Much of modern investment theory and practice is predicated on the Efficient Markets Hypothesis (EMH), the assumption that markets fully and instantaneously integrate all available information into market prices. Underlying this comprehensive idea is the assumption that the market participants are perfectly rational, and always act in self-interest, making optimal decisions. These assumptions have been challenged. It is difficult to tip over the Neo classical convention that has yielded such insights as portfolio optimization, the “Capital Asset Pricing Model”, the “Arbitrage Pricing Theory”, the “Cox Ingersoll-Ross theory” of the term structure of interest rates, and the “Black-S[choles/Merton option pricing model”, all of which are predicated on the EMH (Efficient Market Hypothesis) in one way or another. At few points the EMH criticizes the existing literature of behavioral finance, which shows the difference of opinion on psychology & economics. The field of psychology has its roots in empirical observation, controlled experimentation, and clinical applications. According to psychology, behavior is the main entity of study, and only after controlled experimental dimensions do psychologists attempt to make inferences about the origins of such behavior. On the contrary, economists typically derive behavior axiomatically from simple principles such as expected utility maximization, making it easier for us to predict economic behavior that are routinely refuted empirically
The biggest threats to Modern Portfolio theory is the theory of Behavioral Finance. It is an analysis of why investors make irrational decisions with respect to their money, normal distribution of expected returns generally appears to be invalid and also that the investors support upside risks rather than downside risks. The theory of Behavioral finance is opposite to the traditional theory of Finance which deals with human emotions, sentiments, conditions, biases on collective as well as individual basis. Behavior finance theory is helpful in explaining the past practices of investors and also to determine the future of investors.
Behavioral finance is a concept of finance which deals with finances incorporating findings from psychology & sociology. It is reviewed that behavioral finance is generally based on individual behavior or on the implication for financial market outcomes. There are many models explaining behavioral finance that explains investor’s behavior or market irregularities where the rational models fail to provide adequate information. We do not expect such a research to provide a method to make lots of money from the inefficient financial market very fast.
Behavioral finance has basically emerged from the theories of psychology, sociology and anthropology the implications of these theories appear to be significant for the efficient market hypothesis, that is based on the positive notion that people behave rationally, maximize their utility and are able to prices observation, a number of anomalies (irregularities) have appeared, which in turn suggest that in the efficient market the principle of rational behavior is not always correct. So, the idea of analyzing other model of human behavior has came up.
Further (Gervais, 2001) explained the concept where he says that People like to relate to the stock market as a person having different moods, it can be bad-tempered or high-spirited, it can overreact one day and make amends the next. As we know that human behavior is unpredictable and it behaves differently in different situations. Lately many researchers have suggested the idea that psychological analysis of investors may be very helpful in understanding the financial markets better. To do so it is important to understand the behavioral finance presenting the concept that Investors are not as rational as traditional theory has assumed, and biases in their decision-making can have a cumulative effect on asset prices. To many researchers behavioral finance is a revolution, transforming how people see the markets and what influences prices. “The paradigm is shifting. People are continuing to walk across the border from the traditional to the behavioral camp”. (Gervais, 2001, P.2). On the contrary some people believe that may be its too early call it a revolution. Eugene Fama( Gervais, 2001) argued that Behavioral finance has not really shown impacts on the world prices, and the models contradict each other on different point of times. He gave little credit to behaviorist explanations of trends and “anomalies”(any occurrence or object that is strange, unusual, or unique) arguing that data-mining techniques make it possible to locate patterns.
Other researchers have also criticized the idea that the behavioral finance models tend to replace the traditional models of market functions. The weaknesses in this area, explained by him (Gervais, 2001) are that generally the market behavior displayed is attributed to overreaction and sometimes to under reaction. Where People take the behavior that seems to be easy for the particular study regardless of the fact that whether these biases are the result of underlying economic forces or not. Secondly, Lack of trained and expert people. The field does not have enough trained professionals both academic psychology and traditional finance and so the models that are being put up together are improvised.
