Behavioral Finance Archives

Behavioral Finance: A Comprehensive Approach

Posted on December 22, 2024 | by Laureen

Traditional Finance vs. Behavioral Finance: An Introduction

The term finance can be described as the management of money and other assets. Finance includes all the sectors like, banking, investments, and credits, and so on. Traditional finance is a type of financing that is used when we take the comparison of expected risk with our expected rate of return. It can also be defined as a ratio of risk and return in investment. If the concept of traditional finance is clearly observed then it is concluded that traditional finance is concerned with the risk factor and finding out that what kind of risk can occur for any type of investment. The relationship between the risk and return becomes clear from the study of traditional finance. Quantitative measures are provided by traditional finance for the measurement of a risk that can be faced by all the members involved in the financial activities. In other words, traditional finance includes businesses, and organizations raise, allocate, and use monetary resources over time considering the risks entailed in their projects. In traditional finance, the long term funds are provided by the ownership equity the long-term credit is often in the form of bonds. The balance between them forms a companys capital investment structure. In the short-term funding, the working capital is mostly provided by banks; they analyze the risks before extending a line of credit. Traditional financing encourages savings so that this saving can be used in the future a sense of security is also obtained thru this way. Traditional financing contains every aspect that makes the financial future strong like, retirement, insurance it also provides capital growth solutions. (Ricciardi, 2008).

On the other hand, behavioral finance integrates the concepts of psychology and economics. Behavioral finance does not deal with the quantitative measures of risks rather it deals with the qualitative aspects of risk. It finds out that what effects the risks can have over the psychological and emotional human elements. It can be simply said that behavioral finance depends on the decisions made by the investors. Sometimes, these decisions prove to be the profitable ones, at times these decisions are contradictory. The relationship between the expected risk and return in behavioral finance is nonlinear. (Ricciardi, 2008).

NOTE: You will see that I specifically mentioned to the writer that the correct term is traditional finance and not traditional finance. He/She has ignored this comment throughout the paper.

Introduction to Behavioral Finance

Behavioral finance basically depends on the psychological impacts on the behavior of the investor. The topic of behavioral finance is very interesting to explore as this study finds out the reasons that are responsible for affecting the efficiency of markets, behavior of investors and the affects of the behavior of investors over the market efficiency. In behavioral finance, investors make decisions depending on their psychology. In this situation, sometimes the decisions that are made by the investors end up in a positive result, but at time the decisions seem to be quite inconsistent; hence, the result is negative. Behavioral finance is used to apply psychological theories that try to define anomalies of stock markets (Stock market anomaly is the state, when the market deviates from its regular position). In the context of behavioral finance, it is considered that the psychology of the participants of the market can influence the investment decisions and also the result of the market. (Behavioral finance, n.d).

Investors do have biased expectations which are sometimes beneficial for them, but at times they also have to face huge losses as without having adequate information, the investors got confident and made investments. Another characteristic of behavioral finance investors is the asset segregation as the investors do not take a complete profile where they are making investments. Behavioral finance is quite different from traditional finance approach, which is based on characteristics like, risk aversion, rational expectations and asset integration. Behavioral finance is not concerned with the quantitative measurement of the risks, but it is basically concerned with the quantitative measures, which include the affects of risks over the emotions of the investors. (Minute-class, 2009).

Behavioral finance primarily consists of two major parts: cognitive psychology and limits to arbitrage. Cognitive psychology is one of the many branches of psychology; it deals with the thinking, perception and other mental capabilities. On the other hand, the limits to arbitrage deals with planning that in what conditions the arbitrage forces will be helpful and efficient and when theses forces would not be effective. The models that are being used in behavioral finance involve agents. These agents are not completely balanced because of the unbalanced nature perhaps due to the preferences or due to the misconceptions of investors. Behavioral finance is supposed to be loss aversion, which means that the investors in behavioral finance do not look at the amount of risk while making any investment. The investors in behavioral finance go for large losses as they had not made having proper decisions while making the investment. The result in behavioral finance is always unpredictable, till the very end there are the chances of gain or loss.

Cognitive Psychology

Cognitive psychology is a branch of psychology that deals with the neural processes and activities people use to perceive situations and circumstances, how people learn, remember and determine what actions to take. It is a vast field of science that is connected to many different fields like, neurology, linguistic and philosophy. Basically, cognitive psychology deals with the aspects of how people access, process and then retain the information. Cognitive psychology has very wide range of applications or methods for improving the perception and memory, enhancing the ability to learn or methods to take quick and accurate decisions. This is the field of psychology that relates with concepts like, decision making, thinking and perception and all these factors are closely related with almost every field of life. (Wagner, n.d).

When it comes to behavioral finance then there are many different aspects that are given by various cognitive psychologists. They believe that there are many elements that are related to the mental processes such as, heuristics, confidence, decision making, mental accounting, framing, representativeness, conservatism, dispositions effect, memory and perception and many other such elements.

Information Processing Critiques

Cognitive psychology plays its role when an investor is making an investment in the form of information processing. The information processing process has got positive and negative aspects. It is not possible that every time when the information is being processed, the result is positive or in the form of profits. The information processing also has got some negative facets and these are discussed as given below:

Forecasting Errors

In behavioral finance, errors can be forecasted at the time of information processing. When traders feel that this is a good time for the market, they increase the prices of their commodities. But when the result comes out, it is totally opposite and then they dont have any other option but to decrease the prices. Likewise, when traders belive that the market is slow, they drop down the prices, but when the result comes out, they have bear losses. Thus, it can be stated that the incorrect predictions of traders about the market thru information procession can create forecasting errors.

Overconfidence

The overconfidence is another problem that can occur while processing the information it also results in huge losses. The problem of overconfidence takes place when investors are very much sure of their information and they underestimate the risks by overestimating their information about the market.

Conservatism

It is a common trend that when any new information or announcement is made in the market, then the traders and investors take time in adapting the new strategy or information. The investors take a lot of time in observing the new trends and information and as a result they react very slowly in changing their beliefs.

Sample Size Neglects and Representativeness

The problem of sample size neglects occurs when a sample which was selected for developing the information is not of the appropriate size. The correct sample size counts a lot at the time of gathering the market information and predicting the market conditions.

In the 1960s, psychologists described the human brain as a device that is used for processing information. Psychologists in the field of cognitive psychology, such as, Ward Edwards, Amos Tversky and many others related the field with behavioral finance. Psychologists started comparing the different models of the cognitive psychology, like, the decision making model under the risk with the models related to economics (such as rational behavior). The comparison was made for making the interrelation between these two fields. (Behavioral finance, n.d).

Prospect theory

The prospect theory is also an essential element for behavioral finance. The theory deals with how people can manage the risks and uncertainties. The theory was established by Kahneman and Tversky over a period of 30 years the theory is not only essential for the field of economics, but it is also relevant in the discussion of the financial investing.

The prospect theory looks for the behavior of people when they are facing risks or uncertainties. It judges what will be the reaction of people when they will be facing a risk and having a loss. It further observes the reaction when a risk is end up with a gain. As behavioral finance involves a great deal of risk and uncertainty, this theory is vital for the field of behavioral finance. The reaction of people while facing a risk is very much closely related to their decision making capability. The theory basically shows a risk seeking behavior. It counts a lot in the field of behavioral finance as in economics, good prediction of human behavior is vital. (Watkens, 1996)

Behavioral Biases

The behavioral biases can be defined as the wrong actions or results that are faced because of making any error based decision. The behavioral biases occur because of incorrect decisions and unreasonable mental processes.

