Flaws in conventional economic theory

Anomalies that are regularly observed in conventional economic theory have contributed to the rise of behavioural finance. These anomalies directly violate the modern financial and economic theories that assume rational and logical behaviour. The following is a brief summary of some of the anomalies that have been observed in financial literature.

The January effect

The January effect is named after the phenomenon in which the average monthly return of a small business is always higher in January compared to the other months of the year. This contradicts Eugene Fama's efficient market assumption, which states that company shares evolve in a random market according to new information.

However, a study conducted in 1976 by Michael S. Rozeff and William R. Kinney ("Capital Market Seasonality: The Case of Stock Returns") found that from 1904 to 1974, the average January returns of small businesses were around 3.5%, while yields for the other months averaged around 0.5%. This suggests that the monthly performances of small companies' shares follows a relatively constant pattern, contrary to what is taught by conventional economic theory. As such, a non-conventional factor (other than random market events) must be the cause of this regularly observed pattern.

One explanation is that the rise in yields in January is the result of investors selling their shares in December at a loss to lock in their tax losses. A rebound therefore follows in January, when investors buy back the shares they just sold. The year-end taxes could partly explain this January effect, but not the fact that the phenomenon still exists in places where there are no taxes on capital gains. This anomaly proves that conventional theory cannot take into account everything that happens in the real world.

The winner's curse

One hypothesis is that investors and traders are rational enough to be aware of the true value of an asset and to make offers that are in line with this value.

However, anomalies such as the "winner's curse" - a tendency to exceed the intrinsic value of an object bought at an auction - suggest that this is not the case.

Rational theories assume that all participants involved in an auction have access to all of the relevant information needed to make a proper value assessment. However, differences in price assessments suggest that other factors that are not directly related to the asset affect the auction.

According to the 1988 paper by Richard Thaler on "winner's curse", there are two main factors that undermine the rationality of the auction process: the number of participants and the aggressiveness of the offer. For example, if there are many participants involved, this means you will need to make more aggressive bids to deter others from outbidding you. Unfortunately, bidding aggressively also increases the likelihood that your winning bid will exceed the actual value of the asset.

Take the example of potential buyers bidding for a home. It is possible that the parties are rational and aware of the real value of the house as they've analysed recent home sales in the area. However, variables that have nothing to do with the asset (aggressive offers and the number of bidders) can lead to inaccurate estimates and result in a sale price that is higher than the actual value of the home.

Risk premiums for shares

Risk premiums on shares are another anomaly studied by finance and economics scholars. According to the financial asset valuation model, investors who hold riskier financial assets should be rewarded with higher rates of return.

Studies have shown that over a 70-year period, shares offer yields that exceed government bond yields by 6%-7% on average. Actual equity returns are typically around 10%, while real bond yields are only around 3%. However, scholars believe that a risk premium of 6% is extremely large and it means that the risk inherent in shares is significantly higher than that of bonds. Conventional economic models have indicated that this premium should be far lower. This lack of convergence between the theoretical models and empirical results is an obstacle for scholars who would like to explain why the equity premium is so great.

The response provided by behavioural finance to explain the risk premium offered by equities revolves around people's tendency to have "loss aversion myopia", a situation in which investors - too worried about the negative effects of losses compared with an equivalent amount of profits - have a short-term view of investing. The result is that investors' attention is focused solely on the short-term volatility of their stock portfolio. It is not uncommon for a share to fluctuate a few percent in a very short period of time, but a myopic investor (one with a short-term vision) may not react positively to price dips. Accordingly, we tend to feel that shares should provide a high enough premium to offset investors' high loss aversion. Thus, the premium is considered to be an incentive for market players to invest in shares instead of unsure state bonds.

Conventional economic theory does not take into account all of the situations that occur in the real world. This does not mean that it is invalid, but that the contributions of behavioural finance can help explain the way financial markets react.