Standard Finance Theory Analysis

Standard finance theory as defined by Thaler (1999) assumes “the representative agent” acts rationally by following the principles of the Expected Utility Theory and making future predictions based on rational information. It assumes there is no element of cognitive bias or sentiment affecting asset prices (O’Keeffe, 2014).

The Expected Utility Theorem introduced by Bernoulli (1738) and further developed by Von Neumann and Morgenstern (1947) states that the “decision maker” bases their decision regarding “risky outcomes” solely on their predicted return or “expected utility”, this recognises the risk averse nature of most market participants. This theory forms a basis for Standard finance theory. People place a larger weight on what they stand to gain or lose from an event rather than the expected value of the event’s result. The Von Neumann and Morgenstern (1947) utility theory has four axioms of choice which need to be present in order the theory to be accurate. Transitivity; which assumes peoples choices are consistent, completeness; which assumes people have well defined preferences, independence; which assumes that an individual’s decision will not change despite irrelevant variables being added and finally, convexity/continuity; which assumes that when several different outcomes from which an individual has certain preferences, there should be an outcome which the individual is indifferent to. These axioms allow for the theory of risk aversion to be introduced which suggests that utility functions are concave and show diminishing marginal wealth utility (O’Keeffe, 2014). Kahneman & Tversky (1979) however, believed that individuals displayed more tendencies towards being “risk seeking” and basing their decisions on cognitive ...

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...t believes that in the long-run, mispricing or any perceived anomalies will be eradicated as the market corrects itself. However it can be clearly seen from the above that market participants are indeed susceptible to biases and they do make mistakes based on these biases. Therefore, herding and positive feedback trading do not allow the market to correct and noise traders can affect the markets prices for prolonged periods.

Conclusion

Based on standard finance theory, noise traders should not exist in the market and their presence should not have an impact on prices. However, they do and this can be attributed to the various aspects of behavioural finance which are outlined in this paper. Standard finance theory itself does not stand up to scrutiny when faced with the existence of anomalies and market participants who continually achieve positive abnormal returns.