David Hirshleifer (Gervais, 2001) focuses on the individual behavior influencing asset prices, suggesting that behavioral finance is in its developmental stage and not yet a mature one, there’s a lot of disagreement but productive one. Hirshleifer agrees that applying behavioral-finance concepts to corporate finance can pay off. If managers are imperfectly rational, he says, perhaps they are not evaluating investments correctly. They may make bad choices in their capital-structure decisions. Few people realistically think behavioral finance will displace efficient-markets theory. On the other hand, the idea that investors and managers are not uniformly rational makes insightful sense to many people.
Traditional Finance & Empirical Evidence:
“Traditional theory assumes that agents are rational & the law of one price holds” that is a perfect scenario. Where the law of “One price” states that securities with the same pay off have same price, but in real world this law is violated when people purchase securities in one market for immediate resale in another, in search of higher profits because of price differentials known as “Arbitrageurs”. And the agents rationality explains the behavior of investor “Professional & Individual” which is generally inconsistent with the rationality or the future predictions. If a market achieves a perfect scenario where agents are rational & law of one price holds then the market is efficient.
With the availability of amount of information, the form of market changes. It is unlikely that market prices contain all private information. The presence of “noise traders” (traders, trading randomly & not based on information).
Researches show that stock returns are typically unpredictable based on past returns where as future returns are predictable to some extent. Few examples from the past literature explains the problem of irrationality which occurs because of naïve diversification, behavior influenced by framing, the tendency of investors of committing systematic errors while evaluating public information.(Glaser et al, 2003)
Recent studies suggest that peoples` attitude towards the riskiness of a stock in future & the individual interpretation may explain the higher level trading volume, which itself is a vast topic for insight. A problem of perception exist in the investors that Stocks have a higher risk adjusted returns than bonds. Another issue with the investors is that these investors either care about the whole stock portfolio or just about the value of each single security in their portfolio and thus ignore the correlations.
The concept of ownership society has been promoted in the recent years where people can take better care of their own lives and be better citizen too if they are both owner of financial assets and homeowners. As a researcher suggested that in order to improve the lives of less advantaged in our society is to teach them how to be capitalist, In order to put the ownership society in its right perspective, behavioral finance is needed to be understood. The ownership society seems very attractive when people appear to make profits from their investments. Behavioral finance also is very helpful in understanding justifying government involvement in the investing decisions of individuals. The failure of millions of people to save properly for their future is also a core problem of behavioral finance. (Shiller, 2006)
According to (Glaser et al, 2003) there are two approaches towards Behavioral Finance, where both tend to have same goals. The goals tend to explain observed prices, Market trading Volume & Last but not the least is the individual behavior better than traditional finance models.
- Belief – Based Model: Psychology (Individual Behavior) Incorporates into Model Market prices & Transaction Volume. It includes findings such as Overconfidence, Biased Self- Attrition, and Conservatism & Representativeness.
- Preference Based Model: Rational Friction or from psychology Find explanations, Market detects irregularities & individual behavior. It incorporates Prospect Theory, House money effect & other forms of mental accounting.
Behavioral Finance and Rational debate:
The article by (Heaton and Rosenberg,2004) highlights the debate between the rational and behavioral model over testability and predictive success. And we find that neither of them actually offers either of these measures of success. The rational approach uses a particular type of rationalization methodology; which goes on to form the basis of behavior finance predictions. A closer look into the rational finance model goes on to show that it employs ex post rationalizations of observed price behaviours. This allows them greater flexibility when offering explanations for economic anomalies. On the other hand the behavior paradigm criticizes rationalizations as having no concrete role in predicting prices accurately, that utility functions, information sets and transaction costs cannot be ‘rationalized’. Ironically they also reject the rational finance’s explanatory power which plays an essential role in the limits of arbitrage, which actually makes behavioral finance possible.
