positive experiences the phenomena of
conditioning and the illusion of control are mutually reinforcing. Due to naive extrapolation of
historical trends, individuals expect the recent positive environmental scenarios to last, while the
phenomenon of illusion of control - at least temporarily - immunized against emerging negative news.
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Rapp, H. (2000). Behavioral Finance: Paradgimenwechsel in der Kapitalmarktforschung (S. 87-116).

As shown by Schmalensee (1976), this pattern is particularly strong in economic turning points,
because: "... the adaptation speed generally decreases in turnaround phases.". This pattern of a
decreasing risk sensitivity over time could consistently explain many discontinuities of actual markets
- such as the unexpected appearance of recessions after prolonged upswings or surprising stock market
crashes after years of bull market.

Figure 3:
Individuals are subjects to systematic...

a) perceptual abnormalities:
- Selective perception
- Adaptation of mass opinions - Illusion of control
- Aversion of complexity

b) behavioral abnormalities:
- Overoptimism
- Overreaction
- Conditioning
- Need for harmony

c) decision abnormalities:
- Emotional bindings
- Aversion of complexity
- Cognitive Dissonance - Selectivity
- Illusion of control

As figure 3 concludes, the theory of behavioral finance shows that participants of stock markets are
heavily influenced by psychological anomalies and factors.
Taking all that into account, the average investor does not appear to act as a rational Homo
Oeconomicus, which modern capital market theory preferably implies. For the further discussion,
especially for the complete analysis of stock markets it is crucial, to differentiate between two levels:
a) The level of the individual investor, which is especially characterized through specific features
of information processing and decision making; and
b) The level of the complete market, on which individual behavior anomalies appear in collective
form and are interfere, amplify and escalate in cascaded manner, through mass psychological
effects and mechanisms of action.

5 The ‘mad crowd’ effect: Mass psychological profiles of stock markets

The American economist Robert J. Shiller shapes within the scope of a paper about the functioning of
speculative markets the sentence: ‘Investments in speculative securities are a social action’. Therein it
is expressed, that participants in speculative markets do not make their decisions isolated in an
intellectual-rationale vacuum, but develop these gradually in a complex nexus of emotional and socio-
dynamic influencing factors. Following these thoughts, share prices have to be interpreted as result of
social processes between psychologically influenced and limited rationally acting individuals.
Essential for the further analysis is thus a sociological understanding for the information flow and
behavior in speculative markets.
Against the assumption of modern capital market theory market participants do not process
information independently in regard to their investment decisions, but orientate themselves strongly
towards the investment behavior of other market participants. Therefore investment relevant
information does spread typically through fast proceeding information cascades or in the form of
gradual information diffusion. Information will in this process gradually be leaked, in the sense of
asymmetric information, from well informed groups of investors to less professional groups of ‘naive’
market participants. The explanation for this phenomena lies on the hand in the different proximity of
the market participants to the sources of investment relevant information (such as banks, companies or
research institutes), on the other hand in different distinct intellectual and analytical skills of the
individual participants.
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Rapp, H. (2000). Behavioral Finance: Paradgimenwechsel in der Kapitalmarktforschung (S. 87-116).

