Behavioral finance involves the study of the impact of psychology on the behavior of financial investors and the resultant influence on markets. This study focuses on explaining why financial markets tend to be inefficient. Until 1980's, people only relied on standard market models to predict and explain occurrences in financial markets. However, these efficient markets were facing a problem brought about by volatility in the markets which led to enormous swings in stock prices. It was at this point that behavioral finance grounded a foundation as a field in economics. Through continued research, behavioral finance gained significance and concepts of cognitive dissonance, risk aversion, and heuristics were developed to explain various aspects of the field. Advocates of standard efficient markets did not readily accept behavioral finance as a major probably because they perceived it as less of a science. However, as asserted by Thaler, behavioral finance enriches understanding of financial markets and therefore, it's unavoidable acceptance will lead to its wide application hence deeming it more of a rounded concept than a specific field of study.
Basic Assumptions in Financial Theories
According to Hammond, C. (2015, 9), behavioral finance emerged from prospect theory, in 1979, that attempted to model how people make decisions opposed to them relying on utility decision-making strategies based on the economic theory. The prospect theory argues that people tend to make decisions based on the value of potential gains and losses. Behavioral finance introduced aspects of human behavior in acquiring information and making associated financial decisions. This paradigm tries to predict implications on financial markets by psychological decision-making processes. The prospect theory is of the argument of risk aversion rather than the expected utility argument in standard economics. The argument that pain of making a loss is more felt than the joy of making a gain, explains the habit of risk aversion (Wilmington Trust, 2017, 4). In proposition of risk aversion, actors tend to put more weight on options that are certainty based. The risk aversion prospect argues that investors behave in risk adverse manner even in dealing with small scales of investment. It is argued that people become risk seeking while faced with losses while they get risk-averse when they are perspective of gains.
Another assumption made under prospect theory is associated with framing and mental accounting. Decision frames of an individual are considered to be affected by perception and personal traits. On the other hand, mental accounting considers decision makers to place different risks in separate mental accounts and weighs each risk under prospective decision rules
Contrary, financial economic theory is of the assumption that representative agents in the economy are rational such that they make a decision on the basis of axioms of expected utility theory and they make unbiased market predictions (Thaler, R. 1999, 12). The theory also assumes that the agents act by these two assumptions. The rationality contained in this model is mainly meant to ensure efficiency of the market (Degutis & Novickyte, 2014, 9). Advocates of the standard economic theory agree that some actors in financial markets tend to make poor economic decisions but in their argument, they insist that the poor decisions do not affect markets as long as the marginal investor in such a market remains rational. The decision maker is considered to be aware of opportunities and constraints on his capability of achieving predefined objectives, and their economic decision is not in any way influenced by human-related factors. The actor intends to realize only specified goals at minimum cost.
Based on expected utility theory, standard economics is seen to be of the assumption that wealth has specific utility and decisions elevated to maximize the expected utility and not expected value. The expected utility theory tries to explain the behavior of people under uncertain circumstances, and thus it deals with the risk that people are ready to take under such situations. The Efficient Market Hypothesis in standard economics, represents another assumption. Under this hypothesis, prices are considered as optimum estimates of the actual investment value. It is assumed that actors in the market are all rational and uses available information to maximize the expected utility. Changes in prices in financial markets are unpredictable and are only expected if new information happens to emerge. Efficiency in the market is realized when the price of an asset equals its expected value
The Development of Behavioural Finance
The depart from standard financial and economic theories was brought about by many researchers who perceived the existing theories as inadequate to fully explain the events that occur in financial markets. Selden (1912) advocated for the argument that prices depended on the mental attitude of the investors. As detailed by Sewell (2010, 1), Festinger came up with the theory of cognitive dissonance in 1956 to explain how individuals responded to different inconsistent cognitions. Cognitive dissonance is about how people change investment behavior to support financial decisions (Chaudhary,2013, 89). Further studies by Pratt (1964) brought about concepts of utility functions, risk aversion, and perception of risks as part of the total assets held by an investor. Wilkinson and Klaes, (2012, 14) documents that the concept of mental accounting was introduced by Richard Thaler in 1980.The idea of heuristics which are considered to cause market biases was introduced by Tverskey and Kahneman in 1973. These heuristics explained how individuals evaluated chances of events to occur under given market conditions. These two researchers finally developed the prospect theory which overruled the expected utility theory presented under standard finance (Wilkinson & Klaes, 2012, 14). The proposed prospect theory placed weight on consideration of chances of profits or losses other than utility value that could be attached to an asset within a given duration of time. This theory became the basis on which the behavioral finance paradigm was built and later developed into a wide indispensable field in economics.