Milton Friedman’s theory lays the basis of positive economics. His methodology focuses on how to make a particular prediction; it is irrelevant whether a particular assumption is rational or irrational. According to this methodology, the rational finance model relies on a limited “assumption space’ since all assumptions that are supposedly not rational have been eliminated. This is one of the major reasons behind the little success in rational finance predictions. Despite the minimal results, adherents of this model have criticized the behavioral model as lacking quantifiable predictions that are based on mathematical models. Rational finance has targeted a more important aspect in the structure of the economy, i.e. investor uncertainty, which further cause financial anomalies. In explaining these assertions, the behavioural emphasises the importance of taking limits in arbitrage.
Friedman’s methodological approach falls into the category ‘instrumentalism’, which basically states that theories are tools for predictions and used to draw inferences. Whether an assumption is realistic or rational is of no value to an instrumentalist. By narrowing what may or may not be possible, one will inevitably eliminate certain strategies or behaviors which might in fact go on to maximize utility or profits based on their uniqueness. An assumption could be irrational even in the long run, but it is continuously revised and refined to make it into something useful.
In opposition to this, many individuals have gone on to say that behaviouralists are not bound by any constraints thus making their explanations systematically irrational. Rubinstein (2001) described how when everyone fails to explain a particular anomaly, suddenly a behavioral aspect to it will come up, because that can be based on completely abstract irrational assumptions. To support rationality, Rubinstein came up with two arguments. Firstly he went on to say that an irrational strategy that is profitable, will only attract copy cat firms or traders into the market. This is supported when a closer look is given towards limits to arbitrage. Secondly through the process of evolution, irrational decisions will eventually be eliminated in the long run. The major achievements characterized of the rational finance paradigm consist of the following: the principle of no arbitrage; market efficiency, the net present value decision rule, derivatives valuation techniques; Markowitz’s (1952) mean-variance framework; event studies; multifactor models such as the APT, ICAPM, and the Consumption- CAPM. Despite the number of top achievements that supporters of the rational model claim, the paradigm fails to answer some of the most basic financial economic questions such as ‘What is the cost of capital for this firm?’ or ‘What is it’s optimal capital structure?’; simply because of their self imposed constraints.
So far this makes it seem like rational finance and behavioral finance are mutually exclusive. Contrary to this, they are actually interdependent, and overlap in several areas. Take for instance the concept of mispricing when there is no arbitrage. Behavior finance on the other hand suggests that this may not be the case; irrational assumptions in the market will still lead to mispricing. Further even though certain arbitrageurs may be able to identify irrationality induced mispricing, because of the imperfect market information, they are unable to convince investors of its existence. Over here, the rational model is accepting the existence of anomalies which are affected both through the factors of risk and chance; therefore coinciding with the perspective of behavioral finance. Two instances are clear examples of how rationalization is an important limit of arbitrage: i) the build-up and blow-up of the internet bubble; and ii) the superiority of value equity strategies.
If we focus on the latter, we are able to see behavioral finance literature that highlights the superiority of such strategies in the ability of analysts to extrapolate results for investors. This is possible when rationalization is taken as a limit to arbitrage. Similarly these strategies may also limit arbitrage against mispricing, through the great risk associated with stocks. In explaining most anomalies it is essential that analysts first conclude whether pricing is rational or not. To prove their hypothesis that irrationality-induced mispricing exists, behaviouralists may find it easier if they accepted the role of rationalization in limits of arbitrage. Slow information diffusion and short-sales constraints are other factors that explain mispricing. However these factors alone cannot form the basis of a strong and concrete explanation that will clarify pricing across firms and also across time.
Those supporting the rational paradigm attack behavioral finance adherents in that their predictions for the financial market have been made on irrational assumptions; that are not supported by concrete mathematical or scientific models. In their view the lack of concrete discipline in the methodology adopted in behavior finance leads to the lack of testing in their forecasts. On the other hand the rational model is criticized for its lack of success in financial predictions. The behaviouralists claim that this limitation exists because the supporters of rational finance dismiss aspects of the economic market simply because it may not fall into explainable rational behavior. Both perspectives claim to align themselves with respect to the goals of ‘testability’ and ‘predictions’, while at the same time continue to offer evidence against the other model. In reality however, rather than being exclusively mutual both paradigms assist one another in making their predictions.
