BEHAVIORAL FINANCE: CONTRIBUTIONS TO MODERN FINANCE THEORY
In literature, it has been highlighted that bias and framing effects driven by heuristic, cause market prices to deviate from fundamental values. Additionally, it has been suggested that behavioral finance may offer an explanation for empirical evidence which casts doubt on existing financial models (Brabazon, 2000, p.
5). In 1985, De Bondt and Thaler argued that overreaction or underreaction may occur in financial markets as investors rely on representativeness bias (DeBondt & Thaler, 1985, p. 793). Investors could become excessively optimistic about past winner stocks and excessively pessimistic about past loser stocks, and this bias could cause prices to deviate from the fundamental values. As a result of the biased attitudes of investors, overreaction and underreaction of investors to new information occurs in financial markets. Anchoring and overconfidence may lead analysts to fail to adjust their earnings estimates sufficiently in case of unexpected price changes. This could lead to subsequent price adjustments as analysts revise their incorrect estimates. According to Brabazon, as a result of the arguments of behavioral finance several implications about behavioral patterns may arise in financial markets (Brabazon, 2000, p. 5). Such as the:• Overreaction or underreaction to price changes or news.
• Extrapolation of past trends into the future.
• Lack of attention to fundamentals underlying a stock.
• Focus on popular stocks.
• Seasonal price cycles.
If such patterns exist, there may be scope for investors to exploit the resulting pricing anomalies (differences) to obtain superior risk adjusted returns. On a theoretical level, the exploitable pricing anomalies undermine the current credibility of the EMH and these findings should be accepted as a contribution for a better explanation of the real markets not a as a challenge to the mainstream in finance. In contrast, behavioral finance assumes that, in some circumstances, financial markets are informationally inefficient (Ritter, 2003, p. 430).
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