Merging New Paradigm in Finance Essay Example Pdf

Academic finance has transformed significantly from the days where most academics and practitioners believed that markets were efficient. Traditionalists argue that the market prices assets at their fair value, assuming that all relevant information pertinent and relevant to an asset is known by all market participants-in reality however there is an information asymmetry. In addition to this financial and economic theory have assumed that all economic agents behave in a two way rational manner-the principles of expected utility theory and unbiased prediction of the future thus their decisions and actions must be rational as well. However, events in the last decade such as, the dotcom bubble and the crash of 2008, suggest that in reality markets do not behave as theory suggested but in fact other factors must be taken into account: i.e. human behavior. Traditional finance paradigms have yet to explain the behavior of markets during bubbles and times of uncertainty, even when there is no changes in the fundamentals of a stock the price may plummet or rise. The same principle is applicable to commodities and the foreign exchange market. Traditionally human psychology has not been an integral part of the study of finance despite the fact that financial markets are operated by humans. Behavioral finance is a field that studies the influence of investor psychology and the effect on the markets; it seeks to explain why markets are inefficient and the irrational behavior of investors in other words, if EHM were true then in theory premiums or discounts of financial instruments should not exist. However, in the reality such is not the case but the question really is why? Selden (1912) in his book Psychology of the Stock Market proposed that the movements of prices on financial markets are influenced in large part by the attitudes and behavior of the market participants. Also it is important to consider that as markets became more globalized the number of participants increased.

1.3 Justification

The study of behavioral finance represents an opportunity to revaluate our perceptions of financial theory and adds another dimension to the study of financial markets, a shift occurs from the traditional view of markets as being efficient, extremely analytical and normative into a more realistic view of what actually occurs. By adding the dimension of behavior it is then possible to identify certain patterns of individual and collective behavior that may affect the function of the markets, for example traditional finance has been unable to explain the bubbles in Taiwan, Japan and the United States. Behavioral finance provides a previously non existing bridge between psychology and finance. Both are social sciences but in finance, before behavioral finance, there was little importance placed on individual decision making processes and finance like its mother discipline economics treated decision making as a black box. Finance acknowledges the existence of mental models of choice but it is more concerned with prediction rather than description or explanation. In terms of research Olsen points the fact that financial researchers have almost always found it necessary to offer ex post behavioral explanations for numerical results indicates that behavior has always been important and worthy of study in the field of finance.(Olsen, 1998) Clearly in a social science where individuals are an integral part of the process quantitative results are not sufficient. Behavioral finance is of interest because it helps explain why and how markets might be inefficient (Sewell, 2001) The importance of this literature review of behavioral finance is that it exposes the reader to a highly theoretical paradigm in finance that currently is being discussed at the highest levels of academia at top universities around the globe, and leaves the opportunity of further research to be conducted by others who may be interested in the subject matter. It is also relevant to point out that as of this writing there is no unified theory of behavioral finance thus making this work more important as it provides a very detailed account of the current state of the subject matter and offers insights on possible future research on the topic that may be developed in the near future. Additionally, given the complexity to design an experiment-due to time constraints-and collection of empirical evidence both locally and internationally a literature review demands the same amount, if not more, research and analysis.

1.4 Delimitation

The research limited to the domain of behavioral economics, finance and decision psychology.

1.5 Research Questions

What is behavioral finance? What are the most relevant works on behavioral finance? What are future research topics on behavioral finance?

1.6 General Objective

Demonstrate the implications of decision making processes and their effects on financial markets

1.7 Specific Objectives

Define behavioral finance Discuss the most relevant works on behavioral finance

1.8 Theoretical Framework

For the purposes of this work it is important to identify two distinct areas within finance in order to provide an adequate starting point for the study. A brief introduction of the traditional paradigm of finance and then continue with a discussion of behavioral finance

1.8.1 Traditional Finance

Standard finance is based on the works of Miller and Modigliani in arbitrage theory, Markowitz with portfolio theory, and Black-Scholes-Merton option pricing model. The aforementioned theories/models assume that markets are efficient and that all the agents in the economy are rational. The efficient market hypothesis-here after EMH-the price of an asset reflects all the available information and prices reflect the fair value. The efficient market hypothesis is based on the notion that people behave rationally, maximize expected utility accurately and process all available information (Shiller, 2001). According to EMH it is impossible to make an above average profit and beat the market consistently over time without taking excess risk (Johnsson, Lindblom, Platan , 2002).

1.8.2 Behavioral Finance

The emerging new paradigm of behavioral finance looks to serve as an alternative to the behaviorally incomplete theory if finance now often referred to as standard or modern finance (Olsen, 1998). It is important to note that although it seeks to replace modern finance it does not completely reject the existing theories, it only limits the boundaries in which they are function. Behavioral finance seeks to understand and predict systematic financial market implications of psychological decision processes. In addition, behavioral finance is focused on the application of psychological and economic principles for the improvement of financial decision making (Olsen, 1998). Ritter proposes in his research that behavioral finance is composed of two main elements: cognitive psychology and the limits of arbitrage (Ritter, 2003). Within cognitive psychology distinctive behaviors can be identified: heuristics-rules of thumb which make decision making easier, overconfidence-people are overly optimistic/confident of their skills, mental accounting-when people make two decisions instead of one when the situation demands a single course of action, framing-notion that how a concept is presented to an individual matters (Ritter, 2003), conservatism, and disposition effect.

1.9 Principal Works

Since behavioral finance mixes elements from psychology it then is important to note certain important works that discuss areas pertinent to the study of behavior. In 1959 Leo Festinger introduced the concept of cognitive dissonance. When two simultaneously held cognitions are inconsistent, this will produce a state of cognitive dissonance. Because of the experience of dissonance is unpleasant, the person will strive to reduce it by changing their beliefs (Sewell, 2001). Kahneman and Tversky in 1979 propose prospect theory. According to the theory people give less importance to the outcomes that have less chances occurring versus outcomes that are obtained with certainty. The theory proposes that investors in general are risk averse. Risk aversion is equal to the concavity of the utility function, where marginal utility of wealth decreases. Kahneman and Tversky conducted an experiment in which the concluded that people systematically defy the utility theory. Under prospect theory value is assigned to gains and losses rather than to final assets, also probabilities are replaced by decision weights (Sewell, 2001). In addition to this Kahneman and Tversky also introduced the value function in which they identified four possible risk profiles: risk aversion for high to moderate probability of gains and low probability of losses and risk seeking for low probability of gaining and a high probability of losing. Thaler proposes that there are situations in which consumers in fact act in opposition to economic theory among a the topics discussed were underweighting of opportunity costs, failure to ignore sunk costs, search behavior, choosing not to choose and regret, and recommitment and self-control (Thaler, 1980). In a separate research Kahneman and Tversky further explored the concept of framing and prospect theory in the context of the rational theory of choice. Another important contribution was Shiller's conclusion that stock prices volatility could not be explained merely by information about future dividends, he suggested there were elements that influenced volatility of stock prices. Thaler and De Bondt publish an article titled Does the Stock Market Overreact? They concluded that people tended to overreact to unexpected and dramatic news three years year after the publication of their work, Thaler and De Bondt produced more evidenced that provided further support to their overreaction hypothesis. Other authors such as Rabin propose that expected utility theory does not explain risk aversion over modest stakes (Sewell, 2001). Thaler and Rabin then conclude that expected utility hypothesis is dead. Shiller presents evidence that suggests that the US markets are for the most part overvalued and points to various factors-among them psychological-that may explain the phenomena. Thaler publishes The Winners Curse in which he discusses the tendency of individuals to overestimate/underestimate the value of an item in competitive bidding when information is limited. Thaler and Benartzi discuss in their paper the equity premium puzzle and offer an explanation based on behavioral principles (Sewell, 2001).

1.10 Key Words

Behavioral finance, arbitrage, efficient market, psychology

1.12 Content Scheme

Chapter I: Problem Approach Background Problem formulation Objectives Justification Research Questions Chapter II: Reference Framework Theoretical basis Literature Review Definitions of terms Chapter III: Methodology Research design Chapter IV: Conclusions and Recommendations Conclusions Recommendations

2. Methodology

2.1 Research Paradigm

There are two main paradigms of research: quantitative and qualitative. In order to achieve the objectives of this research a mixture of both methods but the qualitative method will dominate the proceedings.

2.2 Research Techniques

Documentation This literature review will employ articles from journals, papers, dissertations, and other relevant sources of information. The information will be properly classified and categorized accordingly in order to maintain the proper organization of sources.

2.3 Information Processing System

The information processing system to be utilized for the development of the literature review is composed of the following computer applications: Microsoft Word Microsoft PowerPoint Adobe Acrobat Pro 9

2.4 Information Analysis

Information will be analyzed from an editor point of view since the object of the study is to gather all the relevant works regarding behavioral finance and present them in a unified format. Information will be classified according to importance from the most general to the most specific as to cover both macro and micro elements of the subject matter.

3. Organizational and Administrative Elements

1. Chronogram

Activity Week 1 2 3 4 5 6 7 8 9 10 11 12 13 14 Research/Reading x x x x x x Literature Review x x x Analysis x Future Research X Recommendations x End of writing x Review x x First defense x Second defense x

2. Research Budget

Item Price Paper Ream $ 4.00 Office Supplies $ 13.00 Book binding $ 40.00 CD-R $ 3.00 Printing Costs $ 40.00 Total $ 100.00

4. Preliminary Bibliography

BARBERIS, Nicholas C., and Richard H. THALER, 2003.A A survey of behavioral finance.A In: George M. CONSTANTINIDES, Milton HARRIS, and Ren© M. STULZ, eds.A Handbook of the Economics of Finance: Volume 1B, Financial Markets and Asset Pricing. Elsevier North Holland, Chapter 18, pp. 1053-1128. DE BONDT, WERNER F. M., AND RICHARD H. THALER, 1987. Further Evidence on Investor Overreaction and Stock Market Seasonality. The Journal of Finance, 42(3), 557-581. DE BONDT, WERNER F. M., AND RICHARD THALER, 1985. Does the Stock Market Overreact? The Journal of Finance, 40(3), 793-805 FAMA, Eugene F., 1998.A Market efficiency, long-term returns, and behavioral finance.A Journal of Financial Economics,A 49(3), 283-306. JOHNSSON, MALENA., LINDBLOM HENRIK., PLATAN, PETER. Behavioral Finance And the change of investor behavior during and after the speculative bubble at the end of the 1990's. Master Thesis in Finance, School of Economics and Management. Lund University. KAHNEMAN, Daniel, and Amos TVERSKY, 1979. Prospect Theory: An Analysis of Decision under Risk. Econometrica, 47(2), 263-292. KAHNEMAN, Daniel, and Amos TVERSKY, 1996. On the Reality of Cognitive Illusions. Psychological Review, 103(3), 582-591. KAHNEMAN, Daniel, and Amos TVERSKY, 2000. Choices, Values, and Frames. Cambridge: Cambridge University Press. OLSEN, ROBERT A. Behavioral Finance and Its Implications for Stock-Price. Financial Analysts Journal, Vol. 54, No. 2 (Mar. - Apr., 1998), pp. 10-18 RITTER , JAY R. Behavioral Finance. Pacific-Basin Finance Journal Vol. 11, No. 4, (September 2003) pp. 429-437 SELDEN, G. C., 1912. Psychology of the Stock Market: Human Impulses Lead To Speculative Disasters. New York: Ticker Publishing SHILLER, ROBERT J. 2002. From Efficient Market Theory to Behavioral Finance, Cowles Foundation Discussion PapersA 1385, Cowles Foundation for Research in Economics, Yale University. SHILLER, ROBERT J. 2005. Behavioral Economics and Institutional Innovation, Cowles Foundation Discussion PapersA 1499, Cowles Foundation for Research in Economics, Yale University. SHILLER ROBERT J., 1998. Human Behavior and the Efficiency of the Financial System,A A Cowles Foundation Discussion Papers 1172, Cowles Foundation for Research in Economics, Yale University. SLOVIC. PAUL. Psychological Study of Human Judgment: Implications for Investment Decision Making. The Journal of Finance Vol. 27, No. 4 (Sep., 1972), pp. 779-799 THALER, Richard H., 1992. The Winner's Curse: Paradoxes and Anomalies of Economic Life. Princeton, NJ: Princeton University Press. THALER, Richard H., 1999. Mental Accounting Matters. Journal of Behavioral Decision Making, 12(3), 183-206. THALER, Richard, 1980. Toward a Positive Theory of Consumer Choice. Journal of Economic Behavior & Organization, 1(1), 39-60. THALER, Richard, 1985. Mental Accounting and Consumer Choice. Marketing Science, 4(3), 199-214. TVERSKY, Amos, and Daniel KAHNEMAN, 1973. Availability: A Heuristic for Judging Frequency and Probability. Cognitive Psychology, 5(2), 207-232. TVERSKY, Amos, and Daniel KAHNEMAN, 1974. Judgment Uncertainty: : Heuristics and Biases. Science, 185(4157), 1124-1131. TVERSKY, Amos, and Daniel KAHNEMAN, 1981. The Framing of Decisions and the Psychology of Choice. Science, 211(4481), 453-458. TVERSKY, Amos, and Daniel KAHNEMAN, 1986. Rational Choice and the Framing of Decisions. The Journal of Business, 59(S4), S251-S278. TVERSKY, Amos, and Daniel KAHNEMAN, 1991. Loss Aversion in Riskless Choice: A Reference-Dependent Model. The Quarterly Journal of Economics, 106(4), 1039-1061. TVERSKY, Amos, and Daniel KAHNEMAN, 1992. Advances in Prospect Theory: Cumulative Representation of Uncertainty. Journal of Risk and Uncertainty, 5(4), 297-323. von NEUMANN, John, and Oskar MORGENSTERN, 1944. Theory of Games and Economic Behavior. Princeton, NJ: Princeton University Press.

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