The group of ‘naïve’ investors usually does not possess the necessary knowhow and special
knowledge, which is mandatory for a successful stock market investment. Instead the ‘naïve’ investors
will try to copy the dominating market behavior and optimally ‘go with the flow’. The plausibility of
such behavioral patterns, which can also be described as ‘social imitation’, is sufficiently proven
through psychological experiments. According to that individuals show a strong tendency towards
conformity with presumable opinion leaders, authorities or comparable reference groups. As a
consequence of such imitation and diffusion processes diverse market dynamical phenomena can be
expected. Especially the decisions of the so called ‘naïve’ investors, which are last in the diffusion
process, will not be based on actual information. Instead it will solely be reacted on ‘noise’, which is
at that point of time already included in the market prices. Thus aligned behavior of market
participants can even occur, if the underlying information is already outdated or disproved. Mostly the
group of ‘naïve’ investors comprises only a small section of the capital markets, which stays inactive
in the majority of the stock market phases and does not influence stock market events.
In certain phases, which are marked by positive fundamental data and good stock exchange profits,
naive investors will occur at the market, to participate on the stock exchange profits. The so triggered
influx of inexperienced investors (accelerates through positive media), can be described on appropriate
models of clinical medicine as a social infection. To highlight is here the role of mass media as
exchangers and accelerator of social infection. In such phases exponential extending extension of
active investors population leads to a strong market expansion, which is not without consequences for
market process and market pricing. The influx of new market participants as result of social infection
will then cause at the aggregate level a strong homogenization of the market behaviour. The behaviour
of the market participants will orientate than on the majority (or on the opinion leaders) and so create a
strong cohesion, an extensive stability of the market behaviour.
In such cohesion market phases with strong behaviour homogenization, the typical phases of
information diffusion strengthen through social imitation and infection from the naive investors can
trigger pro-cyclical feedback and uncontrollable snowball effects on the capital market. Such
processes are characterized from the actions of naïve investors in pricing and market behaviour.
Consequently, there is euphoric exaggeration, to excess demand and to corresponding overstatement
of traded financial instruments. The following figure 4 schematically shows the above-discussed
connection between cyclical market expansion and the resulting increasing irrationality of market
behavior over time.

Examples of such "explosive", driven by great social dynamic market processes are about the
speculative movements 1928-1929 in the US stock market, the gold bull market of the late 70s, the
speculative bubble from 1986 to 1989 in Japanese equities and the bullish movement in 1990 on the
German stock. (Note: All of these phases ended with a spectacular collapse and losses up to 90%).

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Rapp, H. (2000). Behavioral Finance: Paradgimenwechsel in der Kapitalmarktforschung (S. 87-116).

In addition to these (only intermittent) mechanisms of "social infection" and the "social imitation" can
be assumed that over time the behavior of the stock markets is determined through long-term trends
and cycles in investor behavior. This in turn triggered by the cycles of the real economy, of social
demographic cycles and of which triggered mass psychological effects and influences. The duration of
such trends and cycles plays a major role and in turn determines itself as a feedback factor the
remainder of the price movements. In the course of such cycles, the above described psychological
anomalies interlock and produce on the individual and on the market level characteristic market trends
and patterns.
The concept of psychological cycles in capital markets assumes that long periods of economic
prosperity and good performance on the stock markets (for example in the 20s, 60s, 80s) greatly affect
the psychological attitude and hence the further behaviour of the market participants. Sustained
periods of economic growth associated with predominately positive investment experience of
investors creates a feeling of “feasibility” (illusion of control” and in the course of time it accumulates
exaggerated confidence for the future (over-optimism). This positive impression (conditioning) leads
in the final stage of a cycle – such as in 1987 on every stock exchange in the world – to systematically
over-optimistic and often euphoric expectations. This typically increases the number of market
participants and trading volume (market expansion).
As already explained, the phenomenon of market expansion is characteristic for a late phase of a cycle,
as the “hidden reserves” of “naïve” and bad-informed investors are invested in the stock markets. In
this phase new information will only be perceived and processed by the majority of market
participants if they can be reconciled in accordance to already preconceived positive opinions in the
market (selective perception). This results in the aftermath to a limited and belated acknowledgement
of emerging risks and trend changes (avoidance behaviour) as well as time-delayed decision making
processes and passive investment behaviour in unexpected reversals (displacement). In sum, these
phenomena explain, why in a final stage of a prolonged stock market cycle significantly canted price
levels are always observed (compare figure 5).

As already been shown, strong group dynamic influences on stock markets can temporarily cause a
rectified pattern of behaviour, which is subject to the majority of the market participants (cohesion).
The strength and direction of such behaviours then define the psychological profile of a market. The
psychological profile of a market that has a long-term positive development behind it, is essentially
different from that of a market in an unstable transition period between boom and recession phase of a
cycle.
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Rapp, H. (2000). Behavioral Finance: Paradgimenwechsel in der Kapitalmarktforschung (S. 87-116).

