Finance is being said to be the domain of the perfect rationale. The rationality then creates an environment called “efficient markets”, where maximization of utility takes place and all actors act in this sense – earn more. The classical rationality argues that economical expectation derives the best forecasts as “price (at any time) fully reflect(s) available information on the market” (Fama, 1970), which is the core assumption in the EMH. However observing the day-to-day market behavior one would find that not all players act in this way and an observation of a longer period of asset price fluctuation makes one believe that there are rare people who act mathematically correct or rational with respect to classical utilitarian definition. A growing field of science, behavioral finance, attempts to explain and predict future irrational (or economically inefficient) behavior. Behavioral sciences are motivated by an argument that business finance, being conducted by people, can also include human irrationality aspects to be holistic. Nevertheless, literature adheres to the classical efficient markets theory and psychological effects are being ignored or seen as an extension to it. However, the ex-post analysis of asset prices shows that more data can be explained through application of behavioral science to modern finance. In course of this paper we are going to deliver an overview over the topic of behavioral finance to give a comprehensive explanation on what implications it makes regarding markets. Thus, in the second chapter we are going to introduce the concepts of efficient markets, anomalies on these markets and the respective paradigm shift. The third chapter given an overview over most common biases the human behavior is subject to. The fourth, conclusive chapter summarizes the paper. (written and edited: K. Klineskiy)
EMH & Behavioral Finance: A Paradigm Shift
Today’s literature on finance compromises between the theory and the practice and its anomalies. To understand the characteristics of both standpoints, efficient markets hypothesis (further: EMH) and behavioral finance background is going to be provided. In 1970s’ rationality considerations were a major part of academic discussion and prominent articles building on them were published. For instance, Merton (1973) published “An Intertemporal Capital Asset Pricing Model” which recreated the asset
pricing problem as an equilibrium concept. In 1979 a prominent theory about “consumption betas” was published by Breeden that explained a stock return through its correlation with the market. Nonetheless, in the same time first articles appeared reporting about anomalies on the market, e.g. Fama (1970) “Efficient Capital Markets: A Review of Empirical Work” denoted slight serial dependencies in stock returns. Peper of Fama came to the conclusion that efficient markets work, but the implication that they are not perfectly correct was made. Thereby, modern finance builds on certain central arguments: I. II. III. Portfolio allocation is based upon expected return and underlying risk. Risk-based asset pricing can be derived using return correlation to market risk and return (CAPM). Modigliani and Miller theorem based on agency theory explains contingent claims. These central arguments are based on rational behavior of the investors. While they
revolutionized the understanding of finance and introduced rigorous explanations some observations in practice may give a reason for reconsideration. Example given: while most studies underline the benefits of diversification for risk restriction, many individual investors hold only a very limited number of stocks. The above statements, as argued, explain much, but not all of the behavior of the investors. Hence, anomalies that constitute the gap between actual theory and reality must be analyzed. One of the most discussed anomalies of the modern...