Behavioral Finance

Behavioral Finance

Financial theory usually rests on the assumption that individuals are rational, however this fails to always be the case in real life. The preceding statement is the realm of behavioral finance, a field that studies how irrationality influences the financial world, outlined in a paper by Barberis & Thaler (2003).

The main tenet of the limits of arbitrage assertion is that in real life markets, there are both rational and irrational players. Therefore, irrationality influences outcomes, such as prices, despite what traditional financial models have postulated.

The traditional efficient markets hypothesis (EMH) states that prices will reflect the true value of products, behavioral finance counters that even if some shares are under- or overpriced, investors who notice it may be unable to correct the situation as would be expected under the EMH. The situation is complicated further by the fact that most investors have professionals manage their money for them.

Furthermore, the role of psychology becomes evident as soon as one understands the impact that people’s preconceptions have in matters related to financial economics. The following concepts recurrently cloud people’s judgments: wishful thinking, overconfidence and representativeness. Representativeness can be seen in the situation proposed by Kahneman & Tversky (1974). The author of the present text has simplified and altered their setting, but tried to keep the basic idea intact. Given the description below, please choose Kesha’s likely occupation:

Kesha is artistic, majored in fine arts, and strongly believes in the end of the world in 2012 caused by the mysterious planet X or Nibiru (imagine the year is 2111). What does Kesha do for a living?

a.    fortune teller

b.    grocery store cashier

Psychology is defined as the scientific study of the mind and behavior. Image : © Megan Jorgensen (Elena)

Many respondents will choose ‘a’ despite the fact that statistically speaking, ‘b’ is much more likely to hold, since very few persons hold jobs as fortune tellers as opposed to grocery store cashiers. Such a failure to weigh probabilities is called the sample size neglect, but may also be explained by a hasty jump to conclusions.

An even more rudimentary mistake is the gambler’s fallacy, the irrational belief that a randomly determined streak of losses must be followed by a win. From probability theory, one knows that a fair coin tossed five times with the same result of tails each time, still has the same 50% chance of exhibiting tails.

Other cognitive biases are anchoring and belief perseverance. People tend to seek familiarity, and when in doubt, find an anchor, staying close to, or within a comfortable range of, some predetermined or fortuitous value or number. Belief perseverance simply means that the human mind often clings to its beliefs in spite of contradictory evidence.

References:

    Barberis, N. & Thaler, R. (2003). Chapter 18: A survey of behavioral finance. Handbook of the Economics of Finance, 1(2): 1053-1128.

    Kahneman, D. & Tversky, A. (1974).  Judgment under uncertainty: Heuristics and biases. Science, 185 (September): 1124-1131.