A Survey of Behavioral Finance Summary

Capital markets provide a function which facilitates the buying and selling of long-term financial securities to increase liquidity and their value, Watson & Head (2013). Hence, the Efficient Market Hypothesis (EMH) explains the relationship that exists with the prices of the capital market securities, where no individual can beat the market by regularly buying securities at a lower price than it should be. This means that in order to be an efficient market prices of securities will have to fairly and fully reflect all available information, Fama (1970). Consequently, Watson & Head (2013) believe that market efficiency refers to the speed and quality of how share price adjusts to new information. Nevertheless, the testing of the efficient markets has led to the recognition of three different forms of efficiency in which explains how information available is used within the market. In this essay, the EMH will be analysed; testing of EMH will show that the model does provide strong evidence to explain share behaviour but also anomalies will be discussed that refutes the EMH. Therefore, a judgment will be made to see which structure explains the efficient market and whether there are some implications with the EMH, as a whole.

On the other hand behavioural finance defines the market dynamics and movement in terms of psychology of the participants in the trading process. Behavioural finance proposes that the amount of information available in the market regarding the factors that determine the output or profitability of a particular investment actually serve to determine the movement and output of the market itself (Fama, E.F., 1998).

Second, financial managers use economic principles to guide them in making financial decisions that are in the best interest of the firm. In other words, finance is an applied area of economics that relies on accounting for input.

Financial Assets: Robert Shiller, a Noble Prize winner in Economics, has the belief that our cultural and psychological thoughts influence our financial behavior. Shiller highlights the key factors of the irrational exuberance that exists in the financial market. In his book, Irrational Exuberance, he argues that investors often make irrational decisions. Throughout the book, he explains that there are twelve factors that impact the market behavior from 1995 to 2005 and that eventually led to a financial bubble. Some of these factors can be linked to the Black Thursday of 1929.

Behavioural economics is the study of the effects that psychology has on the decision making of the economy. This tends to be the way that people think and feel when they are spending money on a certain good or service. The great economist Adam Smith was the first follower of this idea through his book “The theory of moral sentiments” which dates back to 1759. However, it took over 100 years to get a more clarified meaning of how big of a role the psychology of a buyer plays in economics. In behavioural economics there are seven basic principles which all contribute to the decision making process. Behavioural economics can explain how people will react to different situations such as times when there are no economic problems and times when

Challenges are presented to people on the daily basis. What to eat, drink, where they have to go, who they need to see, and etc... These things all impact the decision making process and the decisions made. In financial decision making, highly successful people do not make investment decisions based on past sunk outcomes, rather by examining choices with no regard for past experiences; this approach conflicts with what one may expect. In addition to past experiences, there are several cognitive biases that influence decision making.

The answer to this question is how people really make decisions and why human decision making have so many short comings. The author defines the entire field of economics as a decision of science. Political economics involves national and international resource allocation and distribution of wealth. He extends general economics into the fields of political science, sociology and psychology.

It was previously assumed that economic investors and regulators (agents) utilised all available information and thus market prices were a reflection of this information with assets representing their fundamental value, encouraging the position that agents’ actions were rational. The 2007-2008 Global Financial Crisis (GFC) is posited to have originated from the notion that all available information was utilised, causing agents to fail to thoroughly investigate and confirm “the true values of publicly traded securities,” leading to a failure to register the presence of an asset price bubble preceding the GFC (Ball 2009).

With attention to the previous information given, the principle of risk-return tradeoff is based on the thought that individuals are opposed to taking risk, meaning individuals would prefer to get a certain return on their investment rather than risking and getting an uncertain return. (Titman, Keown, & Martin, 2014) This principle tells us that investors will receive higher returns for taking on a bigger risk however; a challenge often seen in investors is how to calculate the tradeoff between risks and return with riskier investments. A higher expected rate of return is not always a higher actual return.

Keynes (1936, p155-56) describes the stock market using an analogy between professional investment and newspaper beauty contest: “Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole…It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligence to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth, and higher degrees.” The Stock Market decisions work based on conventional values too, where each is not concerned with determining the real stock value, but the market value the community will place on the stock, before everyone else does.

The rationalist paradigm (e.g., microeconomics and finance) is focused upon the structure and processes of markets. The market is seen as dominating other potential

According to the Efficient Market Hypothesis, competition will instantaneously cause the effects of new information to be reflected in actual share prices. This assumption presupposes that the participants in a market act rationally. The concept of the homo economicus has a long-standing history in economics and is a relevant premise of efficient markets. According to the founder of economic thought, Adam Smith, the homo economicus is human who constantly peruses self-interest while always acting rational to reach his subjectively defined ends (Coase, 1994). At times, psychologists joined this discussion and challenged the concept of the economic man. Among the most prominent researchers who question the rationality in human decision making is Daniel Kahneman. Kahneman challenged the rationality in decision making processes and is one of the founders of behavioral economics. Behavioral economists argue that markets are not perfectly efficient because various cognitive biases in humans (HBR, 2015). Among the most prominent cognitive biases that influence stock prices are the Overconfidence Hypothesis and the Disposition Effect.

The efficient market, as one of the pillars of neoclassical finance, asserts that financial markets are efficient on information. The efficient market hypothesis suggests that there is no trading system based on currently available information that could be expected to generate excess risk-adjusted returns consistently as this information is already reflected in current prices. However, EMH has been the most controversial subject of research in the fields of financial economics during the last 40 years. “Behavioural finance, however, is now seriously challenging this premise by arguing that people are clearly not rational” (Ross, (2002)). Behavioral finance uses facts from psychology and other human sciences in order to

In a world without uncertainty the rational approach would be (1) to maximize profits and (2) to maximize market value. When uncertainty arises, these statements vanish and change into a utility maximization. The goal is to get more insight in the effect of financial structure on market valuations.

First time this phenomenon was presented by the economists Rajnish Mehra and Edward Prescott in 1985. They discovered that the return from US equity investments in comparison to the return from a risk free government securities had been much far above during the twentieth century to be interpreted by the traditional economic theories (Siegel and Thaler, 1997).