In stable bull markets collaborate several psychological (particularly also group psychological) factors
and cause at the market participants a strong feeling of control over the actual developments of the
market (illusion of control). Positive investment experiences as well as a daily observable positive
market trend triggers a feeling of self-affirmation what makes the investors immune to critical voices
and negative announcements of the real economy.
This process of conditioning and homogenization gets additionally enforced if daily new investors
from the individual circle of friends also buy shares. As a result a feeling of collective security and
accuracy of own investment decisions arises (what everybody does cannot be wrong) what initiates
cohesiveness of the market participants and a vast uniformity of their expectations and investment
decisions. This effect of cohesion gets fostered by the predominant positive reporting of mass media
and gets transmitted in form of "social infection" to further groups of investors. Hence a further
expansion of the market occurs so an ongoing inflow of new investors at the market. This group
dynamic process nourished by illusion of control and conditioning, in which physics is known as
positive feedback, explains the often amazed robustness of mature bull markets against gradually
arriving negative news about the real economy.
The psychological profile of the market is in this phase characterized by the greed for additional
effortless market profits as well as the extensive ignorance about a deterioration of the outline data of
the real economy. The market behavior becomes to be increasingly speculative and fixated on oneself.
In doing so not the question if the prices will increase further but just the question when and how
many points they will increase is in the foreground of market action. Further characteristics of this
phase are amongst others an extremely high market volume since in the meantime a multitude of new
investors act on the market and also the market behavior is more trading oriented. This constellation of
the market can be labelled as a phase of distribution since a high volume of overvalued shares is
transferred from cool calculating investors to the new, euphoric mass of naive investors.
The end of a bull market typically comes with a (sometimes long term) phase of “unstable market
equilibrium”. The stock market reached, after an expansive and euphoric phase, a certain price level,
which was way ahead of the economic reality. Nonetheless, the appropriate correction of stock prices
comes with delay, as the majority of active investors are still experiencing the typically phenomenon
like illusion of control, positive conditioning, over optimism and selective perception. That is why in
this time necessary adaptions of environmental conditions are postponed or suppressed. This passive
behavior of the investors leads to an “apparent” stability of the market, as overvalued stocks for this
time are not sold yet. Therefore the trading volume in this time is relatively moderate. Many investors
– completely misjudging the reality – see this time as an opportunity to for buying again, as the market
seemed strong (technically healthy) by not reacting on the negative fundamental news. This kind of
market constellation creates the famously known “bull traps”, in which the most naïve investors fall
into, as they finally also want to profit from the market, but rather are the first ones which experience
the overdue correction of the market.
The correction begins, as soon as the changed reality (mostly due to an external shock like raise of
interest rates (central bank), negative news about corporations or similar events) can no longer be
ignored by the majority of market participants. Depending on the market constellation and the
prehistory, an abrupt or more gradual transformation into a bear market scenario follows. The actual
procedure orientates itself on the grade of existing control illusion, which leads many investors too
further purchases instead of termination of their positions.

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Rapp, H. (2000). Behavioral Finance: Paradgimenwechsel in der Kapitalmarktforschung (S. 87-116).

Figure 6:Delayed market reaction

Bear markets too have an individual psychological profile, which is identified by the according
atmospheric picture of the majority of market participants. Depending on how the bear market came
into existence, the earlier process of the bull market such as the transformation phase, a bear market
can be short and painful (Crash) or long-term and probably even more painful (steady depreciation of
stock prices). Depending on the mixture of investors which bought at the very end of the market
expansion, different reactions in the phase of correction are observable:

