Financial Behavior: An Overview

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Chapter 1 Financial Behavior: An Overview

H. Kent Baker

University Professor of Finance, Kogod School of Business, American University

Greg Filbeck

Samuel P. Black III Professor of Finance and Risk Management, Penn State Erie, The Behrend

Victor Ricciardi

Assistant Professor of Financial Management, Goucher College


Two major branches in finance are the well-established traditional finance also called standard finance and the more recent behavioral finance. Traditional finance is based on the premise of rational agents making unbiased judgments and maximizing their self-interests. In contrast, behavioral finance studies the psychological influences of the decision-making process for individuals, groups, organizations, and markets. Both schools of thought play an important role in understanding both investor and market behavior. Ackert (2014) provides a comparison of traditional and behavioral finance.

Traditional finance theory assumes normative principles to model how investors, markets, and others should act. In traditional finance theory, investors are supposed to act rationally. Additionally, this normative approach assumes that investors have access to perfect information, process that information without cognitive or emotional biases, act in a selfinterested manner, and be risk-averse. According to Bloomfield (2010, p. 23), traditional finance

...sees financial settings populated not by the error-prone and emotional Homo sapiens, but by the awesome Homo economicus. The latter makes perfectly rational decisions, applies unlimited processing power to any available information, and holds preferences well-described by standard utility theory.

Traditional finance theory is based on classical decision-making in which investors make economic decisions using utility theory in which they maximize the benefit they receive from an action, subject to constraints. In utility theory, investors are assumed to make decisions consistently and independently of other choices. Utility theory serves as the basis for standard finance theories based on modern portfolio theory and asset pricing models. A major tenet of traditional finance is fundamental analysis incorporating statistical measures of risk and return. A primary aspect of this macro-driven model, which is based on a study of investors within the financial markets, is the underlying assumption of investor risk aversion (i.e., investors must be compensated with higher returns in order to take on higher levels of risk). Notable examples in traditional finance include portfolio choice (Markowitz 1952, 1959), the capital asset pricing model (CAPM) (Sharpe 1964), and the efficient market hypothesis (EMH) (Fama 1970).

Modern portfolio theory (MPT) provides a mathematical framework for constructing a portfolio of assets such that the expected return is maximized for a given level of risk, as measured by variance or standard deviation. MPT emphasizes that risk is an inherent part of higher reward. An important insight provided by MPT is that investors should not assess an asset's risk and return in isolation, but by how it contributes to a portfolio's overall risk and return.

Further developments revealed that investors should not be compensated for risk that they can diversify away, which is called unsystematic or diversifiable risk. Instead, they should only be compensated for non-diversifiable risk, also called market or systematic risk. This insight led to the development of the CAPM. This model describes the relation between risk, as measured by market risk or beta, and expected return and is used for pricing of risky securities. Although a cornerstone of modern finance, the CAPM, as a single factor model, cannot pick up other risk factors. Consequently, the CAPM does not perform well in explaining the cross-section of returns across stocks. Hence, others suggest that returns depend on other factors besides the market. For example, Fama and French (1996) identity two additional factors ‒ firm size and the book-to-market ratio. Carhart (1997) extends the Fama–French three-factor model by including a momentum factor. Momentum refers to the tendency for the stock price to continue rising if it is going up and to continue declining if it is going down.

The EMH states that asset prices fully reflect all available information. An implication of this dominant paradigm in traditional finance of the function of markets is that consistently beating the market on a risk-adjusted basis is impossible. Fama (1970) sets forth three versions of the EMH. According to weak form efficiency, prices on traded assets reflect all market information such as past prices. The semi-strong form of the EMH asserts both that prices reflect all publicly available information. The strong form of the EMH states that current asset prices reflect all information both public and private (insider). Numerous research studies report anomalies, which are situations when a security or group of securities performs contrary to the notion of efficient markets. This stream of research was a driving force leading to the birth and growth of behavioral finance (Ackert 2014).

Although the traditional approach provides many useful insights, it offers an incomplete picture of actual, observed behavior. The normative assumptions of traditional finance do not apply to how most investors make decisions or allocate capital. Normative models often fail because people are irrational and the models are based on false assumptions.

By contrast, behavioral finance is based on insights from other sciences and business disciples to explain individual behavior, market inefficiencies, stock market anomalies, and other research findings that contradict the assumptions of traditional finance. Behavioral finance examines the decision-making approach of individuals, including cognitive and emotional biases. Behavioral finance makes the premise that a wide range of objective and subjective issues influence the decision-making process. Various laboratory, survey, and market studies in behavioral finance document that individuals are not always rational and apply the descriptive model from the social sciences that documents how people in real life make judgments and decisions. A basis of the descriptive model is that investors are affected by their previous experiences, tastes, cognitive issues, emotional factors, the presentation of information, and the validity of the data. Individuals also make judgments based on bounded rationality. Bounded rationality is the premise that a person reduces the number of choices to a selection of smaller shortened steps, even when this oversimplifies the decision-making process. According to bounded rationality, an individual will select a satisfactory outcome rather that the optimal one.

In the 1960s and 1970s, the origin of behavioral finance and financial psychology was founded on seminal research from theorists in cognitive psychology, economics, and finance. During the 1980s, behavioral finance researchers began combining the research methods of psychology and behavioral economics with specific investment and financial subject matter. Since the mid-1990s, behavioral finance has been emerging as an important field in academia. For example, some notable developments in behavioral finance include work on prospect theory (Kahneman and Tversky 1979; Tversky and Kahneman 1974, 1981); framing effects, which are rooted in prospect theory; heuristics and biases (Kahneman, Slovic, and Tversky 2000; Gilovich, Griffin, and Kahneman 2002); and mental accounting (Thaler 1985). Baker and Nofsinger (2010) and Baker and Ricciardi (2014) provide a synthesis of the literature on behavioral finance and investor behavior.

In 2002, Daniel Kahneman and Vernon Smith, behavioral finance pioneers, received the Nobel Memorial Prize in Economics for their research in behavioral economics and psychology from the area of judgment and decision-making. This prestigious award was a major turning point for the discipline because it provided wider acceptance within the financial community. Then, the financial crisis of 2007-2008 demonstrated the weakness of standard finance with behavioral finance subsequently receiving even more attention and acknowledgement by academics and practitioners. In 2013, Robert J. Shiller, a noted behavioral economist, shared the 2013 Nobel Memorial Prize in Economic Sciences for empirical analysis of asset prices.

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