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Behavioral Finance Demystified: Introduction and Background

One of the foremost assumptions of financial theory is that participants in an economy are essentially rational. This means they will use the information available to them in a rational way. However, there are countless cases where emotions and psychology influence our decisions in the wrong way. In the end, these “rational” participants typically let their emotions get the better of them. And this paradox is what behavioral finance sheds lights on.

behavioral finance written with people shapes on the background

Behavioral finance is a branch of economics that studies such phenomenon among investors. It’s a relatively new field and it tries to combine behavioral and cognitive psychology with conventional economic theory. The goal is to put forward explanations to why people make irrational financial decisions.

In this article, we’ll talk about the anomalies and irregularities that you can find in the real world. Conventional financial theories have failed to account for such events. Let’s start and dig deeper into this theory.

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The Importance of Behavioral Finance

In this context, the “conventional” and “traditional” refer to the long-used financial theories that propose market participants are rational. Such financial theories include capital asset pricing model (CAPM) and the efficient market hypothesis, among others.

Historically, theories like the CAPM, EMH, and others presented empirical evidences that proved the theories to be successful at predicting and explaining specific types of economic events. However, as time went on, finance and economy academics found anomalies that these conventional theories could not explain.

It became more obvious that traditional theories succeeded in shedding light on certain events. But the real world seemed to be messier and more disorganized. It also became clear that market participants frequently behave in ways that are difficult to predict relying on those models.

What happens in real life?

Nearly every participant in an economy commits irrational decisions, one way or another. For instance, consider the case of people hoping to win a fortune by buying lottery tickets. If we think about it, it’s not really right to continue betting on something when the odds are overwhelmingly stacked against you.

In spite of such realization, millions of people still spend bucks in hopes of winning the big jackpot.

These anomalies are the root reason why academics turned to cognitive psychologies to understand the apparently illogical behavior of participants. Behavioral science came to life and now it attempts to explain our actions.

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Anomalies

ANOMALY written on wooden blocks

As we have mentioned, anomalies exist in the market. Here are some of those anomalies:

January Effect

The January effect refers to the phenomenon where the average monthly return for a small firm is consistently higher in January than in any other time of the year. This goes straight against the efficient market hypothesis, which posits that stocks should move at a “random walk.”

Michael S. Rozeff and William R. Kinney established the January effect theory in a 1976 case study. Rozeff and Kinney found that between 1904 and 1974, the average January returns for small businesses were around 3.5 percent. Meanwhile, the returns for the other months were just near 0.5 percent.

They recorded their findings in a paper entitled “Capital Market Seasonality: The Case of Stock Returns.” The findings indicate that the monthly performance of small stocks follows a relatively consistent pattern. That’s true even though the returns themselves aren’t necessarily consistent between January and other months.

This apparent consistency goes counter to the predictions that conventional financial theories have made. Thus, Rozeff and Kinney proposed that an unconventional factor was helping to the higher-than-average January returns year after year.

There are some theories that could possibly explain the January surges.  One of them says that this boost happens because investors sell dead-end stocks in December, hoping to get tax losses. This can result to returns ballooning up in January as investors have less incentive to sell.

This can be an important factor though it’s not the sole factor, for that matter. Indeed, the January effect still takes place in areas where capital gains taxes do not occur.

The Winner’s Curse

According to traditional financial theories, investors know how to assess an asset’s true value. Therefore, they will bid or pay accordingly. On the flip side, anomalies in this area also exist, suggesting this may not be often the case.  The so-called winner’s curse is among these anomalies.

The winner’s curse refers to the event where the bid for an asset actually tops the intrinsic value of the item. Quite apparently, this goes against the assumption that investors will pay based on the true value of the asset.

Conventional theories suggest that participants have equal access to information. So, they will assess the item based on the information they have, coming up with the same valuation. This simply means that any differences in the pricing of the item exist due to some other factor not directly tied to the item itself.

According to Richard Thaler’s 1988 article on the subject, there are two main factors that undermine the rationality of the bidding process.  First is then number of bidders. And second is the aggressiveness of the bidding itself. Thaler was among the pioneers of behavioral finance.

For instance, if there are more bidders, they will be more aggressive to discourage other bidders to bid for the item. Consequently, more aggressiveness will increase the possibility that a winning bid will exceed the item’s true value.

You can find another example in the case of homebuyers bidding for a house. There’s a high likelihood that the bidders are rational and that they know the house’s true value. However, errors can still occur. Variables like aggressive bidding and multiple bidders can contribute a lot, resulting to such errors in valuation.

The result? The house costs usually 25 percent or more above its true value.

Equity Premium Puzzle

Equity premium puzzle is among the most baffling anomalies to the conventional financial theories. According to CAPM, investors who hold riskier financial assets should get higher rates of returns.

According to long-term studies, stock yields on average are in excess of government bond returns by 6 to 7 percent. Stock real returns are 10 percent; bond real returns are about 3 percent. However, the 6 percent equity premium is too large.  If it’s that large, it should mean that stocks are disproportionately riskier than bonds. If we follow conventional financial models, this premium has to be much lower.

This contradiction between theoretical models and empirical results is a huge puzzle, unsolvable to academics even now.

Behavioral finance, on the other hand, has proposed an explanation to this puzzle. The answer tells us that people tend to have “myopic loss aversion.”  This is a situation in which extremely loss-averse investors tend to have a short-term outlook on investment.

This makes those investors focus too much on the short-term volatility of their stock portfolios.  The investor reacts too negatively to downside changes even though it’s normal for stocks to fluctuate over a short time.

And as a result, behavioral theorists believe that equities must yield high-enough premium. That should be true in order to compensate the investors’ outsized aversion to loss. This way, the equity premium acts as an incentive to convince investors to choose stocks over the safer government bonds.

{RELATED: Asset Allocation: How Much Should Invest in Stocks and Bonds}

Criticisms toward Behavioral Finance

Behavioral finance has gained popularity in the past decades, with many academics following its principles. But behavioral finance also has its fair share of critics and criticisms. The proponents and supporters of the EMH are among its most vocal critics.

Eugene Fama, the founder of the market efficient theory, is one of the most known critics of behavioral finance. He says that despite the anomalies, market efficiency is still the best model for examining and predicting economies.

Fama even goes further and notes that many anomalies could just be chance events. And the market eventually corrects such chance events. In his 1998 paper “Market Efficiency, Long-Term Returns and Behavioral Finance,” he argued that many of the elements of behavioral finance seem to be contradicting one another. He said that behavioral finance itself may just be a pooled collection of anomalies that market efficiency can explain.

Conclusion

Behavioral finance attempts to excel in areas where conventional financial theories failed.  One cannot deny that by understanding the anomalies using behavioral finance, we can get a better view of the market. These anomalies and biases give us some idea how we can better maneuver in an apparently logical AND illogical market.

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