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In the last decades many financial crises have emerged, like the stock crash of 1987, the Asian crisis in 1997 and the global financial crisis that started in 2008. Although those crises occurred for different reasons, they all proved financial markets to be inefficient. Not all traders think rationally. Behavioural patterns cause irrationality ...

Patrick Kemtzian, B.A. MLitt, was born in 1984 in Cologne, Germany.
After completing his Bachelor‘s degree specialised in European Management in Cologne, he decided to pursue a Master’s degree focused on International Business in St. Andrews, Scotland.
This book is the result of his Master’s thesis. During his studies he developed great interest in the connection between Finance and Psychology.
Encouraged by the breakout of the financial crises in his Master year 2009, he critically analyses the repeated appearance of irrational erratic behaviour that led to the crisis.

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Kapitel 2.7, Principal-Agent Problems:
Montier argues that ,arbitrage is the province of a relatively small number of highly sophisticated and specialized investors… running funds for others.’ Scholars have recognized that the separation between principals and agents can affect market dynamics. Montier presents some important implications for arbitrage.
Transferred into the world of specialized arbitrageurs this means that there is a separation between capital provision and information. Generally outside investors (the capital providers) have very little knowledge about the nature of the market, the arbitrageur trades in. This implication leads on the one hand to the tendency that outside investors, due to their lack of knowledge, perform more risk-averse and provide arbitrageurs with limited funds, but on the other hand that arbitrageurs are capital-constrained. The second implication is that unsophisticated capital providers measure the arbitrageur’s performance by past results and consequently allocate funds to them. This means that an agent whose results are poor will have problems to raise money in the future.
These implications are crucial in extreme circumstances and entail that main qualities of efficient arbitrage are captivated and at least powerful in situations, when it is needed most, namely when prices and fundamentals diverge the widest. Of course entering the market at this point would lead to the highest returns for them but in most cases capital providers do not understand these circumstances.
Logically, it would be very beneficial for rational traders to enter markets that are very volatile as mispricing can be exploited to a large extent, but in reality due to the above mentioned problem, arbitrageurs seek to minimize the risk by only specializing into secure markets.
Montier argues that if arbitrageurs are funded by debt rather than equity and the position moves against them, due to fundamental or noise trader risk, the value of securities will decline. As a consequence this erosion of the arbitrageur’s capital basis increases leverage, but decreases the probability of borrowing. In-depth analysis of markets and focusing on markets with a low level of fundamental risk is crucial for arbitrageurs to prevent asset fire sales. This term is defined as a ,situation whereby arbitrageurs are forced to liquidate their positions at a time when the best potential buyers (other arbitrageurs) have limited resources, and prices fall way below the level justified by the fundamentals.’ (Montier, 2002)
3., Methodology:
This work aims to find out the main behavioural patterns that influence the decision-making process of traders and investors. Furthermore it aims to analyse whether herding still exists in a financial crisis.
In order to do so qualitative as well as quantitative methods are used. The author pursues his qualitative research on the fact that reality is understood as subjective, which means that it is based on ontological assumptions. Perceptions and experience may be different for each person, and can change over time and context.
By pursuing quantitative research the author accepts the view of constructionism, which provides that the social actors produce social reality through social interaction and hence can change their views and understanding of social reality through interaction. This means that the researcher is an output of social and cognitive processes. The author’s view is that reality is always pillared by individual and group interpretation.
In the context of epistemology the author accepts the view of critical realism, which takes reality as a material, but nevertheless accepts that people interpret it differently in different terms and contexts. During this work the author presents different approaches to theories because of opinions by the scholars that are citied or different levels of knowledge due to their times of living. (Eriksson & Kovalainen, 2008)
In order to gain the required knowledge to compose the literature review, different reviews and scientific articles of scholars in the fields of finance, economics, behavioural finance and psychology were reviewed and structured. The literature review consists of quantitative research methods implemented by the author. The main scholars citied in chapter two are Fama French and the psychologists Kahneman, Slovic and Tversky, who with their work contributed significantly to the establishing of the EMH and the Prospect Theory. These two theories form the building blocks for investors’ and traders’ decision-making processes. The scholars both used qualitative and quantitative methods in order to prove their assumptions and theories. The author cites primary literature published by the above mentioned scholars on the respective areas.