As soon as these investing group perceived the changed reality, the investing group will flee in a
displacement and avoidance scheme and ignores initial rate losses in the hope that the markets will
recover quickly. This psychological effect manifests itself in an passive expectant behavior of the
investors (“aversion to regret”). This explains furthermore the typical picture of the transitional phase
market with low exchange turnover and low volatility.
If the general expected recovery does not enter, the previous control illusion is gradually destroyed
and the investors are increasingly unsettled. Typical symptoms of this phase are euphoric reactions on
occasional positive news which causes fast but limited positive technical reactions on the stock
market. In the further course of the Baisse-Market the investors loose increasingly the feeling of the
ability to control the situation. If the rates falls further, the earlier feeling of superiority gives way to a
fear and panic behavior. Typically are “the children of the Hausse” those, who sells in a last panicky
reaction their share at lowest rates (“sellout”). Characteristic for this final phase (“selling climax”) are
again the high exchange turnover and the significant low valuations of the traded shares (vgl. Abb. 5
Zyklusmodell).
However, typical for a market in the transitional phase is, that the majority of market participants has
no clear opinion and are therefore easy suggestible with new informations (“news sensitivity”). The
market behavior is in such phases uncertain and unstable and the volatility increases markedly because
the market participants react now on positive as well as on negative news. This leads to the typical,
sometimes multiannual rocking exchanges in which only traders but not long-term oriented investors
can make profit. Only when a stable trend evolves out of this instable market situation, the socio-
economic cohesion forces will appear and produce a long-term Hausse- or Baisse-Market.
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Rapp, H. (2000). Behavioral Finance: Paradgimenwechsel in der Kapitalmarktforschung (S. 87-116).

6 The practise test: Psychological models in an integrated Investment management

The preceding overview shows that the results from Behavioral Finance can explain a range of
phenomena in the speculative markets. On basis of these considerations the question is, if the
statements of Behavioral Finance also prove in critical field tests. With other words: Is it possible that
with the help of Behavioral Finance, the estimation for actual and future market reactions, is better and
preferable to classical estimation methods? And is it possible with the content of Behavioral Finance
to define new indicators for cyclical inflection points, trend reversals or to identify and forecast
situations where the market risk is increased or decreased?
Are the approaches of behavioural financial analyses in general not only useful in an academic sense
but moreover applicable in the daily work with stock markets?
According to the current status of research and the further analysis of the author, this question should
be answered affirmatively. The starting points of the answer are some simple and elementary views
about the mechanism of speculative markets and about the driver “Information” which has a huge
influence in the stock markets.
In general stock markets should be effective institutions, which allocate channel risk investments into
the real economy (allocation function). Related to this context the stock markets have the additional
function to impartial value public tradable Investment projects under consideration of the available
information (valuation function). Both functions operate perfectly on condition reliable and efficient
market mechanism because otherwise misallocation and misevaluation would be the result.
In relation to the discussion before, we know that the real stock markets cannot always fulfil the
requirements of those two functions.

During the last discussion it became clear that these conditions are in the real securities markets not
always true. Evidently there are psychologically related market mechanisms, that can be caused by
over time significant speculative exaggerations and excesses in securities markets. At the same time,
however, such excesses occur only in certain market phases and therefore they don’t belong to the
permanent appearance of the stock market. Nevertheless, it is important to know the conditions for
emergence "irrational" market phases and to understand why they are firmly rooted in the psychology
of the market participants and thus latent a part of it. The mechanics of such processes is always the
same and should briefly recapitulate based on the following picture 7:

Figure 7 represents an attempt, to cover a long-term cycle of the stock market schematically and to
divide into different market phases. These phases define consecutive stages of a dynamic market
development, which are formed by characteristic environmental conditions and corresponding to
particularities of market behavior - so called by typical psychological profiles.
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Rapp, H. (2000). Behavioral Finance: Paradgimenwechsel in der Kapitalmarktforschung (S. 87-116).

This basic model can be applied to almost all securities markets. Typical market constellations can be
characterized by the psychological profiles.