Framing

Framing shows that how a problem, question, situation, condition and option are presented in front of the decision maker. Different decision makers can take different decision for the similar problem. As prospect theory deals with how people manage the risks and problems, so this theory can handle the affects of framing.

Mental Accounting

Mental accounting can be termed as a process by which people prepare the problem in decision making. In mental accounting the investors possess flexibility and they set apart money in to different mental accounts reserved for different purposes. While performing these tasks sometimes improper decisions are made. Mental accounting can be termed as gambling where people continue to make investments by using their previously earned profits and without taking risks under consideration.

Regret Avoidance

A feeling after a post decision that may lead to unavoidable circumstances which an individual experiences failing to choose a better alternative is regret. To avoid these regrets, people make a more conventional decision. People make these decisions to avoid loss from their investments that may lead to financial crisis or psychological pain, which means, to admit a wrong investment strategy. In short, we can say that regret avoidance is like admitting a mistake by wrong investments, which finally results in a financial loss.

Limits to Arbitrage and Market Efficiency

In simplest words, the term arbitrage can be defined as a transaction to gain a profit in a very short span of time usually by taking an advantage of a price differential between two or more than two markets. For example, an asset is bought at a comparatively lower price and immediately sold in a different market at a higher rate. If there are no arbitrage chances in any market then it is known as the arbitrage free market.

On the other hand, the market efficiency is a concept that is essential for finding out the conditions of the market. The term efficient market describes a market where the information is impounded into the price of financial possessions; the term is used to show the operational effectiveness and efficiency of the market. A very well known hypothesis regarding the market efficiency is known as the Efficient Market Hypothesis (EMH). According to EMH, at any instance of time, the price value of assets totally reflects all the available and related information. In this section of the paper, we are going to discuss the limitations attached to arbitrage and the market efficiency. (Dimson, 1998).

Fundamental risk while the price may be low such that you expect a higher return, the actuality is that it may be less than that. While the risk is not correctly priced it is still risk.
Implementation costs it may take a lot of risky traders to push the price to equilibrium, it may not be possible.
Model risk there is the issue of uncertainty in the model itself, ie. CAMP, 3-Factor, etc. non of which represent the true, underlining, actual fact return process.
Equity carve-outs
Closed-end funds

It is a common act that financial assets are often misevaluated and it is difficult to achieve profits out of these misevaluations. There can be two types of misevaluations: one is those that are regular or arbitrage able and the second one is those which are not repeating and are long term in their nature. If the regular misevaluations are taken then the strategies for trading can be profitable and because of this reason evade funds and others controls them from getting too large. So for such assets it can be noticed that market seem to be very efficient and effective. But for the misevaluations that are long term and no repeating it seems to be quite an impossible task to predict the ups and downs of the market as long as they face it and early risks can be faced which can even clean up the capital. Another inferior situation can be if the partners are limited and the investors that are providing the money then the extraction of capital after a losing line can basically end up in the pressure of buying and selling that can in the return result in to the inefficiency. It is never known which investors can make the market efficient and profitable, but there is a group of investors that always struggle to make profit and money by finding out those misevaluations are prevaricative funds. Big and small positions can be taken by the relative value hedge fund, devalued securities can be taken and then high valued securities can be found and can be made short valued. But in contrast, macro hedge funds can take positions that cannot be hedged simply. It is a fact that if the arbitrageurs try and put efforts for making money then the markets can get better and efficient. It happens in the market that large companies do make profits in the long run but sometimes can get failure just in a single season. The companies value gets so much down that they have to liquefy themselves. The companies usually merge together and it is a fact that when the 60-40 is not the ratio of the stock prices then the chances of arbitrage profit exists. Let us take an example for making it clearer; Long Term Capital Management (LTCM) is a very big hedge fund and was established around 9 years ago. Initially, LTCM appeared to be very successful, but after few years, LTCM faced a bad part in which it faced a loss of 4 billion dollars. This huge loss forced LTCM to liquidate the equity capital of LTCM was washed out. Still in the long run, LTCM proved to be right; LTCM used to make trade in the fixed income and derivative market. LTCM lost money on the Royal Dutch/ Shell equity arbitrage trade. The interests of the Royal Dutch from the Netherland and Shell from the UK were merged on 60-40 bases and the dividends were paid on these bases. Simply, it seems that the profit opportunity existed when stock prices were not in 60-40 ratio. In the year 1998, LTCM bought cheap stocks and lost money because of a diversion of the prices. In order to fulfill the liquidity requirements, LTCM along with many other hedge funds sell out their positions this step also made the markets inefficient. In the year 2002, the Royal Dutch was also dropped from the S&P 500 because of eliminating on American companies.

It proves that in case of losses, the selling pressure that has been caused by the market forces the companies to sell out their assets, thus, the market becomes more inefficient these factors make the limitations for the arbitrage. Although, arbitrage can keep the market quite efficient, but the problem is that the arbitrages are not always powerful. There are many traders that are able to misprice and they do this mispricing to the level of variance. In such situations, obviously the arbitrageurs will observe that they are on the negative side of the market and they will be pressurized to end up their positions as soon as misprices are corrected. It is also not possible to find out two mispriced properties having the same level of risk. In majority of the cases, in order to make the arbitrageurs to take benefit from the mispricing with out having any risk but for this the assets should be at the risk that can at least be compared. If this is not the case then it would not be possible to correct the mispricing without any risk. Finally, it is a concept that arbitrageurs do have access to money but this is not the true statement. They actually have got the capital which they are not allowed to use. Mostly the arbitrageurs are the people that are responsible for managing and administering the money of other people so they are restricted by the people who own these capitals. (Ivkovic, 2007).

Like arbitrage, there are some limitations for the market efficiency. There are basically two types of events that usually take place in the market. One is high frequency events and the others are low frequency events. The high frequency events take place often as the name itself shows and the low frequency events occur rarely, but such low frequency events take a long time to get a recovery from them. The high frequency events are supportive for the efficiency of the market as these events take place often, but they are tend to cause less affects to the market; thus, the efficiency is not disturbed to the large extent. It is very much difficult to look for any strategy that can assure only profitability as if there was any such strategy then all investors should have applied that strategy. The low frequency events take long time to get recovered sometimes these events give huge losses to companies; hence, these events are definitely not suitable for the efficiency of the market. The low frequency events are the ones that are unusual and results in huge losses and for this reason it takes a long time to recover from these events because it is not easy to recover the huge losses that have been made to the company. In a sentence, there are some limitations of the market efficiency and arbitrage; nevertheless, there could be many other reasons but these are the major ones. (Ritter, 2003).

Important Heuristics

Heuristics are the rules which are also known as the rules of thumb. The use of heuristics is common in many psychological fields. In behavioral finance, it is used for the decision making purpose. There are many heuristics that have been used in behavioral finance as this field requires a great deal of decision making process. To understand it clearly, we divide it into six general purpose heuristics which are as follows: affect; availability; similarity; causality; fluency; and surprise.

