BEHAVIORAL FINANCE: THEORETICAL BACKGROUND

The field of behavioral finance is not new. At the core of behavioral finance is the idea that the principle derived from these social sciences can be useful to improving knowledge of the behavior of the financial market.

Psychology had largely disappeared from eco­nomic discussions until the 1950s. Later, a number of factors contributed to the resurgence of its use and the development of behavioral economics. Expected utility and discounted utility models began to gain wide acceptance, which generated testable hypothesis about decision-making under uncertainty and intertemporal consumption. An increasing number of empirical studies with evidence supporting the presence of continuous anomalies challenged the rational behavior hy­pothesis. Nonetheless, many principles on which behavioral finance is based are not new. Indeed, they return to the origins of economic theory. Adam Smith, who is considered the father of modern economic thought with his book, “The Wealth of Nations,” wrote a lesser known book called “The Theory of Moral Sentiment.” In this work, there are insights into human psychology, many of which are relevant today in behavioral finance.

The ignorance of the psychological approach in economic theory, and consequently in finance theory, began with the neoclassical revolution in which all the studies in this field were constructed based on the assumption of the nature of homo economicus. In the early part of the 20th century, the works of some economists, such as Vilfredo Pareto, Irving Fisher, and later, John Maynard Keynes, had some psychological insight, however, discussion about the influence of psychology on finance had largely disappeared (Cornicello, 2004, p. 24). During the second half of the 20th century, interest in the psychological principles of economics reappeared. Psychologists like Daniel Kahneman and Amos Tversky started using the economic model as a benchmark against which to contrast their psychological models. Tversky and Kahneman’s 1979 article on prospect theory could be accepted as the main contributor to the growth of “modern” behavioral finance (Kahne- man & Tversky, 1979).

In the 1980s, interest in behavioral finance started to grow rapidly as different studies representing evidence about anomalies -which traditional theories were not able to explain- in the financial markets emerged. This interest in behavioral finance continues to grow today with a number of scholars and practitioners actively involved in these studies, as well as with a far- reaching and growing base of literature. It is necessary to note that behavioral finance theory attracted great favour among finance academics and researchers after Daniel Kahneman won the Nobel Prize in Economics.

However, it is only in recent years that a series of concerted formal studies have been undertaken in this area. Paul Slovic’s paper on individual’s misperceptions about risk (1972), and Amos Tversky and Daniel Kahneman’s papers on heu­ristic-driven decision biases (1974) and decision frames (1979) played seminal roles (Brabazon, 2000). Perhaps the most important paper in the development of behavioral finance was written by Kahneman and Tversky in 1979. This paper, “Prospect Theory: Decision Making Under Risk,” used cognitive psychological techniques to explain a number of documented anomalies in rational economic decision making (en.wikipedia.org). Further milestones in the development of the field include a well-attended and diverse conference at the University of Chicago (see Hogarth & Reder, 1987), a special 1997 edition of the respected Quarterly Journal of Economics “In Memory of Amos Tversky” devoted to the topic of behavioral economics, and the award of the Nobel prize to Daniel Kahneman in 2002 “for having integrated insights from psychological research into econom­ics, especially concerning human judgment and decision-making under uncertainty.”

The results of these studies were at variance with the rational, self-interested decision-maker posited by traditional finance and economics theory. Although several definitions of behavioral finance exist, there is considerable agreement between them.

Lintner defines behavioral finance as being “the study of how humans interpret and act on information to make informed investment deci­sions” (Brabazon, 2000, p. 2).

Thaler defines behavioral finance as “simply open-minded finance,” claiming that “sometimes in order to find the solution to an [financial] empirical puzzle it is necessary to entertain the possibility that some of the agents in the economy behave less than fully rationally some of the time” (Brabazon, 2000, p. 2).

In his study, Olsen asserts that “behavioral finance does not try to define ‘rational’ behavior or label decision making as biased or faulty; it seeks to understand and predict systematic financial market implications of psychological decision processes” (Olsen, 1998, p.11). It should be noted that no unified theory of behavioral finance exists at this time (Brabazon, 2000, p.2).

