Behavioral Finance & Emh

Individual Assignment

1．Behavioral biases

Investors make irrational decisions. Besides, they make irrational decisions in a systematic way according to scholars who study behavioral biases. Behavioral biases are cognitive dissonances, which result in illogical interpretation, irrational judgment and invalid perception.

One of the most renowned biases is over-optimism, which roots from psychological biases such as illusion of control and self-attribution bias. Habitually, investors become over-optimistic about future. They tend to believe that they have control over outcomes and are less at risk of a negative event. Even if they encounter negative outcomes, they merely attribute the events to evil luck instead of insufficient ability.

Another behavioral bias is over-confidence. It describes conditions where people subjectively over-estimate the accuracy of their judgments. People who exhibit this bias exaggerate their skills and knowledge. Rather interestingly, women on average suffer less from over-confidence than men.

Over-optimism and over-confidence are biologically inherent in most people. These two traits, when potently combined, lead private investors change stocks frequently. However, over trade does not necessarily guarantee a positive return. In most time it only shrinks investors' wealth. Terrance Odean (1999) indicated in his research that in speculative trades, the stocks the investors purchased underperformed the ones they sold by 5.07% on average.

Anchoring is another common behavioral bias. This concept describes circumstances where investors anchor their thoughts to a reference point even though it may have no logical relevance. Consider a situation where the price of a stock plummets from $100 to $50 owing to the loss of a major customer. Investors, affected by the anchoring bias, may regard $100 as a reference point. Thus, they may conclude that the stock is undervalued and that the price will gradually restore. Unfortunately, the anchoring point is misleading, and the price may never shoot up again.

Ambiguity aversion bias describes an attitude of preference for known risks over unknown risks. Investors tend to invest in familiar financial vehicles, such as, the stock of their employing company. They thereby can hardly well-diversify their investments to minimize risk while expecting the same level of return.

Other behavioral biases include cognitive dissonance, confirmation bias, conservation bias, representative heuristic, hindsight and so on. Behavioral biases influence the decision-making process and may plague investors.

2．Behavioral challenges to EMH

The Efficient Market Hypothesis (EMH) has been a central proposition for the past several decades. It asserts that the market fully and efficiently incorporate all available information. Andrei Shleifer (2000) claims in his book that any one of the following three conditions can lead to the efficiency. They are rationality, independent deviations from rationality, and arbitrage.

The emergence of behavioral finance has posed a challenge to the three fundamental conditions resulting in EMH. Evidently, investors are not all rational. They make irrational decisions and suffer from behavioral biases. Typical investors may under-diversify due to ambiguity aversion, over-trade due to over-confidence and react insensitively due to conservation bias.

The concept of independent deviations from rationality suggests that irrational investors all act independently and randomly. If it holds, the behaviors of an irrational investor tend to be counteracted by another one. Therefore, the population of irrational investors has a minute impact on market's efficiency. However, behavioral finance suggests that investors do not trade in a random way. Instead, they make mistakes in a habitual and predictable manner. Thus, their influence on the market efficiency is not negligible.

In the situation of arbitrage, investors are classified into irrational amateurs and professionals. Irrational amateurs invest illogically, driving the prices below or above