Behavioural Finance

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Anomalies to Efficient Market Hypothesis and the extent to which they can be explained by behavioural finance theories

Finance that is based on rational and logical theories, such as the capital asset pricing model (CAPM) and the efficient market hypothesis (EMH). These theories assume that people, for the most part, behave rationally and predictably. The Efficient market hypothesis assumes that financial markets incorporate all public information and assets that share prices reflect all relevant to the firm information (Fama, 1970). Relevant information includes past information, publicly available information and private information. Efficient market is divided into three categories. Weak form efficiency is when stock prices reflect only the past information, semi-strong form is when past information and all publicly available information is reflected and strong form is when all the past, publicly available and information only available to company insiders is reflected on the stock prices. However, there are some anomalies and behaviors that couldn't be explained by EMH. Market participants often behaved very unpredictably. However there is a new study called behavioral finance that is trying to explain all these anomalies. Behavioral finance studies the irrational behavior of the investors. Weber (1999) makes the following observation: ‘Behavioral Finance closely combines individual behavior and market phenomena and uses the knowledge taken from both the psychological field and financial theory’. Behavioral finance attempts to identify the behavioral biases commonly exhibited by investors and also provides strategies to overcome them. Some of the main problems with EMH may be cause by heuristic responses to new information, psychological anchors, overconfidence, social fads, framing and regret avoidance and herd behavior. Overconfidence: According to Nevins (2004), overconfidence suggests that investors overestimate their ability to predict market events, and because of their overconfidence they often take risks without receiving commensurate returns. Odean (1998) finds that investors tend to overestimate their ability, unrealistically optimistic about future events, too positive on self-evaluations, over-weight attention getting information that is consistent with their existing beliefs, and over-estimate the precision of their own private information. Overconfidence about private signals causes overreaction and hence phenomena like the book/market effect and long-run reversals whereas self-attribution maintains overconfidence and allows prices to continue to overreact, creating momentum. In the longer-run there is reversal as prices revert to fundamentals. Psychological Anchors, Overreaction: Good news should raise a business' share price accordingly, and that gain in share price should not decline if no new information has been released since. Reality, however, tends to contradict this theory. Oftentimes, participants in the stock market predictably overreact to new information, creating a larger-than-appropriate effect on a security's price. Furthermore, it also appears that this price surge is not a permanent trend - although the price change is usually sudden and sizable, the surge erodes over time. Heuristic responses to new information: Availability heuristic is used to evaluate the frequency or likelihood of an event on the basis of how quickly instances or associations come to mind. When examples or associations are easily brought to mind, this fact leads to an overestimation of the frequency or likelihood of this event. Example: People are overestimating the divorce rate if they can quickly find examples of divorced friends. People tend to be biased by information that is easier to recall. They are swayed by information that is vivid, well-publicized, or recent. People also tend to be biased by examples that they can easily retrieve.( Tversky and Kahneman, 1974) Confirmation bias is a cognitive bias...
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