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Theories of behavioral finance
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The Fama Critique Compared to New Research
1. Introduction
Over the last couple of decades there has been a debate going whether or not there are behavioral aspects in finance. This means that financial markets are subject to different investors’ sentiments and that markets are not efficient, i.e. the efficient market hypothesis (EMH) does not hold. The supporters of EMH argue that all available information is included in the stock prices, which means that any long-term abnormal returns earned are a matter of chance. On the other side, the supporters of behavioral finance argues that because of over- and under-reaction by investors to information, it takes time before prices fully adjust and thus there is an opportunity to earn long-term abnormal returns.
In 1998 Eugene F. Fama published a famous critique on long-term return anomalies. He infers that all anomalies that was pointed out in scientific papers up until then where a matter of chance. His argues that it is easy to show the weaknesses of behavioral models and proof of anomalies. If there is a more or less even split between over- and under-reaction, and continuation and reversal of returns, then this supports the market efficiency hypothesis that any abnormal returns are chance. He also infers that with a reasonable change in methodology used, the anomalies are severely reduced or disappears completely.
In the years after his critique was published there have been a lot of papers contradicting Fama’s view and giving support to the behavioral aspect of finance, saying that EMH is not valid for financial markets due to over- and under-reaction by investors due to overconfidence. In this essay I am going to look closer at two papers which focus on how investors’ different reactions to information increases trading volume on the market (Odean, 1998) and which stocks are traded (Barber and Odean, 2007) . These both find evidence that the over-reaction of investors to certain information influence their trading and thus the market. This contradicts the theory of an efficient market where all reactions in the market are rational.
I will first present some brief theory on the Efficient Market Hypothesis and behavioral finance. Then I give an overview of the critique by Fama (1998). In the next section I will present the main points of the articles by Odean (1998), and Barber and Odean (2007). These are then compared to the relevant conclusions of Fama.
2.
Introduction During the process of research, professionals collect data or identifiable private information through intervention or interaction. While this is a vital part of the scientific and medical fields, every precaution must be taken by researchers to protect the participants' rights. Ethics, outlined by the Belmont report; requirements, described by the Department of Health and Human Services (DHHS); and regulations, laid out by the Food and Drug Administration (FDA) are verified by an Institutional Review Board (IRB). This procedure ensures that all human rights are safeguarded during the entire research process. The Institutional Review Board The IRB is an administrative body which has been established to make sure research participants' rights are protected.
Fama and French findings shocked the modern portfolio theory and their study was nick named "Beta is Dead". With respect to CAPM they found that stocks with high betas did not have consistently higher returns than low-beta stocks. Furthermore, Fama and French concluded that a high book value to market value was the most important variable related to predicting high stock returns on small cap stocks. These findings were published in a 1992 paper titled "The Cross-Section of Expected Stock Returns".
Assuming that there are no costs applied, and the investors have the ability to buy and sell securities and they also have the knowledge of any change; no costs for buying or selling of securities for brokers for example. Modigliani and Miller’s assumption is that all of these capital market factors which is needed for trading of securities are all perfect.
The efficient market hypothesis has been one of the main topics of academic finance research. The efficient market hypotheses also know as the joint hypothesis problem, asserts that financial markets lack solid hard information in making decisions. Efficient market hypothesis claims it is impossible to beat the market because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information . According to efficient market hypothesis 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. As such, it should be impossible to outperform the overall market through expert stock selection or market timing, and that the only way an investor can possibly obtain higher returns is by purchasing riskier investments . In reality once cannot always achieve returns in excess of average market return on a risk-adjusted basis. They have been numerous arguments against the efficient market hypothesis. Some researches point out the fact financial theories are subjective, in other words they are ideas that try to explain how markets work and behave.
The efficient market, as one of the pillars of neoclassical finance, asserts that financial markets are efficient on information. The efficient market hypothesis suggests that there is no trading system based on currently available information that could be expected to generate excess risk-adjusted returns consistently as this information is already reflected in current prices. However, EMH has been the most controversial subject of research in the fields of financial economics during the last 40 years. “Behavioural finance, however, is now seriously challenging this premise by arguing that people are clearly not rational” (Ross, (2002)). Behavioral finance uses facts from psychology and other human sciences in order to explain human investors’ behaviors.
