Five Most Significant Breakthroughs in Behavioral Finance

Five most significant breakthroughs in behavioral finance

Introduction:

As Alistair and Mike (2008) described that behavioral finance was “ Financial decisions of investors can be less than fully rational due to behavioral biases .”  They summarized all evidences of biases which come from psychology literature have been applied in a financial context. This essay choose the most significant four of them which conflict with efficient market hypothesis and explain powerful causes of mispricing in real market: Overconfidence and Sample size Neglect(errors in information processing), Mental accounting and Prospect Theory(behavioral biases). Behavioral finance theory also counters that mispricing may persist since arbitrage is risky and costly(Shleifer and Vishny 1997). In the following sections, we discuss each evidence above briefly and specify their contribution to behavioral finance respectively.The final section of this review provides a bibliography.

Errors in information processing

      Overconfidence and Overaction.   In the aspect of psychology, people tend to overestimate the precision of their forecasts and their abilities(Daniel,  Hirshleifer & Subrahmanyam, 1998). This irrational behavior accounts for the phenomenon that overall trading volume in equity markets is excessive since investors with too much confidence in their skills often buy and sell too often. As Barber and Odean(2001) provided an example: trading activity is highly predictive of poor investment performance.It provided a reasonable explanation that overactions of investors caused by overconfidence will result in poor investment performance. Evidences above can draw the conclusion that poor investment may be caused by overaction, and overaction is resulted from overconfidence to a great extent.

      Moreover, such overconfidence may be responsible for the prevalence of active versus passive investment management, which provided a violation of efficient market hypothesis(Odean,1999). As an assumption of  investor errors in information processing, market participants may  “push” financial market into mispricing by overaction which is potentially resulted from overconfidence. So overconfidence has explained possible causes of mispricing through the relation of overaction and developed the theory system of behavioral finance significantly by linking heavily with psychology.

      Representativeness Bias. The representativeness heuristic involves investors assessing situations based on superficial characteristics rather than underlying probabilities. There are three causes of representativeness bias.

       Commonly, the bias was resulted from sample size neglect: infer a pattern too quickly based on a small sample and extrapolate apparent trends too far into the future, which is consistent with overaction. Therefore, the short-lived run of high stock return lead to optimistic future performance estimation of investors. Thus, the buying pressure will exaggerates the price run-up. Another finding from Cooper,Dimitrov, and Rau(2001)show that investors can be influenced also by the name a company adopts, which also consistent with the representativeness heuristic: “Investor mania”proves that the actions of investors are not always relate to subjective probabilities assessing. Moreover, Shefrin and Statman(1995) found out the assumption from huge amount of irrational investors that the share of a “good company” will be a good investment. Recently Statman, Fisher, and Anginer (2008) find results consistent with Shefrin and Statman(1995):large companies with low book-to -market ratios are tend to have poor subsequent returns. The posing of representativeness bias provided powerful explanations of  mispricing caused by error information caused by sample neglect, investor mania and “good company” misunderstanding.

Behavioral biases

       Mental accounting. Even if information processing were perfect, many studies conclude that individuals would still tend to make irrational decisions using that information.Mental accounting is a kind of behavioral biases: investors may segregate accounts or monies and take risks with their gains that they would not take with their principal(Stateman, 1997).Simply, the house money effect refers that investors will be more risk taking when they face with their earning as”winning account”. Similar, after a stock market run-up, investors become more tolerant of risk, using lower discount rate for future cash flow and thus further push up prices.It shows that the theory of irrational mental accounting contributed the explanation of the momentum in stock prices.

       Moreover, Shefrin and Statman(2000) concluded that optimal behavioral finance theory portfolios are also different from optimal CAPM portfolios, and then Statman(2008) pointed out that behavioral approach views investors as building their portfolios in “distinct mental account layers in a pyramid of assets”. They also indicates that mental accounting makes important points about portfolio management.

      Prospect Theory. Prospect theory modifies the analytic description of rational risk-averse investors in traditional financial theory.(Kahneman and Tversky,1979). The conventional description of a risk averse investor shows that higher wealth provides higher satisfaction but at a diminishing rate, so investors will reject risky products that don’t offer a risk premium. However, the prospect theory points out that the satisfaction(utility) actually depends on changes in wealth from current levels, which helped to explain higher historical average equity risk premium in reality. Moreover, the prospect theory criticized that investors will be risk seeking rather than risk averse when they face with losses, which was a huge breakthrough from traditional financial theory in the area of risk-averse investor analysis. Coval and Shumway(2005) observed the fact which supports prospect theory strongly: traders tend to accept greater risk in following afternoon sessions if they lost money in morning. It means that the change of earning will influence the attitude of risk taking of investors. This kind of irrational behavior may result in the huge imbalance of risk averse investors and risk seekers if the whole market goes down even though they got full information, which can also contribute the mispricing of market to some extent.