Behavioural finance theory

Behavioural finance theory

Presentation and context

According to conventional financial theory, most people are rational in their quest to maximise their wealth.

However, there are many cases where emotions and psychology influence our decisions, which can then become unpredictable or irrational.

Behavioural finance aims to combine behavioural and cognitive psychological theories with traditional economics and finance in order to understand what influences investors that make irrational decisions.

Before we explore the specific concepts of trader psychology, we will examine how it compares to conventional finance.

 

Why is behavioural finance necessary?

"Traditional" or "modern" descriptions of finance are based on rational and logical theories, such as the capital asset pricing model (CAPM) or the efficient market hypothesis (EMH). These theories assume that people tend to behave in a rational and predictable manner.

For a long time, the theoretical and empirical evidence suggested that the CAPM, EMH and other sound financial theories did a good job predicting and explaining certain events. However, finance and economics scholars have found anomalies and behaviours that cannot be explained by these theories. These theories can explain certain "idealised" events but in reality the world is a place where people's behaviour is often unpredictable.

 

Homo economicus

One of the most basic assumptions is that people are rational so that they can maximise their wealth in order to improve their well-being. According to conventional economics, emotions and other external factors do not influence people when it comes to making economic choices.

However, in most cases this assumption does not reflect the way people actually behave in the real world. In reality, people often do things that don't make sense. Consider the number of people who buy lottery tickets hoping to hit the jackpot. From a purely logical perspective, it doesn't make any sense to buy lottery tickets because the chances of winning are minimal.

These anomalies have led scholars to turn to cognitive psychology to explain irrational and illogical behaviour that modern finance has failed to explain. Behavioural finance seeks to explain our actions, while modern finance seeks to explain the actions of an economic man (Homo economicus).

 

Criticisms

Efficient market theory is considered to be one of the foundations of modern financial theory. However, this theory does not take into account irrationality, because it assumes that the price of a stock reflects the impact of all relevant information.

The most notable critic of behavioural finance is Eugene Fama, the person that first wrote about efficient market theory. Fama suggests that even though there are anomalies that cannot be explained by modern financial theory, efficient market theory should not be completely abandoned in favour of behavioural finance.

In fact, it states that most of the anomalies observed in traditional theories can be considered to be short-term random events that are eventually corrected over time. In his article entitled "Market efficiency, long-term returns and behavioural finance", Fama argues that most trader psychology findings seem to contradict each other, and that - as a whole - behavioural finance itself seems to be a collection of anomalies that can be explained by market efficiency.

Contents - behavioural finance theory

-> Behavioural finance theory
-> Flaws in conventional economic theory
-> Anchoring
-> Mental accounting
-> Confirmation bias and retrospective
-> The player's error
-> Traders' herd behaviour (coming soon!)
-> Investors with excessive confidence (coming soon!)
-> Overreacting and traders' availability bias (coming soon!)
-> Prospect theory (coming soon!)
-> Conclusion (coming soon!)

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