There are also six special purpose heuristics which are as follows: attribution; substitution; outrage; prototype; recognition; and choosing. Some of the most important heuristics of behavioral finance are as follows:

Affect: This heuristics is based on how quickly the feeling of goodness and badness can be sensed.
Availability: It deals with observing that whether the available information is enough or other options should be looked for the process of decision making.
Similarity: It is based on observing the recent situations and the working models of those situations. It basically finds out the similarity between the appearance and reality. (Sewell, 2008).

Do Investor Biases Affect Asset Prices?

Normally, investors are reluctant to invest in an unstable market. This occurs due to biased behavior of investors that creates differences in a market. It creates differences between the risk seeking trade and informed trade. When an investor is going to invest some capital in a product that has a less value, the investor remains bias with the market condition and sells that product at a higher price than its actual value.

Usually, the result of this type of biasness is a nightmare for the investor as he suffers from heavy losses. This attitude further leads to reduce the prices of higher value commodities; thus, the prices change because of these reluctant investors rather than the unbiased investors. The behavior has a very deep impact over the position and price of an asset so it can be said that an investor biases can affect the price value of any asset. (Coval, 2005).

Patterns in the Trade of Individual Investors

Individual investors are basically the people who are able to buy small amount of assets or security for their own sake. Individual investors are opposite to institutional investors. As the name is suggests, in an individual investment, a single person makes an investment, whereas, the institutional investors are the organizations that invest huge amount of money. So, in this sense, it can be said that individual investors are opposite to the institutional investors. It is always recommended by financial experts that individual investors should avoid trading as they can face many huge losses when they trade on their own as they are individuals so all the losses have to be faced by a single person and cannot be divided as in the case of the institutional investment. There are four types of institutional investors: corporations, dealers, foreigners and mutual funds. It has been observed many times that individual investors fail in front of institutional investors. Institutional investors are more compact with their investments as their investments are in companies which are providing them with fixed profits or pre-decided profit percentagea. In contrast, individual investors are bound to lose money because of their scattered investments. [NOTE: explain more clearly] There can be two types of trade transactions: aggressive trades and passive trades. The type of trade depends on the order that is beneath this trade. There are three steps for the aggressive and passive trade. In the first step, for every supply, a time sequence for clearing prices is established. The data is compiled and brought into the desired order and then put in front of the people in the market. In the second step, all the orders that have been placed are classified as aggressive or passive orders. This classification is done by comparing the prices of the orders. In the third and final step, all the orders are matched for the trade. (Barber, 2006).

Patterns in Stock Return

The term stock return is also known as the return on investment or the rate of return. It is actually the division of money that has been gained or lost over the life of the investment. It shows how much cash has flown out from the investment or how much profit has been made. Many views have been made in order to explain the patterns in the stock returns. These views include:

Daniel, Hirshleifer and Subrahmanyam (19988, 2001): In this paper, the patterns of the stock return were described using the attributes of over confidence and the self attribution. The attribute of over confidence creates over the reaction it enhances the phenomena of the long run and the book market. The attribute of self attribution strongly supports the over confidence, which made the prices to continue overacting.
Barberis, Shleifer and Vishnay (1998): According to this theory, the extrapolation creates sequences that are random in nature; on the other hand, agents continue to expect the patterns in small samples. And because of this, the over reaction is created.
Hong and Stein (1999): According to this theory the slow diffusion of news can cause momentum. In the return the traders who purchase depending on the past output establishes the overreaction and the reason for this is that they trait the actions of precedent momentum traders to news and so they do not buy more stocks. (Subrahmanyam, n.d).

Objections to Behavioral Finance

Behavioral finance has already been faced many critics, and still has been criticized by saying that biases do exist in almost every field of economics. There should be a limit to the affects and importance of these biases. The market prices also show huge biases the process can bring back to the rational levels. This theory has said to be a non rigorous theory. The methodologies that have been used in behavioral finance are irrelevant. Many different methodological problems have been indicated by a critic Gregory Curtis in behavioral finance. Behavioral finance is very much criticized by Eugene Fama, who supports the efficient market theory in comparison to behavioral finance. According to critics, behavioral finance does not have any supportive evidence that can make it a true branch of finance. They argue that behavioral finance is just a collection of many different anomalies and that these anomalies can be priced out of the market easily. According to Fama, the anomalies that are being used by behavioral finance and have been established by the advocates of behavioral finance are nothing, but just a chance, and there is no rule or methodology lying behind these anomalies.

As discussed earlier, behavioral finance is based on cognitive psychology and it depends on the perception of a person that how does he take the things; thus, critics consider behavioral finance as it has no grounds the results are just considered as by chance results. (What are the critics saying? n.d).

Conclusion

The paper has provided an in-depth analysis of and idear related to behavioral finance. Firstly, the comparison between behavioral and traditional finance has been made. Thru this comparison, it has been found that traditional finance provides the quantitative measures of risks that how much loss will be suffered in case of a problem; whereas, behavioral finance provides the qualitative measures of the risk which means that what psychological affects will be caused by a risk or a problem.

Traditional finance gives a linear relation between the expected risk and return, whereas, behavioral finance gives a non-linear relationship between the expected risk and the return on it. Behavioral finance depends on the psychological impacts over the behavior of an investor. It involves cognitive psychology to a great extent as cognitive psychology deals with the thinking, opinions and perception of a human being.

It can be stated that cognitive psychology plays a great role in the decision making and information processing operations of behavioral finance. In behavioral financing, investors make decisions that are totally based on their own perceptions and information which were gathered by them.

Moreover, there are some information processing inadequacies exist, like, forecasting error, overconfidence, conservatism and sample size neglect. It is not necessary that any decision made by an investor in behavioral finance tends to be right. At times, the decisions are quite inconsistent. Many theories like the prospect theory and heuristics such as affect, availability and similarity and so on are involved in behavioral finance which was widely used for making decisions. The paper also discussed about an individual investment and concludes that an institutional investment is far better than an individual investment as any loss can affect an individual greatly as compared to an institution. The criticism on behavioral finance has also been discussed in the paper. The critics believe that behavioral finance does not have any solid ground. Thus, the results of the investments made in behavioral finance are quite inconsistent and very risky.

References

Avanidhar Subrahmanym, Behavioral finance: A review and synthesis (no date)
Behavioral finance (no date) Web.
Behavioral finance, Facts, discussion forum and encyclopedia article (no date) Web.
Brad M. Barber, Just how much do individual investors lose by trading? (2007) Web.
Elroy Dimson, A brif history of market efficiency (1998) Web.
Inya Ivkovic, Significance of market efficiency: Why should investors care whether the wheels are running smoothly? (2007)
J R Ritter, Behavioral finance (2003)
Joshua D. Coval, Do behavioral biases affect prices (2005)
Kendra Van Wagner, What is cognitive psychology? (no date)
Martin Sewell, Behavioral finance (2008) Web.
Minute-class.com- Blog archive- Finance assumptions- Traditional versus Behavioral (2009)
Thayer Watkins, Kahneman and Tverskys prospect theory (1996)
Victor Ricciardi, SSRN- Risk: Traditional finance versus behavioral finance by Victor Ricciardi (2008) Web.
What are the critics saying? Pensions at work (no date)

Behavioral Finance and Efficient Market Hypothesis

Posted on December 2, 2024 | by Laureen

In week one, two related topics are put under discussion. In this week the efficient market hypothesis is analyzed for identifying the market factors influencing the decision making. The application of behavioral finance in taking decisions in the inefficient market is also analyzed. The behavioral factors involved in the investment market decisions are discussed here for identifying the importance of behavioral finance. “Behavioural finance is the study of the influence of psychology on the behavior of financial practitioners and the subsequent effect on markets.” (Sewell, 2008).

