Developing the Stock Pricing Model based on Bounded Rationality Theory

Subject Areas : Financial and Economic Modelling

Mohammad Noroozi ¹ , Daruosh Foroghi ² , farzad Karimi ³

1 - Department of Accounting, Shahrekord Branch, Islamic Azad University, Shahrekord, Iran
2 - Department of Accounting, University of Isfahan, Isfahan, Iran.
3 - Department Management, Mobarakeh Branch, Islamic Azad University, Mobarakeh, Iran.

Received: 2021-09-09 Accepted : 2022-01-09 Published : 2023-01-01

Keywords: Behavioral Finance, bounded rationality, Investors' Sentiment, Stock Pricing Model,

Abstract :

The occurrence of unexpected phenomena in recent decades in financial markets around the world,led to the development of theories,beyond the defined principles and criteria of classic finance.These theories are based on financial psychology and they are explaining the role of psychology in financial sciences as an influential factor and became irreplaceable in financial markets and investor decisions.One of the important theories in this field is the bounded-rationality-theory,which can explain the behavior of decision-makers about financial and economical issues based on defined theoretical frameworks and assumptions.This study developed the stock pricing model by comparing the predicted stock price based on the bounded-rationality-theory and the real stock price through collecting the data of 122 companies listed on the Tehran Stock Exchange during the period 2011to 2019.The results of this study show the effectiveness of the bounded-rationality-theory based on the separation of stock return components and measuring the irrationality coefficient and emotional reactions of investors' decisions in stock prices.Accordingly,the limitations of investors 'ability to process information seem to affect the level of use of reasoning and rationality in decision-making and the effect of bounded-rationality through the irrationality and limited attention on stock pricing.Therefore,it is expected that knowledge about the process of bounded-rationality based on the rational-bounded of investors and the behavioral biases resulting from the irrational part of their thinking,will provide a good explanation for the process of changes in financial markets.This can provide both profit opportunities and costs in investment management so that it can be used in modeling,analysis and investment strategies.

References:

[1] Chauhan, Y., Ahmad, N., Aggarwal, V., and Chandra, A., Herd Behaviour and Asset Pricing in the Indian Stock Market, IIMB Management Review, 2020, 32(2), P. 143-152. Doi: 10.1016/j.iimb.2019.10.008.

[2] DeAngelo, G., and Cannon, B. C., Theory of Mind Predicts Cooperative Behavior, Economics Letters, 2017, 155, P. 1-4. Doi: 10.1016/j.econlet.2017.02.009.

[3] Elhaei Sahar, M., Hejazi, R., Salehi, A. K., and Moltafet, H., Stock Price Momentum Modeling: A Grounded Theory Approach, Advances in Mathematical Finance and Applications, 2020, 5(2), P. 167-181. Doi: 10.22034/AMFA.2020.1882300.1324.

[4] Fama, E. F., and French, K. R., A Five-Factor Asset Pricing Model, Journal of Financial Economics, 2015, 116, P. 1-22. Doi: 10.1016/j.jfineco.2014.10.010.

[5] Figliolia, B., Lemes, S., and Lima, F. G., In Search for Good News: The Relationship between Accounting Information, Bounded Rationality and Hard-to-Value Stocks, Emerging Markets Review, 2020, 44, P. 274-297. Doi: 10.1016/j.ememar.2020.100719.

[6] Gabaix, X., A Sparsity Based Model of Bounded Rationality, The Quarterly Journal of Economics, 2014, 129(4), P. 1661-1710. Doi: 10.1093/qje/qju024.

[7] Jokar, H., Shamsaddini, K., and Daneshi, V., Investigating the Effect of Investors' Behavior and Management on the Stock Returns: Evidence from Iran, Advances in Mathematical Finance and Applications, 2018, 3(3), P.41-52. Doi: 10.22034/AMFA.2018.544948.

[8] Kahneman, D., Maps of Bounded Rationality: Psychology for Behavioral Economics, The American Economic Review, 2003, 93(5), P. 1449-1475. Doi: 10.1257/000282803322655392.

[9] Kalantari, B., Herbert A. Simon on Making Decisions: Enduring Insights and Bounded Rationality, Journal of Management History, 2010, 16(4), P.509- 520. Doi: 10.1108/17511341011073988.

[10] Liang, H., Yang, C., and Cai, Ch., Beauty Contest, Bounded Rationality, and Sentiment Pricing Dynamics, Journal of Economic Modelling, 2017, 60, P. 71-80. Doi: 10.1016/j.econmod.2016.09.010.

[11] Liang, H., Yang, C., Rengui, Zh., and Cai, Ch. Bounded Rationality, Anchoring-and-Adjustment Sentiment, and Asset Pricing, North American Journal of Economics and Finance, 2017, 40, P.85-102.

Doi: 10.1016/j.najef.2017.02.001.

[12] Mushinada, V. N. C., and Veluri, V. S. S., Elucidating Investors Rationality and Behavioural Biases in Indian Stock Market, Review of Behavioral Finance, 2019, 11(2), P. 201-219. Doi: 10.1108/RBF-04-2018-0034.

[13] Nigam, R. M., Srivastava, S., and Banwet, D. K., Behavioral Mediators of Financial Decision Making: A Meta-Analysis, Review of Behavioral Finance, 2018, 10(1), P. 2-41. Doi: 10.1108/RBF-07-2016-0047.

[14] Rabin, M., Incorporating Limited Rationality into Economics, Journal of Economic Literature, 2013, 51(2), P.528- 543. Doi: 10.1257/jel.51.2.528.

[15] Rezaei, N., and Elmi, Z., Behavioral Finance Models and Behavioral Biases in Stock Price Forecasting, Advances in Mathematical Finance and Applications, 2018, 3(4), P.67-82. Doi: 10.22034/AMFA.2019.576127.1118.

[16] Sent, E. M., Rationality and Bounded Rationality: You Can’t Have One Without the Other, The European Journal of the History of Economic Thought, 2018, 25 (6), P.1370- 1386. Doi: 10.1080/09672567.2018.1523206.

 [17] Simon, H. A. A Behavioral Model of Rational Choice. The Quarterly, Journal of Economics, 1995, 69(1), P.99-118. Doi: 10.2307/1884852.

[18] Simon, H. A., Bounded Rationality, In: Eatwell J., Milgate M., Newman P. (eds) Utility and Probability. The New Palgrave. Palgrave Macmillan, London. Doi: 10.1007/978-1-349-20568-4_5.

[19] Tseng, K. C., Behavioral Finance, Bounded Rationality, Neuro-Finance, and Traditional Finance, Investment Management and Financial Innovations, 2006, 3(4), P. 7-18.

[20] Yang, C. and Li, J., Investor Sentiment, Information and Asset Pricing Model, Economic Modelling, 2013, 35, P. 436-442. Doi: 10.1016/j.econmod.2013.07.015.

[21] Yang, Ch., and Zhang, R., Sentiment Asset Pricing Model with Consumption, Journal of Economic Modelling, 2013, 30, P. 462-467. Doi: 10.1016/j.econmod.2012.11.004.