Nicholas Barberis and Richard Thaler
In this handbook, Barberis and Thaler define the differences between traditional finance and behavioral finance.
Traditional finance is rational.Rationality means two things; correct Bayesian Updating and choises consistent with expected utility. On the other hand behavioral finance assumes that market is not fully rational and analyzes the facts when the some of the princibles are loosen up.
This essay also discusses about two main topics; limits to arbitrage and psychology. These two topics are known as the two buildings blocks of the behaviour finance.
In the normal markets security prices equal to fundamental value.In this sitiuation. expected cash flows can be easily calculate with the markets’ discount rates. This hypothesis called Efficient Market Hypothesis.According to this hypothesis; as soon as there will be a deviation from fundemantal value and mispricings will be corrected by rational traders.
An arbitrage is an investment strategy that offers riskless profits at no cost. The rational traders le became known as arbitrageurs because of the belief that a mispriced asset immediately creates an opportunity for riskless profits. Behavioral finance argues that this is not true. According to behavioral finance “prices are right” and “there is no free lunch” statments are not equal.
If the market value of a stock is not equal to fundemantal value of the stock, arbitrageurs can not enter the position easily. Because there are some risks and costs. First of all there is a fundemantal risk. If the negative shock occurs to the stock , there is not a prefect substitude to hedge theirselves.
Second risk is about noisy traders. Noisy trader can be caused to decrease according to their pessimistic behavior. Noisy traders forces the arbitrageurs to liquidate their position early. This is called seperation of brains and capital. Trading in the same direction of noisy traders and arbitrageurs can also caused problems.
Execution or implementation costs are also limitting to arbitragesuch as commisions, bid/ask spread; Price impact, short sell costs and identification cost. So far, we see how the difficult for the rational traders such as hedge funds to exploit market market inefficiencies.
In Evidence part of the hand book they discuss if there is some evidence that arbitrage is limited. If arbitrage were not limited, the mispricing would quickly disappear. It is not easy to identify mispricings. when a mispriced security has a perfect substitute, arbitrage can still be limited if arbitrageurs are risk averse and have short horizons and the noise trader risk is systematic, or the arbitrage requires specialized skills, or there are costs to learning about such opportunities. Index ınclusions are shown as a good example of evidence supporting limits to arbitrage in the handbook. It almost says that stock prices jups premanantly and gives examples from S&P.
The theory of limited arbitrage shows that if irrational traders cause deviations from fundamental value, rational traders will often be powerless to do anything about it.In this part Barberis and Thaler summarize the psychology and summarize what psychologists have learned about how people appear to form beliefs in practice.
Overconfidence, optimism and wishful thinking , representativeness, conservatism, belief perseverance, anchoring, availability biases are some of beliefs that explain in the book.The important thing of all these biases that according to observations when the bias is explained, people often understand it, but then immediately proceed to violate it again. On the other hand, people, through repetition, will learn their way out of biases; that experts in a field, such as traders in an investment bank, will make fewer errors; and that with more powerful incentives, the effects will...