Testing behavioural finance theories on a frontier market:the case of Nairobi securities Exchange

This study investigates whether the revision of the Nairobi Securities Exchange share index-NSE-20 share index yields abnormal returns and also if investor decisions in the market depict psychological biases (overconfidence) as is predicted by behavioural finance. On the one hand, any attempt to exploit abnormal returns resulting from any index revisions comes with costs and risks (limits-to-arbitrage argument). On the other hand, the expanding trading volume at the NSE over time could signal excessive trading that translates into loss in wealth for those engaged in it as is predicted by the overconfidence bias. We employ financial time series econometrics techniques to achieve our objectives. The study’s findings indicate that while the periodic revision of the NSE-20 share index yields abnormal returns, they are not statistically significant. Further, investment decisions depict psychological biases of overconfidence and its dynamic counterpart; biased self- attribution. Unlike in developed markets where the level of overconfidence depends on the precision of investor forecasts, in frontier markets overconfidence is high even when forecasts are highly imprecise. In addition to other factors, over-confidence-based trading contributes to excess volatility in the market. The study recommends that Kenya’s financial consumer protection programme that deals with financial regulation and financial literacy should be behavioural finance-biased since there is evidence that behavioural biases are at play in this market. It is expected that well informed and psychologically astute investors can better their capital allocation decisions.