In figure nr. 7 the stock market cycle starts in a neutral phase (‘trendless volatility’) without greater
price changes. The market has typically a longer downwards movement behind which eliminates the
past excess and a lead to a tendential undervaluation of stocks. The market behavior is in this phase
more or less ‘insecure’ hence the majority of investors is still informed by the previous correction.
Because of that, market participants ignore or doubt the implicative improvements of fundamental
data. The market sentiment is supported by negative news of mass media, which says ‘just do not have
any own stocks’. Consequently, only a few (most professional) investors are active while the group of
‘naive’ investors stay away from the market. The perspective for market profit in this phase of
‘trendless volatility’ is low hence lack of real investor interest no consistent upward trend can occur.
However, foresighted (rational) investors will start to buy new positions at low prices in this phase.
The second market phase is the one of the ‘coherent trend’. A coherent trend occur when indicated
improvements of fundamental data cross the prescription of public. Thus, more and more investors are
willing to accept the vision of future improved fundamental data what leads to a sustainable and stable
demand for stocks and therefore to higher market prices. The market behavior and the market
sentiment are rational long-term since the upward movement simply retraces the improvement of
fundamental data. In case of doubt the phase of ‘coherent trend’ can last for several years if it is
justified through favorable economic development (as the time from 1982-1986 at the international
stock markets.
This marketphase represents an ideal investment environment for the professional investor, because
„coherent trends“ usually bring positive returns while simultaniously only a small risk of market
corrections exists. For this reason the investment-amount should be close to maximum during phases
of „coherent trends“. The phase of the „coherent trend“ experiences an acceleration due to
inexperienced investors who join the market, who discover the by now improved fundamentals. The
market behaviour gets more and more driven by the phenomenon „social immitation“ which leads to a
market expansion. The late phase of the „coherent trend“ is shaped by an accelerated trend of new
investors joining the market who invest their money due to positiv conditioning, „social infection“ as
well as the prospects of trying their luck as an investor. The general sentiment gets more and more
overoptimistic but is still within a rational boundary relating to the fundamentals.
The phase of the „coherent trend“ usually only ends after another acceleration of inexperienced
investors rushing in the markets. Those get attracted by positive articles in the massmedia and are now
looking for easy and spectacular gains in the capital markets. The „coherent trend“ gets more and more
overlayered by a soley speculative investor behaviour. Usually this phase is acompanied by new
investmentproducts such as options, new funds, new IPOs etc. The volume on the stock exchange also
rises and fueles an speculative acceleration in the build-up of stock prices. The picture 8 caputures
some of the most important indicators and warning-signs of this phase.

Indicators of irrational market behavior

 Strong deviation of market prices of "fair value" models.
 High sensitivity of market news
 Topic fixing of the market (“Fundamentals” vs. “Market)
 Degree of market expansion / information diffusion
 Market consensus / Sentiment Indicators ("over-optimism")
 Stock market turnover (absolute / relative)
 Volume and quality of new issues
 Price patterns (“exponential curves/patterns”)

The stock market has now reached the stage of "trend acceleration". The prices are deviating more and
more from the economic reality. The irrational greed for quick capital gains is dominating more and
more the investment behavior and the prevailing mood of the market (i.e. the so-called "consensus") is
characterized by "over-optimism", "selective perception" and "illusion of control". These elements of
the psychological market profile gets regular very clearly identified in the current market
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Rapp, H. (2000). Behavioral Finance: Paradgimenwechsel in der Kapitalmarktforschung (S. 87-116).

