Behavioral Finance

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Investment Analysis & Portfolio Management (FIN630)

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Behavioral Finance:

Behavioral finance is the study of the influence of psychology on the behavior of financial

practitioners and the subsequent effect on markets. Sewell says "I think of behavioral

finance as simply "open-minded finance". Thaler says 'This area of enquiry is sometimes

referred to as "behavioral finance," but we call it "behavioral economics." Behavioral

economics combines the twin disciplines of psychology and economics to explain why and

how people make seemingly irrational or illogical decisions when they spend, invest, save,

and borrow money."

This paper examines the case for major changes in the behavioral assumptions underlying

economic models, based on apparent anomalies in financial economics. Arguments for such

changes based on claims of "excess volatility" in stock prices appear flawed for two main

reasons: there are serious questions whether the phenomenon exists in the first place and,

even if it did exist, whether radical change in behavioral assumptions is the best avenue for

current research. The paper also examines other apparent anomalies and suggests conditions

under which such behavioral changes are more or less likely to be adopted. Because

psychology systematically explores human judgment, behavior, and well-being, it can teach

us important facts about how humans differ from traditional economic assumptions. In this

essay I discuss a selection of psychological findings relevant to economics. Standard

economics assumes that each person has stable, well-defined preferences, and that she

rationally maximizes those preferences. Section 2 considers what psychological research

teaches us about the true form of preferences, allowing us to make economics more realistic

within the rational choice framework. Section 3 reviews research on biases in judgment

under uncertainty; because those biases lead people to make systematic errors in their

attempts to maximize their preferences, this research poses a more radical challenge to the

economics model. The array of psychological findings reviewed in Section 4 points to an

even more radical critique of the economics model: Even if we are willing to modify our

familiar assumptions about preferences, or allow that people make systematic errors in their

attempts to maximize those preferences, it is sometimes misleading to conceptualize people

as attempting to maximize well-defined, coherent, or stable preferences.

Market efficiency survives the challenge from the literature on long-term return anomalies.

Consistent with the market efficiency hypothesis that the anomalies are chance results,

apparent overreaction to information is about as common as under reaction and post-event

continuation of pre-event abnormal returns is about as frequent as post-event reversal. Most

important, consistent with the market efficiency prediction that apparent anomalies can be

due to methodology, most long-term return anomalies tend to disappear with reasonable

changes in technique.

The field of modern financial economics assumes that people behave with extreme

rationality, but they do not. Furthermore, people's deviations from rationality are often

systematic. Behavioral finance relaxes the traditional assumptions of financial economics by

incorporating these observable, systematic, and very human departures from rationality into

standard models of financial markets. We highlight two common mistakes investors make:

excessive trading and the tendency to disproportionately hold on to losing investments

while selling winners. We argue that these systematic biases have their origins in human

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Investment Analysis & Portfolio Management (FIN630)

psychology. The tendency for human beings to be overconfident causes the first bias in

investors, and the human desire to avoid regret prompts the second.

Behavioral finance is a rapidly growing area that deals with the influence of psychology on

the behavior of financial practitioners. Behavioral finance is the application of psychology

to financial behavior--the behavior of practitioners. Behavioral finance is the study of how

psychology affects financial decision making and financial markets. Behavioral finance

argues that some financial phenomena can plausibly be understood using models in which

some agents are not fully rational. The field has two building blocks: limits to arbitrage,

which argues that it can be difficult for rational traders to undo the dislocations caused by

less rational traders; and psychology, which catalogues the kinds of deviations from full

rationality we might expect to see. We discuss these two topics, and then present a number

of behavioral finance applications: to the aggregate stock market, to the cross-section of

average returns, to individual trading behavior, and to corporate finance. We close by

assessing progress in the field and speculating about its future course.

Behavioral finance and behavioral economics are closely related fields which apply

scientific research on human and social cognitive and emotional biases to better understand

economic decisions and how they affect market prices, returns and the allocation of

resources.

Risk aversion:

Risk aversion is a concept in economics, finance, and psychology related to the behavior of

consumers and investors under uncertainty. Risk aversion is the reluctance of a person to

accept a bargain with an uncertain payoff rather than another bargain with more certain, but

possibly lower, expected payoff.

Example:

A person is given the choice between two scenarios, one certain and one not. In the

uncertain scenario, the person is to make a gamble with an equal probability between

receiving $100 or nothing. The alternative scenario is to receive a specific dollar amount

with certainty.

Investors have different risk attitudes. A person is;

Risk-averse if he or she would accept a certain payoff of less than $50 (for example,

$40) rather than the gamble.

Risk neutral if he or she is in different between the bet and a certain $50 payment.

Risk-seeking (or risk-loving) if the certain payment must be more than $50 (for

example, $60) to induce him or her to take the certain option over the gamble.

The average payoff of the gamble, known as its expected value, is $50. The dollar amount

accepted instead of the bet is called the certainty equivalent, and the difference between it

and the expected value is called the risk premium.

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