A cognitive bias is a person’s tendency to make errors, based on cognitive factors. Forms of cognitive bias include errors in statistical judgment, social attribution, and memory that are common to all human beings. (Crowell, 1994, p. 1) “Cognitive bias is the tendency of intelligent, well-informed people to consistently do the wrong thing”. The reason behind this cognitive bias is that the Human brain is made for interpersonal relationships’ and not for processing statistics.
The paper discusses facility of forecasts. Generally it is said that the world is divided into two groups. One who forecasts positively and one negatively. These forecasts exaggerate the reliability of their forecasts and trace it to the “illusion of validity” which exists even when the illusionary character is recognized. (Fisher and Statman, 2000) discussed five cognitive bias, underlying the illusion of validity that are Overconfidence, Confirmation, Representativeness, Anchoring, and Hindsight
(Shiller, 2002) discusses, that irrational behavior may disappear with more learning and a much more structured situation. As the past research proves it that may of cognitive biases in human judgment value uncertainty will change, they may be convinced if given proper instructions, on the part-experience of irrational behavior. There are three main themes in behavioral finance and economics
Heuristics: People often make decisions based on approximate rules of thumb, not strictly rational analysis. See also cognitive biases and bounded rationality.
- Prospect theory
- Loss aversion
- Status quo bias
- Gambler’s fallacy
- Self-serving bias
- Money illusion
Framing: The way a problem or decision is presented to the decision maker will affect their action.
- Cognitive framing
- Mental accounting
Market inefficiencies: There are explanations for observed market outcomes that are contrary to rational expectations and market efficiency. These include mis-pricings, non-rational decision making, and return anomalies. Richard Thaler, in particular, has described specific market anomalies from a behavioral perspective.
Anomalies (economic behavior)
- Disposition effect Endowment effect
- Inequity aversion Intertemporal consumption
- Present-biased preferences Momentum investing
- Greed and fear Herd behavior
Anomalies (market prices and returns)
- Equity premium puzzle Efficiency wage hypothesis
- Limits to arbitrage Dividend puzzle
Models in behavioral economics are typically addressed to a particular observed market anomaly and adjust standard neo-classical models by describing decision makers as using heuristics and being affected by framing effects. In general, economics sits within the neoclassical framework, though the standard assumption of rational behavior is often challenged.
Loix et. Al in their paper “Orientation towards Finances” explains the individual financial management behavior, people dealing with their financial means. They have analyzed the Non-specific Financial behavior as already we see extensive research on the specific finance behavior such as saving, Taxation, Gambling, amassing debt. But they had given a lot of importance to stock market, investors and households. The analysis of general public`s behavior was done, where an ordinary man is not sure and simply act according to the guesses over their money related issues. It was also found that people interested in economic and financial matters are much more active in collecting specific information than general public, stating that financial behavior of household is an important relevant topic that needs to be discussed in much more details. Household financial management is similar to the financial management. The construct of orientation towards finances was developed where the individual ORTO FIN focuses on competencies (interest and skills). Having stronger money attitude is an indication of stronger orientation towards finances and much more effective competencies. Therefore we expect some relevance and similarity between corporate and household management behavior as both require organizing, forecasting, planning and control.
(Loix et. al, 2005) analyzed general public’s behavior in basically dividing them into two groups, Financial Information & Personal financial planning. Also explaining some practical and theoretical gaps in the area of psychology of money usage, they concluded that ORTOFIN (Orientation towards finance) indicates the involvement of individuals in managing their finances. Proving out the point that active interest in financial information and an urge to plan expenses are two main factors. A stronger ORTFIN indicates: Greater use of debit accounts, Higher savings account, Wide variety of investments, Greater awareness of one’s financial Intimate knowledge of the details of Ones savings/deposit accounts obsessed by money, Higher achievement and power in monetary terms, Further age is also inversely proportional.