One idea core to behavioral finance is that the principles derived from the social sciences can improve the knowledge about investors’ behavior in financial markets. This research doesn’t imply a rejection of previous theories. On the contrary, it provides a useful theoretical framework upon which studies on behavior finance try to improve. Despite strong evidence that securities markets are highly efficient, there is a growing body of evidence that long-term historical phenomena con­tradict the efficient market hypothesis and cannot be captured plausibly on models based on perfect investor rationality. The “irrational investors ap­proach” assumes that securities market arbitrage is imperfect, and thus that prices can be too high or too low (Baker, Ruback, & Wurgler, 2004, p. 1). These phenomena are referred to as stock market anomalies. Behavioral finance seeks to understand and explain these recognized phenomena.

The underlying assumptions of the efficient market hypothesis are that transaction costs are zero, markets are not segmented, and there is easy entry into the security markets (Hollman, 2005, p. 22). The behavioral assumptions that underlie the efficient market hypothesis argue that investors act in an unbiased fashion to maximize the values of their portfolios, which is usually referred to as rational expectations, and that investors always act in their own self-interest (Hollman, 2005, p. 22). Behavioral finance questions the validity of these last two assumptions. Researchers in cognitive psychology and the decision sciences have docu­mented that people systematically make errors in judgment and mental mistakes. Behavioral finance as a new area for research may be able to explain these anomalies in the efficient market hypothesis.

Eugene Fama, the pioneer who identified the three forms of the efficient market theory, argued that the theory survives the criticisms of behav­iorist academics who point out anomalies in the markets. Fama claimed that market anomalies are chance results. Any new models introduced to explain anomalies should be considered in relation to how they view the big picture. Fama believed existing behavioral models are inadequate because they seek to explain specific anomalies, and there is no overriding theory that could overturn the ef­ficient markets model. It appears that until there is a unifying theory, there is no validity (Fama, 1998, p.283). However, this does not mean that there are no anomalies in the markets and the EMH is performing perfectly in the market mechanism (Hollman, 2005, p. 23).

According to Shiller, the basic problem with the efficient markets hypothesis is that it is tell­ing a half-truth. The hypothesis is useful when presenting market efficiency as a simple concept to college students and amateur investors, but they may come to believe that it is easy to get rich quickly. However, this is not the case when trading in speculative financial markets. The short-run, day-to-day or month-to-month profit opportunities that people imagine they have found are probably not there. Shiller’s response to Fama emphasized that the real world is not very similar to the world presented in Fama’s assumptions (Shiller, 2002, p. 11).

In his 2003 paper, Glaeser wrote that psy­chology is not going to argue that human beings do not respond to incentives, nor is psychology going to suggest that risk-free opportunities for profit will be possible. If anything, situationalism creates more of a problem for psychology than for economics. In the real world, situations are man-made. To understand heterogeneity across time and space, psychologists need theories that explain how exogenous variables shift the supply of cues, framing, and other situational factors. For example, psychology tells us that people form beliefs in large part by listening to people around them, so it isn’t a surprise that there can be cognitive errors in their decision making process.

It should not be underestimated that the theories related with psychology used to support behavioral finance, and to challenge the efficient market hypothesis. Within the last two decades, finance literature has accumulated a substantial number of observations of anomalies inconsistent with the efficient market hypothesis. These anomalies suggest that the underlying principles of the effi­cient market hypothesis are not entirely correct. It may be necessary to look also to other models of human behavior that have been studied in social sciences (Shiller, 1999, p. 1307).

Behavioral finance offers a forum that goes beyond the limits of economic assumptions in pursuit of a better model of financial behavior that includes both cognitive and emotional behav­iors. One could argue that prospect theory is the behavioral theory that has the most remarkable impact on economic research. Thus, in the next subsection of this study will briefly discuss the prospect theory of Kahneman and Tversky.