Medoc Company

Topics: Economics, Financial economics, Rational choice theory Pages: 24 (8324 words) Published: January 28, 2011
Investment Management and Financial Innovations, Volume 3, Issue 4, 2006

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BEHAVIORAL FINANCE, BOUNDED RATIONALITY, NEURO-FINANCE, AND TRADITIONAL FINANCE K.C. Tseng* Abstract
The principal purpose of this study is to piece together the important development and contributions by efficient market hypothesis, bounded rationality, behavioral finance, neurofinance, and the recently introduced adaptive market hypothesis. In the process the author will review the selected literature so that they can be linked together for further consideration and development. When monthly and daily data for S&P 500, DJIA, and NASDAQ indexes were analyzed from 1971 to 2005, the author found long string of positive and significant autocorrelations and great volatility, which were not consistent with the efficient market hypothesis. The international market indexes from Japan, Hong Kong, Singapore, Mexico, Taiwan, and Canada are also very volatile even though they show less volatility compared to the U.S. indexes. Since AMH was introduced in 2004, it is promising but is still at its infant stage of development. Finally, the neural/medical finance can help us understand the brain activities when investors are making investing and trading decisions, and the effect of drugs on brain and investment decision-making. The future of neurofinance and AMH appears to be promising. Key words: adaptive market hypothesis, affect and emotion, behavioral finance, bounded rationality, efficient market hypothesis, excessive volatility, neurofinance, and psychophysiology. JEL classification: N2, N20.

1. Introduction
In recent years new fronts have been rapidly developing in investments and financial markets. In particular, the behavioral finance, evolutionary finance, and neurofinance are challenging the traditional finance. Whether the financial markets, in particular the stock markets, are efficient or not and whether market participants are rational or not, depend to a large extent on the ways people look at the markets. They look at exactly the same empirical evidence or findings, but they may interpret the observations quite differently. People are yet different biologically, genetically, in education and training, in experience, in opportunities, and many other aspects. Financial market participants and researchers have diversified background in education, training, experience, investment objectives, available information, time constraint, capability of analyzing and processing available data, and the ability to predict the future uncertain conditions. Active investors and academic researchers are quite different in many aspects just mentioned. Technical analysis, which is inconsistent with efficient market hypothesis (EMH), has been an important tool for most market participants since the beginning of financial markets. The key controversy between proponents of EMH and advocates of behavioral finance centers on the extent or degree of market efficiency, investors’ rationality, and interpretations of many empirical findings. The theoretical foundations of EMH rest on three basic assumptions. First, market participants are perfectly rational and are able to value securities rationally. Second, even if there are some investors who are not rational, their trading activities will either cancel out with one another or will be arbitraged away by rational investors (Shleifer, 2000). Finally, market participants have well defined subjective utility functions which they will maximize. According to Simon (1982, vol. 2, p. 408), “Rationality denotes a style of behavior that is appropriate to the achievement of given goals, within the limits imposed by given conditions and constraints. Theories of rational behavior may be normative or descriptive, that is, they may prescribe how people or organizations should behave in order to achieve certain goals under certain *

Craig School of Business, California State University at Fresno, USA.

© K.C. Tseng, 2006...

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