Shiller in 2006, in his article talked about the the co-evolution of neo-classical and behavior finance. In 1937 when A. Samuelsson one of the great economists wrote about people maximizing the present value of utility subject to a present vale – budget constraint. Another judgment he realized was time being consistent human behavior where if at any time t
0 < t < b
Where people reconsidered the problem of maximization from that date forward, they would not change their decision where as in real life it is totally opposite for example people sometimes try to control themselves by binding their future decision as from history we find out that that some of man make irrevocable trust in the taking out of life insurance as a compulsory savings measure. (shiller, 2006, p.) Considering personal saving rate, saving and down for no reason has emerged as a weakness of human self control. People seem to be vulnerable to complacency from time to time about providing for their own future.
The distinction between neoclassical and behavioral finance have therefore been exaggerated. Both of them are not completely different from each other. Behavioral finance is more elastic willing to learn from other sciences and less concerned about the elegance of models whereby explaining human behavior
Investing and cognitive bias:
Money Managers & Money management is a very popular phenomenon. The performance in the stock market is measured at the daily basis and not to wait for a highly subjective annual review of one’s performance by one’s superior. Market grades you on a daily basis. The smarter one is, the more confident one becomes of one’s ability to succeed, clients support them by trusting them that eventually helps their careers. But the truth is that few money managers put in sufficient amount of time and effort to figure out what works and develop a set of investment principles to guide their investment decisions (Browne, 2000). Further Browne discussed the importance of asset allocation and risk aversion, in order to understand why we do what we do regardless of whether it is rational or not. General public opts for money Managers to deal with their finances and these managers are categorized in three ways: Value Managers, Growth Managers and Market Neutral Managers. The vast majority of money managers are categorized as either value managers or growth managers although a third category, market neutral managers, is gaining popularity these days and may soon rival the so-called strategies of value and growth. Some investment management firms even are being cautious by offering all styles of investments. What too few money managers do is analyze the fundamental financial characteristics of portfolios that produce long-term market beating results, and develop a set of investment principles that are based on those findings. Difference of opinion on the definition of Value is the problem.The reasons for this are two-fold, one being the practical reality of managing large sums of money, and the other related to behavior. As the assets under management of an advisor grow, the universe of potential stocks shrinks
Analyzing that why individual and professional investors do not change their behavior even when they face empirical evidence, that suggests that their decisions are less than optimal. An answer to this question is said to be that being a contrarian may simply be too risky for the average individual or professional. If a person is wrong on the collective basis, where everyone else also had made a mistake, the consequences professionally and for one’s own self-esteem are far less than if a person is wrong alone. The herd instinct allows for the comfort of safety in numbers. The other reason is that individuals try to behave the same way and do not tend to change courses of action if they are happy. If the results are not too painful individuals can be happy with sub-optimal results. Moreover, individuals who tend to be unhappy make changes often and eventually end up being just as unhappy in their new circumstances.
According to the traditional view of Investment management, fundamental forces drive markets, however many other investment firms considers to be active and working out based on their experienced Judgment. It is also believed that Judgmental overrides of Value & Fundamental forces of markets can be lethal as well as a cause of Financial Disappointment. From the history it has been found that people Override at the wrong times and in most cases would be better off sticking to their investment disciplines (Crowell, 1994) and the reason to this behavior is the Cognitive bias. According to many researchers, stocks of small companies with low price/book ratios provide excess returns. Therefore, given a choice among small cheap stocks & large high priced stocks, prominent investors (financial analysts, senior company executives and company directors) will certainly prefer the small cheap ones. But the fact is opposite to this situation where these prominent investors would opt for large high priced ones and so suffer from cognitive bias and further regret. According to a survey in 1992/1993, a research was carried out that included senior executives & directors where they were suppose to rate companies in their industries on eight factors: Quality of management, Quality of products & services, Innovativeness, Long term investment value, Financial soundness, Ability to attract, develop and keep talented people, Responsibility to the community and environment, Wise use of corporate assets.
The assumptions that we made were that that “Long term investment value should be negatively correlated with size since small stocks provide superior returns. Long term Investment value should have a negative correlation with Price/book since low Price/Book stocks provide superior returns”.(Crowell, 1994).