In the third chapter the works of Hamilton (later reviewed by Cowless) and Makiel are citied by the author as secondary literature in order to give an overview about the general analysis methods, used by traders and investors. For this chapter the author mostly used books in order to cover the topic.
Both, Fischer Black and Shleifer composed their findings through qualitative and quantitative research methods. Their theories show the interaction between irrational and rational investors and are directly citied by the author by using primary literature in the fourth chapter.
The author mainly used academic and financial journals to collect his material needed to conduct the in-depth review of the literature. The main electronic sources that were used in order to find the required journals and articles were the library homepage of the University of St. Andrews as well as Google Scholar.
The analysis of behavioural patterns is composed by knowledge gained through quantitative research. By reviewing the relevant literature related to the topic, the author decided to choose seven behavioural patterns that are common in behavioural finance. The difficulty at this stage lies in the selection of the seven most influential patterns, as opinions may diverge concerning the importance and classification of these patterns. The author used the approach of studying various books dealing with behavioural finance and identifying the patterns that are most frequently used by other scholars in their scientific working in connection with the topic.
The chosen behavioural patterns of traders and investors affecting them in the decision-making process were tested quantitatively and qualitatively. The author’s orientation in the fifth chapter, to the role of theory in relation to research, is deductive as well as inductive.
Deductive theory represents the most common view of the nature of the relationship between theory and research. By using a deductive approach the researcher uses a common hypothesis and tests it. The hypothesis is then subjected to empirical scrutiny issued by the researcher by implementing the theory into practice. Inductive theory is widely known as the opposite approach to the deductive approach. Here, the researcher tries to find out something new from his empirical studies and hypothesises his findings to develop a new theory out of it.
As a qualitative research method, an informal interview is used by the author, to pursue a deductive strategy. By using the interview, the author wants to prove that the behavioural patterns that have been analysed by him exist and are influential in the financial world. The interviewee is Thomas Vittner, a sophisticated full-time Austrian trader and investor, who has been very successful on the financial markets and has many years of experience with the stock market behaviour. He published various articles and books about trading. The interview was conducted through the telephone and took thirty minutes. It is called an informal interview as Mr. Vittner was the only one interviewed for this dissertation. His main statements are discussed in the Empirical Evidence of Behavioural Patterns chapter and the full interview can be found in the Appendix of this work. The author divided the interview into two subject areas. The first part deals with general questions about his trading experience and the second part with his experience in observing behavioural patterns by traders and investors. Especially the second part was pursued with a deductive strategy in order to prove the subsequent analysis.
The herding behaviour is tested by the author in a quantitative manner by using an experiment. He analyses the herding behaviour in the current financial crisis and pursues an answer to the question of how strong the herding behaviour holds in a global financial crisis and its recovery, hence pursuing an inductive strategy. The author argues that the financial crisis hit the mainstream on September 15. 2008, when the investment bank Lehman Brothers went bankrupt. In the experiment, three observation periods are used in order to evaluate six randomly chosen stocks from different industries providing either a ,selling’ or ,buying’ recommendation by analysts from influential banks. The observation periods are one month. In the first observation period the author analysis six stocks starting in the time frame from 28th July 2008 – 11th August. The first period is called ,Stock before the crisis’. For the second observation period a time frame within the financial crisis was picked where the public trust in banks was very low. This observation period started from 20th November 2008 – 16th December 2008. This observation period was called ,Stocks in the crisis’. The third observation period started on 1st July 2009 – 10th July 2009. The results are presented in the sub-chapter Evaluation of Experiment. The analysts’ recommendations were extracted from www.handelsblatt.de and are outlined in a table in the Appendix. Each stock performance over a one-month observation period was gathered from Yahoo Finance and is presented in tabular form in the Appendix. This method is used in order to see if a buying recommendation by analysts leads to a price increase in a one-month period as the demand for the stock increases and if a selling recommendation leads to the opposite behaviour as the demand for the stocks declines and as a consequence should lead to a decrease in the share price.