The first topic is related to the efficient market hypothesis. In this topic, the features of the efficient market hypothesis are discussed to compare it with behavioral finance.

Through this topic, I understood that in EMH the available information in the market influences the market prices. “According to the EMH, “stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices.” (Efficient market hypothesis- EHM, 2009).

An efficient market consists of a large number of rational investors, actively participating in the competition and the information in the market is easily accessible for all of the investors. The free availability of information to all of the investors on a real-time basis facilitates the investors to make use of this information for taking adequate decisions in the investment market. Thus the actual prices of individual securities in the market should reflect the effects of information relating to events that have already occurred or are expected to occur shortly.

The second topic is related to behavioral finance. The question discussed is “In what ways can behavioral finance be used to find and exploit inefficiencies in the market?” in this topic I discussed the implications of behavioral finance in the inefficient market system.

Behavioral finance is based on the concept that market inefficiencies can be identified and effectively exploited for making accurate predictions on future investment market movements. It is an alternative view of the efficient market hypothesis or EMH.

“Behavioural finance is the study of investors’ psychology while making financial decisions. Investors fall prey to their own and sometimes others’ mistakes due to the use of emotions in financial decision-making.” (Velma, 2004).

The discussion revealed that several behavioral factors influence the decisions. They are overconfidence, anchoring, availability bias, errors of preferences, and loss aversion. “Behavioural Finance has the potential to be a valuable supplement to the traditional financial theories in making investment decisions.” (Venkat, 2005).

This week’s activities helped me greatly to empower the knowledge relating to the different market systems and their impact on the investment decisions of the investors. The opportunities in the inefficient market system can be effectively exploited through applying behavioral finance. The suggestions for investors for successful investment in the inefficient market are given below; ”

“Accept that investing is a probabilistic art.
Recognize and avoid the circumstances leading to undue confidence.
Deliberately seek out the contrary view.
Have a written plan for each position, especially the exit.” (Practical behavioral finance n.d.).

The topic of efficient market systems discussed in the week is not new to me as I am familiar with the efficient market system. But the topic of behavioral finance is new to me. In the week I attend six days in the class. My participation in the class helped me greatly to understand the different aspects of leadership in organization management. It helped me to enhance the learning process in the investment market field. The research paper on the topic is successful as the data collection seems to be lesser effort.

References

Efficient market hypothesis- EHM: what does efficient market hypothesis – EHM mean? 2009, Investopedia: A Forbes Digital Company.
Sewell, M 2008, Behavioural finance: introduction. Web.
Velma, V 2004, Behavioural finance as investment concept: can you explain behavioural finance is and how it works, Business Line.
Venkat, S 2005, Behavioural finance: challenges, Indianmba.com.

A Behavioral Finance Perspective on Corporate Mergers and Takeovers

Posted on December 2, 2024 | by Laureen

Corporate America has been called to task for losing sight of the proper goals of the business: generating economic returns, obtaining the resources and setting strategy for competitiveness and long-run growth, briskly fending off competition within NAFTA and from overseas, and in all other ways ensuring benefits for all stakeholders of the enterprise. Instead, CEOs and Boards have been distracted in their roles of ‘corporate raiders’ or defenders at the drawbridge as they fend off unexpected attacks. Worse still, takeovers have often been followed by stripping and selling off “unrelated” or “underperforming” operations; as a result, the combined value of merged businesses went down in the medium term.

Announcements of takeover bids usually perk up stock markets and generate favorable press because of the underlying rationale that they make economic sense. Strategically, the acquiring company may be looking to gain valuable R & D strengths, enlarged market share (and hence, greater leverage in the marketplace), goodwill, established brands, greater operational scale, and broader distribution reach, among others.

Roll (1986) offers the “hubris” hypothesis as an alternative explanation for takeovers judged by capital markets to diminish shareholder value.

Coming from the Greek for “overweening pride or arrogance” that propels the rich and mighty to tragically flawed decisions. In the context of mergers and takeovers, Roll’s hubris hypothesis is a compelling explanation for takeover bids that erroneously exceed book and market value.

The author suggests that there is empirical support for executive hubris explaining exaggerated valuation just as well as tax benefits, corporate synergy, and turning around inefficient operations do.

Going by an examination of a decidedly nonrandom sample of takeovers, the author contends that hubris is the only explanation for company boards pursuing tenders above the market price – absent any economic benefits – when, in fact, they do the rational thing and avoid tenders when valuations are below the market price.

Roll suggests that a hubris hypothesis has predictive value because, around the time when a bid is announced and is pending approval of both sets of shareholders, hubris supports such phenomena as “…

the combined value of the target and bidder firms should fall slightly,
the value of the bidding firm should decrease, and
the value of the target should increase” (1986, p. 213).

Perhaps this theory could have benefitted from new data about mergers and takeovers since the work was published in the mid-1980s. At the time, however, the empirical observations available to Roll suggested mixed results. Combined value increased in some cases but fell in others. The stock value of the bidding firm increased at statistically significant rates in certain instances but decisively dropped in other cases.

Yet, the author dismisses these inconsistencies by arguing that the market that is the source of value perceptions does not always receive access to perfect information from either the bidding or target firm.

Since market valuation is an imperfect criterion, the author bolsters his case for the rigor of the hubris hypothesis by contending, first of all, that the available evidence does not reject the implication of hubris.

Second, the hypothesis does not imply that corporate boards consciously act against the economic interests of shareholders. Rather, they do so de facto by tendering share prices beyond those prevailing in the marketplace and already discounting future value of, say, investments in new product development and market penetration.

Thirdly, hubris does not posit systematic bias in market prices. Rather, the author contends, the possibility that anyone company may be either bidder or takeover target cancels out that possibility. Finally, Roll counters that hubris does not discount strong form efficiency. Instead, it is likelier that the big picture of rational decisions made by profit-maximizing firms is diluted in the long run by the non-economic prices and allocations of hubris-motivated enterprises.

References

Roll, R. (1986). The hubris hypothesis of corporate takeovers. The Journal of Business, 59 (2), 197-216.

The Behavioral Finance Articles

Posted on December 2, 2024 | by Laureen

Table of Contents

Annotated Bibliography
Discussion
References

Annotated Bibliography

Ding, S., Lugovskyy, V., Puzzello, D., Tucker, S., & Williams, A. (2018). Cash versus extra-credit incentives in experimental asset markets. Journal of Economic Behavior & Organization, 150, 19-27.

In their research, Ding et al. (2018) seek to answer the question of whether experimental asset markets are an alternative to the traditional financial principles of organizing economic flows. In particular, the authors note that cash sessions can theoretically be replaced by extra credit as an adequate reward medium (Ding et al., 2018). Behavioral finance, in this case, is little touched upon and concerns the investment intentions of the subjects considered from the perspective of experimental financial payments. The lack of this data does not allow obtaining a comprehensive picture since the main emphasis is on the differences between cash and extra-credit sessions but not the features of stimulating intentions.

