Behavioral Finance

Topics: Decision making, Financial economics, Efficient-market hypothesis Pages: 13 (2783 words) Published: October 7, 2014

Behavioral Finance

Behavioral finance attempts to explain what, why, and how of finance and investing from a human perspective. More specifically, behavioral finance integrates psychology and economics into the study of human judgment and biases in decision making under conditions of uncertainty. (David, 2004) In order to clearly define and explain the origin of behavioral finance, it is important to first define finance, which is the foundation of behavioral finance. Finance is a field within economics that deals with the allocation of assets and liabilities over time under conditions of certainty and uncertainty. Finance aims to price assets based on their risk level and their expected rate of return (“Finance”, 2014). Within finance, there are many types of financial models and theories. The Modern Portfolio Theory (MPT), Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) are the quantitative models that form basis theories for modern finance. Back in the 1980s, researchers found that there were many anomalies in the finance markets that could not be explained.  In 1990, a large number of high-quality theoretical and empirical literature research emerged on the study to apply behavior on the finance. One must know the Efficient Market Hypothesis (EMH) in order to understand behavioral finance. The Efficient Market Hypothesis is the theory that prices of securities fully reflect all available information and that all market participants receive and act on all relevant information as soon as it becomes available. (Ricciardi & Simon, 2000) Shiller (2013) defines it as the idea that speculative assets prices such as stock prices always incorporate the best information about fundamental values and that prices change only because of good, sensible information meshed very well theoretical trends. The Efficient Market Hypothesis was developed by Professor Eugene Fama at Booth School of Business of the University of Chicago as an academic concept of study through his published Ph.D. thesis in the early 1960s at the same school. Fama and French (1993 & 1996) showed that the cross-section average returns and individual trading behavior were not easily understood by aggregate stock market and financial experts applied cognitive psychology study the investor’s behavior. It was widely accepted up until the 1990s, when behavioral finance economists, who had been a fringe element, became mainstream. (“Efficient Market Hypothesis”, 2014) The foundations of EMH rest on three basic arguments 1) investors are assumed to be rational and hence they value securities rationally, 2) to the extent that some investors are not rational, their trades are random and hence cancel each other out ultimately having no effect on prices, and 3) if investors are irrational, they will be met in the market by rational arbitrageurs who will eliminate any influence they have on the market (Lawrence, McCabe & Prakash, 2007). Research from the field of behavioral investment suggests that investor’s emotions drive to emulate the actions of others, and the general aversion to loss influences one’s investment decisions more than the numbers on the page of an investment prospectus or financial report. Gilovich, Griffin and Kahneman (2002) compiled the most influential research in the heuristics and biases tradition by identifying six general purpose heuristics and six special purpose heuristics  in their book ‘The Psychology of Intuitive Judgment’.   Heuristics are simple, efficient rules which people often use to form judgments and make decisions. These rules work well under most circumstances, but they can lead to systematic deviations from logic, probability or rational choice theory.  They studied how people make real-world judgments and the conditions under which those judgments are unreliable. This research challenged the idea that human beings are rational actors, but provided a theory of information...

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