- Recent debates in the field of finance involve the progression of what has known as behavioral finance, which can best be referred as the irrational behavior of investors in the financial market.
- Fromlet (2001) states that behavioral finance is the combination of individual behavior, market phenomena and the use of knowledge taken from both psychological field and financial theory. From the financial theory perspective, behavioral finance seeks to understand and predict systematically the implication of psychological decision process towards financial market.
- The conventional and modern finance are based on rational and logical theories such as the Efficient Market Hypothesis (EMH) as well as the Capital Asset Pricing Model (CAPM) where they assume that investors behave rationally. Rationality means when investors receive new information, agents update their beliefs correctly, in the manner described by Bayes’ Law (Barberis and Thaler, 2003).
- However, as time goes by, most finance and economic experts found that there are some anomalies and behaviors unexplained by theories available. Investors nowadays are frequently behaved irrationally.
- For instance, The recent downturn in the US economy also shows some irrational behavior of investors which drag the market from bad to worse. The unpredictable confidence and different processes endangered by fear has become among the reasons why recession are so difficult to forecast.
THE ORIGINS OF BEHAVIORAL FINANCE
- One of the earliest (if not the first) call for a scientific melding of psychological and financial research came from the article titled “Possibility of an experimental approach to investment studies by Professor O.K. Burrell, University of Oregon in 1951, followed by the W. Scott Bauman, Burrell and Bauman on “Scientific Investment analysis: Science or fiction?” in 1967 and continued by Paul Slovic who published a detailed study of the investment process from a behavioral perspective.
- The renewed interest in the area appears to have triggered by two developments. The first was mounting empirical evidence that existing financial theories appeared to be deficient in fundamentals way. The second was the development of prospect theory by professors Daniel Kahneman of Princeton University and Amos Tversky of Stanford University. Kahnmen and Tversky (1979) present a model of decision making that was an alternative to subjective expected utility theory with more realistic behavior assumptions.
- They show that judgments tend to be made using a representativeness heuristic, whereby people try to predict by seeking the closest match to past patterns, without attention to the observed probability of matching the pattern. For example, when asked to guess the occupations of people whose personality and interests are described to them, subjects tended to guess the occupation that seemed to match the description as closely as possible, without regard to the rarity of the occupation.
BEHAVIORAL FINANCE – AS TIME PASSES BY
- Behavioral finance, which comes from broader social science perspectives, has now become one of the most vital research programs and it stands in sharp contradiction to much of efficient markets theory. In the 1970s, the Efficient Market Theory and CAPM were very popular and reached its high dominance in the academic circles.
- Siegel (2002) suggested that the 1980s were a time of important academic discussion of the consistency of the efficient markets model for the aggregate stock market with econometric evidence about the time series properties of prices, dividends and earnings.
- In the 1990s, a lot of the focus of academic discussion shifted away from these econometric analyses of time series on prices, dividends and earnings toward developing models of human psychology as it relates to financial markets.
THE MARKET ANOMALIES
- The regularly occurring anomalies were a big contributor to the formation of behavior finance whereby it assumes rationale and logical behavior. Among of the anomalies are January Effects, and The Winner’s Curve.
- The January effect is the most important calendar anomaly. The returns on common stocks in January are much higher than in other months, and this phenomenon is due to smaller-capitalization stocks in the early days of the month. The January Effect occurs because many investors choose to sell some of their stockright before the end of the year in order to claim a capital loss for tax purposes. Once the tax calendar rolls over to a new year on January 1st these same investors quickly reinvest their money in the market, causing stock prices to rise.
- The Winner’s Curve anomaly is the tendency of winning bid in an auction setting to exceed the intrinsic value of the item purchased. Rational-based theories assume that all participants involved in the bidding process will have access to all relevant information and will all come to the same valuation. Any differences in the pricing would suggest that some other factor not directly tied to the asset is affecting the bidding.
- Other main important elements and concepts that exist in behavioral finance are overreactions and the availability of bias, and overconfidence. Normally, when the company raised some good issues (such as paying a good dividend), it should also raise the business’ share price accordingly to the news. And whenever there’s no news coming up later on, it should not bring the share price go down.
- However, in reality, participants in the market overreact to the new information which creates a larger effect on a security’s price. The availability bias is when people tend to heavily weight their decisions toward more recent information, making any new opinion biased toward that latest news. This happens in real life all the time.
- For example, suppose you see a car accident along a stretch of road that you regularly drive to work. Chances are, you’ll begin driving extra cautiously for the next week or so. Although the road might be no more dangerous than it has ever been, seeing the accident causes you to overreact, but you’ll be back to your old driving habits by the following week.
- Overconfidence is not a trait that applies only to fund managers. Consider the number of times that you’ve participated in a competition or contest with the attitude that you have what it takes to win – regardless of the number of competitors or the fact that there can only be one winner.
- There’s a fine line between confidence and overconfidence. Confidence implies realistically trusting in one’s abilities, while overconfidence usually implies an overly optimistic assessment of one’s knowledge or control over a situation.