Behavioral Finance Essay ⋆ Business Essay Examples ⋆ EssayEmpire

Behavioral finance is closely related to the study of behavioral economics and seeks to integrate cognitive psychology into the study of financial markets and institutions. Due to the availability of data, behavioral finance is the branch of economics were the application of behavioral ideas has had its greatest impact.

Behavioral finance argues that individuals attach different levels of satisfaction to gains and losses (a concept referred to in the literature as “prospect theory”). Strong risk aversion among individuals suggests that they view losses as significantly more painful than equivalent gains. Such behavior may therefore manifest itself in a strong unwillingness to sell failing investments since it would force the individual to realize real losses. A further development on this, referred to as “mental accounting,” suggests that people evaluate the effects of financial decisions by separating gains and losses, implying that satisfaction is dependent on the ways in which gains arise rather than their effects on final, overall wealth.

A second aspect of behavioral finance is the belief that investment behavior is heavily influenced by simplifying forecasting strategies (“heuristics”) that assist market participants in making investment decisions. Whereas standard theory argues that it is useless to form such decisions based on an extrapolation of past exchange rate movements, stock price movements, or earnings trends, research suggests that investors actually do employ this simple technique. “Heuristics” can lead investors to have a disproportionate view of their abilities, possibly make them believe they can directly influence outcomes, and so make decisions without adequate information. Such cognitive biases have the potential to generate systematic errors and can, in extreme cases, generate stock market bubbles or crashes.

A third aspect is the view that investors do not engage in full portfolio diversification, but overinvest in areas they understand or are comfortable with (“familiarity breeds investment”). Furthermore, individuals who regularly deal with financial risk may be unable to fully comprehend the risks associated with different investments, so leading them to attach higher risk premiums to certain investments. A limited knowledge of foreign markets, for example, may lead investors to place a higher risk premium on foreign investments over domestic investments.

Behavioral finance draws upon a large body of research that highlights the inability of standard models to explain a number of financial phenomena. Historical data has highlighted a dramatic disparity between actual share price movements when compared with those calculated via the dividend discount model (which calculates the value of a share price, at any moment in time, as being equal to the sum of discounting future dividends). Such evidence has led many behavioral economists to conclude that cognitive psychology must play an important role in determining stock market volatility. For example, cognitive biases can exert powerful effects on asset prices, with investors under reacting or over reacting to new information. Research on the behavior of stock prices suggests that investors may push prices too high in response to good news, or push them too low in response to bad news.

Attempts have been made to salvage the idea of rational and efficient capital markets by arguing that the existence of only a few rational agents in the market will negate the effects of behavioral factors. A simple example will illustrate this idea. Assume that there are two kinds of agents in the market, those who conform to the standard model of economic rationality, group R, and those who do not conform to the standard model and who instead employ some heuristic rule in forming their decisions, group H. If, via the use of their heuristic rule, group H drive the exchange rate above its fundamental value, it is argued that group R will response to the profit opportunity and bring to rate back down. The outcome, in other words, is seen to be consistent with the rational economic model even through some of the participants are following simplifying rules-of thumb to make their decisions. Such arguments do not appear to be borne out by the available evidence however, and some economists have argued that it may take a significant number of group R traders to eliminate the actions of group H traders.

By seeking to place the human element firmly at the center of the investment decision-making process, the study of behavioral finance has important implications for policy regulation of financial markets.

Bibliography:

M. F. De Bondt and R. Thaler, “Does the Stock Market Overreact?” Journal of Finance (v.40/3, 1985);
De Grauwe and M. Grimaldi, The Exchange Rate in a Behavioral Finance Framework (Princeton University Press, 2006);
Schleifer, Inefficient Markets: An Introduction to Behavioral Finance (Oxford University Press, 2000);
Thaler, ed., Advances in Behavioral Finance (Russell Sage, 1993).

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