At the same time, the article is useful as a resource that shows that the insignificant difference in perception does not allow experimental asset markets to be called the dominant form. Among all the studies involved, the research by Ding et al. (2018) is the only one that brings up this topic. In this regard, the differences and similarities in the assessment of cash and extra-credit systems can be utilized usefully to evaluate the extent to which market participants tend to rely on alternative asset flows.

This resource will be used in future discussion as a justification for the fact that when choosing experimental economic instruments, motives depend on different criteria and not only on personal incentives. The article will help supplement the reasoning regarding behavioral finance and contribute to evaluating alternative asset markets. The juxtaposition of cash and extra-credit sessions will be cited as an important rationale in the context of the motivations for a particular choice.

Huang, J. Y., Shieh, J. C., & Kao, Y. C. (2016). Starting points for a new researcher in behavioral finance. International Journal of Managerial Finance, 12(1), 92-103.

Huang et al. (2016) aim to assess the phenomenon of investor behavior and influencing factors in academic literature and pay particular attention to irrational decisions and their causes. Behavioral finance is examined from the perspective of the impact of non-standard situations on specific motives, and the article reviews the findings from various resources on this topic. The key conclusion that the authors make is asserting the prevalence of empirical research in the field under consideration over other forms of evaluating behavioral incentives from different financial perspectives (Huang et al., 2016). The article, however, focuses more on the assessment of existing findings rather than individual research, which allows summarizing the results but not making unique statements.

In terms of evaluating findings, of all the articles on behavioral finance involved, this study provides the broadest analysis. In addition, the article offers research data from many years, thus covering a large period. Nevertheless, in addition to a systematic review, the study does not contain controversial or unique arguments, which allows using it as an auxiliary resource but not as a background for making new hypotheses, unlike some other articles.

The findings from the study by Huang et al. (2016) can be used in future discussions as a justification for the relevance of the topic of behavioral finance in different years. The arguments about the prevalence of empirical research will make it possible to make a verdict on the role of personal assessments in the perception of relevant motives. The role of non-standard environments will also be cited as an important decision-making criterion.

Klein, P. O., Turk, R., & Weill, L. (2017). Religiosity vs. well-being effects on investor behavior. Journal of Economic Behavior & Organization, 138, 50-62.

The main research question of this article aims to address the relationship between religiosity and investor behavior, thereby identifying the corresponding correlations and the influence of personal beliefs on the response to fluctuations in the stock market. Klein et al. (2017) conclude that religion largely shapes financial behavior and should be considered as a criterion that determines relevant trends in financial markets. The article examines only the religious aspect and does not address other factors related to behavioral finance. Through complex digital assessments of the stock market models, connections are built between investor behavior and the management of financial flows, which can be utilized as a justification for the impact of external factors on investor decisions.

The article by Klein et al. (2017) is the only one among the others involved that considers the factor of religiosity in the context of behavioral finance. As with several other studies, this research utilizes complex formulas to identify relevant correlations and provide accurate data. This information allows talking about the validity of the findings and confirms the practical value of the calculations with regard to investor behavior manifestations.

The outcomes of this study will be used in future discussion, and external criteria, particularly religiosity, will be mentioned as drivers that determine investor behavior. Assessing the connections between the environment and specific motives is critical to mention in the context of the topic of behavioral finance. The arguments about cultural incentives will be included in the discussion to highlight the relevance of their role in investor decision-making.

Krokida, S. I., Makrychoriti, P., & Spyrou, S. (2020). Monetary policy and herd behavior: International evidence. Journal of Economic Behavior & Organization, 170, 386-417.

The main objective of Krokida et al. (2020) is to measure how existing monetary policies and changes in the financial sector affect investor reactions and behaviors. The authors draw a parallel between traditional and unconventional policies and mention herd behavior as one of the criteria to take into account when analyzing behavioral finance (Krokida et al., 2020). Market indicators of different countries are analyzed with an emphasis on the European market. The findings confirm the relationship between changes in the financial sector and investor response and compared to European countries, changes in monetary policies affect market herding more strongly in the US.

Along with several other studies involved, this article considers investor behavior one of the significant factors, which brings practical significance to the analysis of this topic. Numerous graphs and tables increase the validity of the findings and make the overall study more readable. Krokida et al. (2020) do not address specific incentives, such as religiosity, and their work covers the realm of finance in general, with an emphasis on fluctuations and their effects. The lack of cultural characteristics is a limitation, and a more detailed discussion of these factors could enhance the value of the research.

The arguments about the role of changes in monetary policies and their relationship to investor reactions will be mentioned in future discussions as essential aspects of behavioral finance. This is important to mention these correlations in view of the clearly traced connections and psychological criterion of influence. The findings of herd behavior will be included in the discussion as evidence supporting the collective nature of fluctuation perceptions in the financial sector.

Xu, Y., Briley, D. A., Brown, J. R., & Roberts, B. W. (2017). Genetic and environmental influences on household financial distress. Journal of Economic Behavior & Organization, 142, 404-424.

Xu et al. (2017) study the role of genetic factors and their unique manifestations in relation to the topic of behavioral finance and seek to answer the question of the role of individual properties. The key findings support positive correlations between financial distress and personality traits, particularly cognition, at the genetic level. The researchers also argue for environmental criteria, such as family relationships, and note the influence of these factors on relevant behaviors (Xu et al., 2017). Cognitive abilities and socioeconomic status are seen as critical aspects and predictors of financial distress. Collective manifestations are not considered in the article, which does not allow drawing conclusions about general trends, but the data on personal predispositions are no less important.

This study is the only one among those involved in which the DNA information is discussed. In addition, unique genetic aspects are identified, which distinguishes the article from the others and allows it to be used as a guideline for assessing personal predispositions for specific behaviors. The formulas and calculations make it possible to prove the existence of the considered correlations and explain the relationship between the variables under consideration, thereby increasing the credibility of the research.

The key value of this article for the future discussion is an opportunity to use the arguments about genetic and environmental stimuli that influence behavior in the financial sector. The research will be useful use due to the proven correlations between individual characteristics, including cognition and socioeconomic status. The information about personal criteria will be mentioned in the context of behavioral finance with an emphasis on the value of DNA analysis.

Discussion

The factors influencing the behavior of different financial market participants are based not only on external drivers, for instance, fluctuations in stocks or sales figures, but also on internal motives that determine individual preferences and decisions. In this regard, the concept of behavioral finance has developed as a theory that reflects the personal incentives of investors or sellers associated with psychological aspects of perception. Reactions to specific events or economic shifts largely convey the individual sentiments of the participants involved but, at the same time, can be viewed from the perspective of a collective attitude towards certain changes. In conditions of high dynamics of financial trends and fluctuating economic balance, the analysis of these aspects are of great importance. This discussion explores the distinctive manifestations of this perception and uses the factors of investor reaction, genetically determined behavioral incentives, experimental asset markets as drivers for behavior change, and the general theory of behavioral finance.