In summary, investors on the whole are rational and contribute to an efficient market through prudent investment decisions. Each investor?s optimal portfolio will be different depending on the feasible set of portfolios available for investment as well as the indifference curve for that particular investor. Lastly, risk free borrowing and lending changes the efficient set and gives the investor more opportunities to either get a higher expected return with the same amount of risk or the same amount of return with less risk.
The purpose of this critique is to analyze the design of a research study conducted by; Donna Kazemi, Maureen Levine, Jacek Dmochowski, Mary Nies, and Linman Sun called “Effects of Motivational Interviewing Intervention on Blackouts Amoung College Freshman”. It was accepted in January 21st, 2013 and was published in the Journal of Nursing Scholarship.
According to Perold (2004), ‘CAPM can be served as a benchmark for understanding the capital market phenomena that cause asset prices and investor behavior to deviate from the prescript...
The efficient market hypothesis states that it is not possible to consistently outperform the market by using any information that the market already knows, except through luck. Information or news in the EMH is defined as anything that may affect prices that is unknowable in the present and thus appears randomly in the future.
Traditional finance perspective theorist believes that individuals who have will to venture into investment activities does not allow their emotions to be guided by how investment information is presented to them. However, the same cannot be said for the behavioural finance perspective. Through psychological studies, researchers of behavioural finance have come to the understanding of how human behaviour and behavioural finance connected. This connection can create behavioural biases which can positively or negatively impact on the growth of investment opportunities. This research is on behavioural biases is categorized into two specific groups, cognitive errors and emotional biases.
A crucial reason in favour of mental accounting and overconfidence is decision efficiency. Real-life investing scenario changes every moment Time-consuming and systematic thinking process seldom is allowed during the intense decision-making (Stewart Jr et al., 1999, Busenitz and Barney, 1997). Additionally, the ‘small world’ used by the economic theory, which only applied to strict condition, is not necessarily applicable in the practical investment decision. As the assumption in those analysis approach may not conform with real life well and for most of times, cognitive heuristics is more suitable for the uncertainty(Gigerenzer and Gaissmaier, 2011). However, there is also a few argument against them, for it may hinder people from examining their investment choice thoroughly. Research shows that they did not perceive themselves as risk taker, but in fact, they are more likely to take relatively low return alternatives as ‘opportunities’, indicating that they are risk-taking to a great extent(Palich and Ray Bagby, 1995). As a result of the illusion created by such factors, decision makers tend to be narrow-minded in composing strategies and unable to bring enough information into thought(Schwenk, 1988). It was demonstrated by several researches that decisions made by means of biases and heuristics impose
Chapter 11 closes our discussion with several insights into the efficient market theory. There have been many attempts to discredit the random walk theory, but none of the theories hold against empirical evidence. Any pattern that is noticed by investors will disappear as investors try to exploit it and the valuation methods of growth rate are far too difficult to predict. As we said before the random walk concludes that no patterns exist in the market, pricing is accurate and all information available is already incorporated into the stock price. Therefore the market is efficient. Even if errors do occur in short-run pricing, they will correct themselves in the long run. The random walk suggest that short-term prices cannot be predicted and to buy stocks for the long run. Malkiel concludes the best way to consistently be profitable is to buy and hold a broad based market index fund. As the market rises so will the investors returns since historically the market continues to rise as a whole.
There is a lot of research work going on in this particular field, more so since the crisis of 2008. The purpose of this article was to make readers aware of the subject .Behavioral finance is an interesting mix of logics, psychology and economics. Budding investors and management students should look into this in more detail so that they are better equipped to make financial decisions.
It is human nature to want to be liked and accepted by other individuals and groups. The intelligent individual could have also engaged in these behaviors due to normative social influence. Conformity for normative reasons occurs in situations so that we, as humans, will not attract attention, be made fun of, get into trouble, or be rejected. Since this individual is new to the university, he does not want to be ostracized from groups. Nor does he want to be the individual who is constantly picked on since he did not engage in the “normal” activities on campus. Of course, he wants to be liked by other individuals and have friends. Individuals conform so that they will be liked and accepted by other people. They conform to the social norms-implicit
This paper will define and discuss five financial theories and how they impact business decisions made by financial managers. The theories will be the Modern Portfolio Theory, Tobin Separation Theorem, Equilibrium Theory, Arbitrage Pricing Theory (APT), and the Efficient Markets Hypothesis.