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Investment Analysis and Portfolio Management

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Investment Analysis & Portfolio Management (FIN630)
Lesson # 24
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
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
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.
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.