commentaries, interviews and similar mood reports, while at the same time signs of a deterioration of
economic fundamentals are apparent. The phase of the "trend acceleration" is therefore a market phase
with a significantly increased risk that already settles the bases for future sharp turnaround or a sudden
break in the trend. This is caused by the present significant overvaluation of the stock market as well
as the psychologically induced change (or only selective perception) of the emerging fundamental risk
factors (such as rising market interest rates). Despite these risks, the phase of the "trend acceleration"
the professional investor who works with limited inset (for example, with options) can offer
extraordinary gains, as the final phase of the trend acceleration is often characterized by extreme price
jumps.
Despite these risks, the phase of „trend acceleration“ can offer outstanding gains to the professionel
investor, who is working with limited resources (e.g. options), because the end phase of a trend
acceleration is marked most of the time by extreme price jumps. In many cases, the trend acceleration
phase is followed by an extensive „market transition phase“ with a subsequent trend reversal. As
previously stated, the market behaviour in this phase is clearly irrational and strongly driven by
„overoptimism“ or „illusion of control“. Increasingly, the mechanisms of „cognitive dissonance“ also
come into play, as well as „limited risk perception“, and postpone the overdue correction.
Accordingly, the market behaviour, in light of declining revenue, often seems stable and relatively
unimpressed by the deteriorated quality of fundamentals. In the view of an investor without special
knowhow of these circumstances, this market phase ranks amongst the most dangerous: Despite
markets not showing clear signs of weakness (which can lead to carefree investments), beneath the
surface, all preconditions for a severe drop are present. In this phase, the smart portfolio manager will
withdraw from the equity market almost entirely. This requires, however, a high level of conviction
and discipline.
The conclusion of a „trend reversal“ most of the time follows a consistent pattern: At a certain point in
time, the deterioriation of fundamentals cannot be overlooked anymore. Thus, rational investors begin
selling their assets. Often, shortselling by large arbitrageurs deliver the decisive impulse. Again, a
coherent trent is forming, in the course of which more and more investors are selling their shares. This
development is not offset with sufficient buyers on the other side. Consequently, the market finds
itself - corresponding with the lesser quality of fundamentals - in a downward trend (which does not
yet show signs of irrational „selling panic“). At this point, the transition to an intensified downward
trend is already predetermined, because - according to the theory of „delayed market reaction“ - still a
significant number of irrational market participants is holding onto their now overvalued stock of
shares. As soon as prices drop further, and „cognitive dissonance“ has dissolved, the psychological
pressure becomes too large and they, as well, sell their shares. As a consequence to the large number
of potential sellers (as a consequence of the previous market expansion), this leads to an increasing
„selling avalanche“, which is becoming visible as a sharp „trend acceleration“. The market sentiment
in this phase is again irrational and bears all signs of a „real panic“. Stocks are sold at very low prices,
because the former optimists now envision a perpetual continuation of the downturn. This again leads
to a distinct undervaluation of shares and accordingly, the revenues in this phase are quite high, becaue
besides many (irrational) sellers, an increasing number of calculating (rational) buyers are present in
the market. For the professional investor, the phase of trend acceleration during a downward trend is
an ideal environment, because longterm portfolios can be built relatively cheaply. After conclusion of
the trend acceleration and often times crowned by a massive „sellout“ by „naive“ investors, the market
more and more transitions into a phse of „trendless volatility“. The „mass-pychological forces of
cohesion“ have evaporated and, instead, general uncertainty about the further course of the market
prevails. Herewith, the floor for a new, multi-year stock market cycle is formed, and the „stock market
game“ starts anew.

From these considerations it becomes clear that methods of Behavioral Finance can really make a
contribution for the professionele investment management. Who is able to understand the cyclic
mechanisms of the market behaviour and, in addition, also recognises the certain psychological
profiles of certain market phases, can estimate opportunities and threats on capital markets better than
it would be possible by useing models of modern capital market theory.
A important fact is, that also a typical investment behaviour is given by a basic understanding of the
market psychology: In phases of coherent trends (mostly longer) the professional investor completely
will be fully invested. and he will reduce his exposure only in the course of a clear change in trend.
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Rapp, H. (2000). Behavioral Finance: Paradgimenwechsel in der Kapitalmarktforschung (S. 87-116).

After this turnaround point he will leave the market complete or bear the market. Therefore the earned
capital in the positive market trend is preserved also in the bear market. After the phase of «trendless
volatility» the investor has the chance to start long term investing in a priceless market again.
It is obvious that in the long term this methodology – in contrast to the assumptions of the modern
capital market theory – make a clear out performance compared to the market index possible. This is
valid at least if capital markets in reality develop in oscillatory boom and recession phases. Due to the
psychological anomalies of investors ("homo sapiens"), this is certain for the next years and decades
(as well as for the last years and centuries).

7 Finale review, critical evaluation and forecast

The majority of the big institutional assets (funds, pension funds etc. ) are still managed under the
rules of the modern capital market theory. This fact should thought-provoking inn consideration of the
backgrounds shown here. It contradicts all laws of logic to use a theory their most important
assumptions increasingly appear as wrong as navigator in the jungle of complicated and chaotic
financial markets.

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