Whereas the results of the survey were contrary that stated that Long Term Investment had a positive correlation with the size and also that the Long term investment value had a positive correlation with the Price/Book stocks. According to Shefrin and statman, prominent investors overestimate the probability that a good company is a good stock, relying on the representative heuristics, concluding that superior companies make superior stocks. Aversion to Regret: aversion to regret is different from aversion to risk, Regret is acute when the individual must take responsibility for the final outcome. Aversion to regret leads to a preference for stocks of good companies. The choice of the stocks of bad companies involves more personal responsibility and higher probability of regret. Therefore, we find there are two major Cognitive errors:
“We have a double cognitive error: a Good company make good stocks (representativeness), and involves less responsibility(Less aversion to regret” (Crowell, 1994,p.3)
The Anti Cognitive bias actions would be admitting to your owned stocks, admitting earlier investment mistakes. Further Taking the responsibility for the actions to improve their performance in the future. The reasons for all the available disciplines, tools, and quantitative techniques is to deal with the Cognitive bias error, where the quantitative investment techniques enables the investment managers to overcome cognitive bias, follow sound investment, and eventually be successful contrarian investor(one who rejects the majority opinion, as in economic matters).
Behavioral finance also is very helpful in understanding justifying government involvement in the investing decisions of individuals. The failure of millions of people to save properly for their future is also a core problem of behavioral finance. With the help of two very important examples Shiller explains how Government involvement can influence financial investments of individuals.
In April 2005 “Tony Blair” stated a program when all new born babies were given a birthday present of 250 to 500. The present were to choose among a number of investment alternatives to invest until child comes of age. This is an effect done in order to make the parents feel connected with investments and modern economy.
Another example: as it is said that people should be heavily active in stock market when they are young and so generally should reduce the activity with age. According to the conventional rule people should have
100 – Age = % age of investment
In 2005 president bush also portfolio announced one such plan for personal account “life – cycle fund” which would be among the option that works will be offered to invest their personal account. It was A centerpiece of the president’s proposal bur a major point to be noticed was the default option.
An important aspect of behavioral finance is the human attention is capricious focuses heavily tat same times on financial calculations and are subject to distraction and dissipation of default option is central. All this brings us a question that what should an intertemporal optimizer do to manage his portfolio over the lifetime. According to Samuelson someone who wished to maximize the expected value of his intertemporal utility function by managing the allocation of the portfolio between a high yielding asset and less yielding asset would not actually change the allocation through time. Neoclassic finance appears highly relevant to such a discussion in that it offers the appropriate theoretical framework for considering what people ought to do with the portfolio if not what they actually do. Behavioral is beginning to play an important role in public policy such as in social
Global culture Culture & Social Contagion:
The selective attention exhibited by a human mind is the concept of culture. Every nation, tribe or asocial group has a social cognition reinforced by conversation ritual and symbols, rituals and supposition of a particular nation has a subtle but far reliability affect on human behavior. Some researchers found that the unique customs of people actually arise as a logical consequence of a belief system of a nation group of people. Cultural factor were found to have great influence on rational or irrational behavior. We find many factors that are same across countries , e.g fashion, music, movies, youthful rebellious, other than these we find more factors in producing internationally- similar human behaviors then just rational reactions. Therefore it is a difficult job to decide in what avenues global culture exerts
Cite This Work
To export a reference to this article please select a referencing stye below:
Related ServicesView all
Related ContentAll Tags
Content relating to: "Finance"
Finance is a field of study involving matters of the management, and creation, of money and investments including the dynamics of assets and liabilities, under conditions of uncertainty and risk.
Rights and Duties in a Letter of Credit Transaction
This dissertation highlights the imbalance of the rights and duties of the parties in a letter of credit transaction by emphasising deficiencies in the letters of credit system....
General Dynamics and Lockheed Martin Comparison
Financial Statement Analysis General Dynamics vs. Lockheed Martin Executive Summary: This analysis provides a comparison of two major companies within the Aerospace and Defense industry, General Dyna...
DMCA / Removal Request
If you are the original writer of this dissertation and no longer wish to have your work published on the UKDiss.com website then please: