A Survey of Behavioral Finance Summary

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A Survey of Behavioral Finance 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

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