Investment decisions are considered to be either of subjective or objective risk. Standard theories are the core of the assumption that investment decisions are made with agents being rational and informed through consideration of all available market information (Thakral et al., 2013, 30). Market anomalies tend to contradict efficient market hypothesis, and they indicate possibilities of realizing abnormal gains by adopting strategies that take advantage of the anomalies. By adopting the said strategies, people depict considerations for simple rules by which they make decisions when the problem at hand is complex, or there is no sufficient information available (Venkatapathy & Sultana, 2016, 38). Market anomalies may be perceived to occur due to use of an erroneous pricing model or can be viewed as normal occurrences in an inefficient market. The main market anomalies include; size effect, value effect, momentum effect, Post-earnings announcement price drifts, and calendar anomalies.
The size effect relates to a case of small companies tending to outdo larger companies operating in the long run. The value effect anomaly accounts for cases where stocks with low merits outperform the market. The low value is associated with higher risk and capital loss.
Anomaly on momentum effect is based on an argument that performing stocks will outdo the less performing stocks in short to medium term of business operations in financial markets. In an attempt to explain momentum anomaly, it has been argued that market prices are altered gradually, market actors take time to synthesize new market information, and that these actors invest in stocks depending on their recent past performance in the market. It is notable that momentum anomaly holds for a limited time span and will diminish or suffers reversal effect in the long run.
The post-earnings announcement drift relates to price drift in the direction of an earnings surprise. This anomaly is also referred to as earnings momentum. In an efficient market, new market information should lead to a spontaneous change in prices. However, prices tend to change gradually due to incomplete response to earnings.
Calendar anomalies constitute market characteristics where a given asset tends to perform well at some period while it may underperform at a different period. An evident case of calendar anomaly applies is like in Turn of the Month Effect where stocks in financial markets give higher returns at the end and on early days of a month.
The behavioral finance, explains these anomalies through conservatism; where market actors choose to remain in their old beliefs instead of changing with new market information. Secondly, overconfidence; where investors are considered to overate their ability and accuracy of their information while making financial decisions. Thirdly, biased self-attribution; an argument for which actors in a market prefers events that suit their beliefs and takes their ability to account for positive outcomes, while negative outcomes are deemed as circumstantial. Fourthly, limited computational abilities; explains how people only take to consider a sub-set of available information, in contradiction to EMH assumption that market actors acquire all information before making an investment decision. Sixth, attention bias; highlights tendency by investors to pay more attention to renowned institutions even when smaller, there exists smaller firms with proven market potential, under-diversification of investment firms by investors, and disposition effect; where investors prefer to sell shares that have increased prices and keep those that have falling prices.
Advantages and Disadvantages of Behavioural Finance
Behavioral finance has an advantage over standard financial theories in that the former has a realistic perception of nature of investors while standard theories view investors as rational beings a case which does not correspond to real life occurrences.
Standard theories are faulted due to their assumption that high risks are linked to high returns. This is contradicted by the risk aversion concept under which investors are observed to be sensitive to risks even in circumstances where small values of capital investment are involved.
Financial markets are faced with anomalies and tend to be irrational as viewed from a standard economic point of view. While this seems to work for behavioral finance, it disputes the basis of market efficiencies hypothesized under standard economic theories.
Standard approaches assume that investors in financial markets decide after evaluating all information at their disposal whereas, people will in real sense act under time and resources constraints and therefore only consider the information which they consider as relevant to inform their investment decision.
Behavioral finance is limited in the sense that it is studied qualitatively within population's samples which may not imply the actual trait for a diverse population. Similarly, standard finance theories are elevated to applying precise mathematical models of which, real markets cannot meet the level of accuracy prescribed through the models.
The Future of Behavioral Finance
Behavioral finance is related to study of non-professional investment decision making because, in the real business world, it is not possible to separate human psychological factors from financial markets (Bikas, Jureviciene, & Novickyte, 2012, 872). In f...
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