By synthesizing the information and findings obtained from the analysis of relevant academic sources, one can conclude that personal motives play an essential role in the perception of the characteristics of the financial market and largely determine corresponding behaviors. The studies by Huang et al. (2016) and Kliger et al. (2014) emphasize the significance of different environments and their influence on behavioral aspects and confirm the value of conducting empirical research to identify specific trends. The findings on the distinctive perceptions of cash and extra credit and concerning drivers of financial decision-making in conditions of alternative asset markets, discussed by Ding et al. (2018), also deserve particular attention. The results of the study by Krokida et al. (2020) complement the theoretical framework on the impact of shifts in monetary policies on investor reactions. Any market fluctuations are regarded as incentives that affect behavioral aspects, and this is crucial to take these influences into account to make relatively accurate forecasts concerning the development of the financial market. Moreover, along with economic incentives, including the aforementioned monetary policies, some sociocultural criteria are also associated with the concept of behavioral finance. As Klein et al. (2017) state, religiosity, being one of such aspects, determines investor decision-making and is the incentive that depends on the individual views of the participants in financial processes. These findings are consistent with those of Huang et al. (2016) on the role of personal value judgments and confirm the ideas of Kliger et al. (2014) on independent behavioral patterns based on intrinsic motives. The research by Xu et al. (2017) on the role of genetic factors revealed through the DNA analysis and psychological aspects of personality that influence investor perception can be considered along with the findings of Klein et al. (2017) on the role of the environment, for instance, the family, in shaping corresponding financial decisions. Thus, the topic of behavioral finance, when viewed from the perspective of external and internal incentives, addresses a wide range of motives that determine the perception of certain trends, and from an empirical perspective analyzed by Kliger et al. (2014), individual attitudes play a significant role. Therefore, the assessment of personal judgments always accompanies this research field.

To expand the knowledge of the industry and obtain new data on behavioral finance, subsequent research may address narrower aspects of the topic. For instance, in addition to the findings of Huang et al. (2016) on non-standard environments that affect the behavior of financial market participants, specific situations can be considered, for example, the crisis conditions of the economy and their impact on investor reaction. The study by Xu et al. (2017) can be valuable background for a more detailed analysis of genetic aspects but not just cognition and socioeconomic indicators. While taking into account external stimuli, the ideas of Klein et al. (2017) and Krokida et al. (2020) may become the basis for a deeper assessment of personal motivators concerning not only religiosity but also other factors, for instance, geographic location, cultural incentives, and other criteria. The evaluation of the topic raised by Ding et al. (2018) could be augmented since, in addition to alternative asset markets, other forms of non-standard financial management principles may be reviewed. As a result, the range of topics covered allows for delving deeper into the study of behavioral finance.

References

Huang, J. Y., Shieh, J. C., & Kao, Y. C. (2016). Starting points for a new researcher in behavioral finance. International Journal of Managerial Finance, 12(1), 92-103.

Klein, P. O., Turk, R., & Weill, L. (2017). Religiosity vs. well-being effects on investor behavior. Journal of Economic Behavior & Organization, 138, 50-62.

Kliger, D., van den Assem, M. J., & Zwinkels, R. C. (2014). Empirical behavioral finance.Journal of Economic Behavior & Organization, 107(Part B), 421-427.

Krokida, S. I., Makrychoriti, P., & Spyrou, S. (2020). Monetary policy and herd behavior: International evidence. Journal of Economic Behavior & Organization, 170, 386-417.

Xu, Y., Briley, D. A., Brown, J. R., & Roberts, B. W. (2017). Genetic and environmental influences on household financial distress. Journal of Economic Behavior & Organization, 142, 404-424.

Behavioral Finance: A Comprehensive Approach

Posted on December 2, 2024 | by Laureen

Traditional Finance vs. Behavioral Finance: An Introduction

The term finance can be described as the management of money and other assets. Finance includes all the sectors like, banking, investments, and credits, and so on. Traditional finance is a type of financing that is used when we take the comparison of expected risk with our expected rate of return. It can also be defined as a ratio of risk and return in investment. If the concept of traditional finance is clearly observed then it is concluded that traditional finance is concerned with the risk factor and finding out that what kind of risk can occur for any type of investment. The relationship between the risk and return becomes clear from the study of traditional finance. Quantitative measures are provided by traditional finance for the measurement of a risk that can be faced by all the members involved in the financial activities. In other words, traditional finance includes businesses, and organizations raise, allocate, and use monetary resources over time – considering the risks entailed in their projects. In traditional finance, the long term funds are provided by the ownership equity – the long-term credit is often in the form of bonds. The balance between them forms a company’s capital investment structure. In the short-term funding, the working capital is mostly provided by banks; they analyze the risks before extending a line of credit. Traditional financing encourages savings so that this saving can be used in the future – a sense of security is also obtained thru this way. Traditional financing contains every aspect that makes the financial future strong like, retirement, insurance – it also provides capital growth solutions. (Ricciardi, 2008).

NOTE: You will see that I specifically mentioned to the writer that the correct term is ‘traditional finance’ and not ‘traditional finance.’ He/She has ignored this comment throughout the paper.

Introduction to Behavioral Finance

Behavioral finance primarily consists of two major parts: cognitive psychology and limits to arbitrage. Cognitive psychology is one of the many branches of psychology; it deals with the thinking, perception and other mental capabilities. On the other hand, the limits to arbitrage deals with planning that in what conditions the arbitrage forces will be helpful and efficient and when theses forces would not be effective. The models that are being used in behavioral finance involve agents. These agents are not completely balanced because of the unbalanced nature – perhaps due to the preferences or due to the misconceptions of investors. Behavioral finance is supposed to be loss aversion, which means that the investors in behavioral finance do not look at the amount of risk while making any investment. The investors in behavioral finance go for large losses as they had not made having proper decisions while making the investment. The result in behavioral finance is always unpredictable, till the very end there are the chances of gain or loss.

Cognitive Psychology

Information Processing Critiques

Cognitive psychology plays its role when an investor is making an investment in the form of information processing. The information processing process has got positive and negative aspects. It is not possible that every time when the information is being processed, the result is positive – or in the form of profits. The information processing also has got some negative facets and these are discussed as given below:

Forecasting Errors

In behavioral finance, errors can be forecasted at the time of information processing. When traders feel that this is a good time for the market, they increase the prices of their commodities. But when the result comes out, it is totally opposite and then they don’t have any other option but to decrease the prices. Likewise, when traders belive that the market is slow, they drop down the prices, but when the result comes out, they have bear losses. Thus, it can be stated that the incorrect predictions of traders about the market thru information procession can create forecasting errors.

Overconfidence

The overconfidence is another problem that can occur while processing the information – it also results in huge losses. The problem of overconfidence takes place when investors are very much sure of their information and they underestimate the risks by overestimating their information about the market.

Conservatism

Sample Size Neglects and Representativeness

Prospect theory

The prospect theory is also an essential element for behavioral finance. The theory deals with how people can manage the risks and uncertainties. The theory was established by Kahneman and Tversky over a period of 30 years – the theory is not only essential for the field of economics, but it is also relevant in the discussion of the financial investing.

Behavioral Biases

Framing

Mental Accounting

Regret Avoidance

Limits to Arbitrage and Market Efficiency

In simplest words, the term arbitrage can be defined as a transaction to gain a profit in a very short span of time – usually by taking an advantage of a price differential between two or more than two markets. For example, an asset is bought at a comparatively lower price and immediately sold in a different market at a higher rate. If there are no arbitrage chances in any market then it is known as the arbitrage free market.

