19-07-2013, 01:53 PM
A Survey of Behavioral Finance
Behavioral Finance[.ppt (Size: 770.5 KB / Downloads: 14)
Introduction
The traditional finance paradigm seeks to understand financial markets using models in which agents are “rational.”
Rationality means two things.
First, when they receive new information, agents update their beliefs correctly, in the manner described by Bayes’s law.
Second, given their beliefs, agents make choices that are normatively acceptable, in the sense that they are consistent with Savage’s notion of Subjective Expected Utility (SEU).
Behavioral finance is a new approach to financial markets that has emerged, at least in part, in response to the difficulties faced by the traditional paradigm.
In broad terms, it argues that some financial phenomena can be better understood using models in which some agents are not fully rational. More specifically, it analyzes what happens when we relax one, or both, of the two tenets that underlie individual rationality.
In some behavioral finance models, agents fail to update their beliefs correctly.
In other models, agents apply Bayes’s law properly but make choices that are normatively questionable, in that they are incompatible with SEU.
Limits to Arbitrage – Market Efficiency
Behavioral finance argues that some features of asset prices are most plausibly interpreted as deviations from fundamental value, and that these deviations are brought about by the presence of traders who are not fully rational.
A long-standing objection to this view that goes back to Friedman (1953) is that rational traders will quickly undo any dislocations caused by irrational traders.
Some researchers accept that there is a distinction between “prices are right” and “there is no free lunch,” they believe that the debate should be more about the latter statement than about the former.
We disagree with this emphasis. As economists, our ultimate concern is that capital be allocated to the most promising investment opportunities.
Whether this is true or not depends much more on whether prices are right than on whether there are any free lunches for the taking.
Limits to Arbitrage - Theory
Fundamental Risk
The most obvious risk an arbitrageur faces if he buys a mispriced security is that a piece of bad news about that particular security’s fundamental value causes the stock to fall further, leading to losses.
Of course, arbitrageurs are well aware of this risk, which is why they short a substitute security.
The problem is that substitute securities are rarely perfect, and often highly imperfect, making it impossible to remove all the fundamental risk.
Shorting substitute security protects the arbitrageur somewhat from adverse news about the particular industry as a whole, but still leaves him vulnerable to news that is specific to the security.
Psychology - Beliefs
Second is sample-size neglect.
When judging the likelihood that a data set was generated by a particular model, people often fail to take the size of the sample into account: after all, a small sample can be just as representative as a large one.
Conservatism
It appears that if a data sample is representative of an underlying model, then people overweight the data.
However, if the data is not representative of any salient model, people react too little to the data and rely too much on their priors - an overreliance on prior information.