Fundamental risk – while the price may be low such that you expect a higher return, the actuality is that it may be less than that. While the risk is not correctly priced it is still risk.
Implementation costs – it may take a lot of risky traders to push the price to equilibrium, it may not be possible.
Model risk – there is the issue of uncertainty in the model itself, ie. CAMP, 3-Factor, etc. non of which represent the true, underlining, actual fact return process.
Equity carve-outs
Closed-end funds

It is a common act that financial assets are often misevaluated and it is difficult to achieve profits out of these misevaluations. There can be two types of misevaluations: one is those that are regular or arbitrage able and the second one is those which are not repeating and are long term in their nature. If the regular misevaluations are taken then the strategies for trading can be profitable and because of this reason evade funds and others controls them from getting too large. So for such assets it can be noticed that market seem to be very efficient and effective. But for the misevaluations that are long term and no repeating it seems to be quite an impossible task to predict the ups and downs of the market as long as they face it and early risks can be faced which can even clean up the capital. Another inferior situation can be if the partners are limited and the investors that are providing the money then the extraction of capital after a losing line can basically end up in the pressure of buying and selling that can in the return result in to the inefficiency. It is never known which investors can make the market efficient and profitable, but there is a group of investors that always struggle to make profit and money by finding out those misevaluations are prevaricative funds. Big and small positions can be taken by the relative value hedge fund, devalued securities can be taken and then high valued securities can be found and can be made short valued. But in contrast, macro hedge funds can take positions that cannot be hedged simply. It is a fact that if the arbitrageurs try and put efforts for making money then the markets can get better and efficient. It happens in the market that large companies do make profits in the long run but sometimes can get failure just in a single season. The companies value gets so much down that they have to liquefy themselves. The companies usually merge together and it is a fact that when the 60-40 is not the ratio of the stock prices then the chances of arbitrage profit exists. Let us take an example for making it clearer; Long Term Capital Management (LTCM) is a very big hedge fund and was established around 9 years ago. Initially, LTCM appeared to be very successful, but after few years, LTCM faced a bad part in which it faced a loss of 4 billion dollars. This huge loss forced LTCM to liquidate – the equity capital of LTCM was washed out. Still in the long run, LTCM proved to be right; LTCM used to make trade in the fixed income and derivative market. LTCM lost money on the Royal Dutch/ Shell equity arbitrage trade. The interests of the Royal Dutch from the Netherland and Shell from the UK were merged on 60-40 bases and the dividends were paid on these bases. Simply, it seems that the profit opportunity existed when stock prices were not in 60-40 ratio. In the year 1998, LTCM bought cheap stocks and lost money because of a diversion of the prices. In order to fulfill the liquidity requirements, LTCM along with many other hedge funds sell out their positions – this step also made the markets inefficient. In the year 2002, the Royal Dutch was also dropped from the S&P 500 because of eliminating on American companies.

It proves that in case of losses, the selling pressure that has been caused by the market forces the companies to sell out their assets, thus, the market becomes more inefficient – these factors make the limitations for the arbitrage. Although, arbitrage can keep the market quite efficient, but the problem is that the arbitrages are not always powerful. There are many traders that are able to misprice and they do this mispricing to the level of variance. In such situations, obviously the arbitrageurs will observe that they are on the negative side of the market and they will be pressurized to end up their positions as soon as misprices are corrected. It is also not possible to find out two mispriced properties having the same level of risk. In majority of the cases, in order to make the arbitrageurs to take benefit from the mispricing with out having any risk but for this the assets should be at the risk that can at least be compared. If this is not the case then it would not be possible to correct the mispricing without any risk. Finally, it is a concept that arbitrageurs do have access to money but this is not the true statement. They actually have got the capital which they are not allowed to use. Mostly the arbitrageurs are the people that are responsible for managing and administering the money of other people so they are restricted by the people who own these capitals. (Ivkovic, 2007).

Like arbitrage, there are some limitations for the market efficiency. There are basically two types of events that usually take place in the market. One is high frequency events and the others are low frequency events. The high frequency events take place often as the name itself shows and the low frequency events occur rarely, but such low frequency events take a long time to get a recovery from them. The high frequency events are supportive for the efficiency of the market as these events take place often, but they are tend to cause less affects to the market; thus, the efficiency is not disturbed to the large extent. It is very much difficult to look for any strategy that can assure only profitability as if there was any such strategy then all investors should have applied that strategy. The low frequency events take long time to get recovered – sometimes these events give huge losses to companies; hence, these events are definitely not suitable for the efficiency of the market. The low frequency events are the ones that are unusual and results in huge losses and for this reason it takes a long time to recover from these events because it is not easy to recover the huge losses that have been made to the company. In a sentence, there are some limitations of the market efficiency and arbitrage; nevertheless, there could be many other reasons but these are the major ones. (Ritter, 2003).

Important Heuristics

Affect: This heuristics is based on how quickly the feeling of goodness and badness can be sensed.
Availability: It deals with observing that whether the available information is enough or other options should be looked for the process of decision making.
Similarity: It is based on observing the recent situations and the working models of those situations. It basically finds out the similarity between the appearance and reality. (Sewell, 2008).

Do Investor Biases Affect Asset Prices?

Patterns in the Trade of Individual Investors

Individual investors are basically the people who are able to buy small amount of assets or security for their own sake. Individual investors are opposite to institutional investors. As the name is suggests, in an individual investment, a single person makes an investment, whereas, the institutional investors are the organizations that invest huge amount of money. So, in this sense, it can be said that individual investors are opposite to the institutional investors. It is always recommended by financial experts that individual investors should avoid trading as they can face many huge losses when they trade on their own – as they are individuals so all the losses have to be faced by a single person and cannot be divided as in the case of the institutional investment. There are four types of institutional investors: corporations, dealers, foreigners and mutual funds. It has been observed many times that individual investors fail in front of institutional investors. Institutional investors are more compact with their investments as their investments are in companies which are providing them with fixed profits or pre-decided profit percentagea. In contrast, individual investors are bound to lose money because of their scattered investments. [NOTE: explain more clearly] There can be two types of trade transactions: aggressive trades and passive trades. The type of trade depends on the order that is beneath this trade. There are three steps for the aggressive and passive trade. In the first step, for every supply, a time sequence for clearing prices is established. The data is compiled and brought into the desired order and then put in front of the people in the market. In the second step, all the orders that have been placed are classified as aggressive or passive orders. This classification is done by comparing the prices of the orders. In the third and final step, all the orders are matched for the trade. (Barber, 2006).

Patterns in Stock Return

Daniel, Hirshleifer and Subrahmanyam (19988, 2001): In this paper, the patterns of the stock return were described using the attributes of over confidence and the self attribution. The attribute of over confidence creates over the reaction – it enhances the phenomena of the long run and the book market. The attribute of self attribution strongly supports the over confidence, which made the prices to continue overacting.
Barberis, Shleifer and Vishnay (1998): According to this theory, the extrapolation creates sequences that are random in nature; on the other hand, agents continue to expect the patterns in small samples. And because of this, the over reaction is created.
Hong and Stein (1999): According to this theory the slow diffusion of news can cause momentum. In the return the traders who purchase depending on the past output establishes the overreaction and the reason for this is that they trait the actions of precedent momentum traders to news and so they do not buy more stocks. (Subrahmanyam, n.d).

Objections to Behavioral Finance

Behavioral finance has already been faced many critics, and still has been criticized by saying that biases do exist in almost every field of economics. There should be a limit to the affects and importance of these biases. The market prices also show huge biases – the process can bring back to the rational levels. This theory has said to be a non rigorous theory. The methodologies that have been used in behavioral finance are irrelevant. Many different methodological problems have been indicated by a critic Gregory Curtis in behavioral finance. Behavioral finance is very much criticized by Eugene Fama, who supports the efficient market theory in comparison to behavioral finance. According to critics, behavioral finance does not have any supportive evidence that can make it a true branch of finance. They argue that behavioral finance is just a collection of many different anomalies and that these anomalies can be priced out of the market easily. According to Fama, the anomalies that are being used by behavioral finance and have been established by the advocates of behavioral finance are nothing, but just a chance, and there is no rule or methodology lying behind these anomalies.

As discussed earlier, behavioral finance is based on cognitive psychology and it depends on the perception of a person that how does he take the things; thus, critics consider behavioral finance as it has no grounds – the results are just considered as by chance results. (What are the critics saying? n.d).

Conclusion

References

Avanidhar Subrahmanym, Behavioral finance: A review and synthesis (no date)
Behavioral finance (no date) Web.
Behavioral finance, Facts, discussion forum and encyclopedia article (no date) Web.
Brad M. Barber, Just how much do individual investors lose by trading? (2007) Web.
Elroy Dimson, A brif history of market efficiency (1998) Web.
Inya Ivkovic, Significance of market efficiency: Why should investors care whether the wheels are running smoothly? (2007)
J R Ritter, Behavioral finance (2003)
Joshua D. Coval, Do behavioral biases affect prices (2005)
Kendra Van Wagner, What is cognitive psychology? (no date)
Martin Sewell, Behavioral finance (2008) Web.
Minute-class.com- Blog archive- Finance assumptions- Traditional versus Behavioral (2009)
Thayer Watkins, Kahneman and Tversky’s prospect theory (1996)
Victor Ricciardi, SSRN- Risk: Traditional finance versus behavioral finance by Victor Ricciardi (2008) Web.
What are the critics saying? Pensions at work (no date)

JP Morgan Behavioral Finance Case Study

Posted on December 2, 2024 | by Laureen

According to the case, there are various prevalent social and psychological biases. Age-induced bias occurs when older people gain investment knowledge and experience but also experience cognitive aging, which reduces their skills and capacities (Investopedia 100 Top Financial Advisors of 2019, 2020). According to research, investors’ investment performance declines as they age (Investopedia 100 Top Financial Advisors of 2019, 2020). Investing solely during specific political and climatic conditions is another illustration of psychological and social prejudice. For instance, while a Republican president is in office, Democrats are less likely to be upbeat about investing (Investopedia 100 Top Financial Advisors of 2019, 2020). There are also local and home biases, which indicates that some investors are more likely to be more upbeat about investing when there are well-known and domestic firms (Investopedia 100 Top Financial Advisors of 2019, 2020). The performance of investments could be better by overconfidence. Several stated biases exacerbate when the information gained is imprecise, and value ambiguity is more significant.

Getting rid of certain biases can be challenging, but we can try to regulate them. Self-awareness is the first step toward controlling biases. Instead of making investment decisions based solely on emotion, we need to be aware of all the internal and external variables. A contrarian paradigm was the foundation for JP Morgan’s creation of the Intrepid Funds (Baker & Sesia, 2007). The fund’s objective was to act in opposition to everyone else. Due to this mindset, Intrepid Funds has had tremendous success. By becoming aware of typical behavioral biases, they could do this. They used momentum stocks to profit from the overconfidence bias and value stocks to profit from the loss aversion bias as their two key investment philosophies. Realizing one’s prejudices and moderating them are the first steps in managing anchoring and recency. In order to control recency, it is critical to consider a company’s historical performance and its most recent results. Additionally, anchoring can be controlled by maintaining an open mind and approaching new information as if it were the first time.

Complin and his team thought a trading method could be used to profit from this irrational conduct that led to market oddities. There were two market oddities between 1951 and 2005 (Index Fund Advisors, Inc. (IFA.COM), n.d.). First, inexpensive stocks performed better than pricey stocks (value investing). According to a JP Morgan analysis, these equities had an average annual return of 15.8%, whereas more expensive stocks only had an average annual return of 2.8% (Baker & Sesia, 2007). The second anomaly discussed how specific recently performing equities outperformed lately underperforming stocks (momentum investing). The same JP Morgan survey showed that investors who chose to stake their money in the year’s top performers had an average annual return of 15.2% (Baker & Sesia, 2007). On the other hand, their average return was only 3.4% when they invested in the year’s weakest performers. Behavioral biases can be used to explain these two abnormalities as they cannot be rationally explained (Baker & Sesia, 2007). Overconfidence and loss aversion, two of the most prevalent biases, were viewed by Complin and Silvio Tarca, lead portfolio manager of the IntrepidFunds, as the primary causes of the value and momentum abnormalities.

There is no way to predict when or how long they will survive. It is known that these behavioral biases have been in humans for a very long time. It will take generations for our brains to change into reason, which may or may not be achievable. These biases are a part of who we are. For instance, there was “Dutch TulipMania” in 1637 (Hayes, 2022). Although their intrinsic value was close to nil, tulip bulbs reached a peak price of $76,000 (Hayes, 2022). This biased perception of its value has persisted for millennia and is still in the bitcoin sector today. For these reasons, it is anticipated that these investment possibilities will endure indefinitely.

Investors who do not recognize their prejudices cannot change them or overcome them. It is necessary to be self-aware in order to eradicate anything. Although behavioral biases cannot be removed entirely, they can be made aware. The asset managers in JPMorgan’s asset management business were instructed on how to control the behavioral biases of their clients. It emphasizes unequivocally that while you cannot control the conduct, you can manage it: “The unfortunate thing is that you cannot eliminate these irrational behaviors in your client, so you must manage them. This can only be done through a consistent and repeatable process”(Baker & Sesia, 2007). Furthermore, there will be fewer profitable investing opportunities if, eventually, most investors become aware of these biases and learn to handle them. However, it is wondered if that will ever be the case. Humans will continue to behave this way, so investment opportunities will always exist.

Equity analysts amplify asset mispricings, since equity analysts are also people, they are susceptible to behavioral biases. Researchers from The University of Miami discovered that analysts are vulnerable to “in-group prejudice” in 2016 (Engelberg et al., 2020). According to this survey, analysts expect businesses with CEOs who share their demographics to perform better, which is why they rate them as a “buy” (Engelberg et al., 2020). Analysts anticipate that a company with a different demographic than they do will perform poorly, so when the company releases a solid financial report, it comes as a surprise. The typical investor uses these analyst reports. They turn to analysts they feel will assist them in obtaining a good return since they need more knowledge or competence to do their studies. When it comes down to it, analysts succumb to the same prejudices that we do, amplifying asset mispricings.

References

Baker, M.P., & Sesia, A. (2007). Behavioral Finance at JP Morgan. Harvard Business Publishing Education. Web.

Engelberg, J., McLean, R. D., & Pontiff, J. (2020). Analysts and anomalies. Journal of Accounting and Economics, 69(1), 101249. Web.

Hayes, A. (2022). Tulipmania: About the Dutch Tulip Bulb Market Bubble. Investopedia. Web.

Investopedia 100 Top Financial Advisors of 2019. (2020). Investopedia. Web.

Index Fund Advisors, Inc. (IFA.COM). (n.d.). Web.