A Survey of Behavioral Finance Summary

A Survey of Behavioral Finance Nicholas Barberis and Richard Thaler In this handbook, Barberis and Thaler define the differences between traditional finance and behavioral finance. Traditional finance is rational. Rationality means two things; correct Bayesian Updating and choises consistent with expected utility. On the other hand behavioral finance assumes that market is not fully rational and analyzes the facts when the some of the princibles are loosen up. This essay also discusses about two main topics; limits to arbitrage and psychology.

These two topics are known as the two buildings blocks of the behaviour finance. In the normal markets security prices equal to fundamental value. In this sitiuation. expected cash flows can be easily calculate with the markets’ discount rates. This hypothesis called Efficient Market Hypothesis. According to this hypothesis; as soon as there will be a deviation from fundemantal value and mispricings will be corrected by rational traders. An arbitrage is an investment strategy that offers riskless profits at no cost.

The rational traders le became known as arbitrageurs because of the belief that a mispriced asset immediately creates an opportunity for riskless profits. Behavioral finance argues that this is not true. According to behavioral finance “prices are right” and “there is no free lunch” statments are not equal. If the market value of a stock is not equal to fundemantal value of the stock, arbitrageurs can not enter the position easily. Because there are some risks and costs. First of all there is a fundemantal risk.

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If the negative shock occurs to the stock, there is not a prefect substitude to hedge theirselves. Second risk is about noisy traders. Noisy trader can be caused to decrease according to their pessimistic behavior. Noisy traders forces the arbitrageurs to liquidate their position early. This is called seperation of brains and capital. Trading in the same direction of noisy traders and arbitrageurs can also caused problems. Execution or implementation costs are also limitting to arbitragesuch as commisions, bid/ask spread; Price impact, short sell costs and identification cost.

So far, we see how the difficult for the rational traders such as hedge funds to exploit market market inefficiencies. In Evidence part of the hand book they discuss if there is some evidence that arbitrage is limited. If arbitrage were not limited, the mispricing would quickly disappear. It is not easy to identify mispricings. when a mispriced security has a perfect substitute, arbitrage can still be limited if arbitrageurs are risk averse and have short horizons and the noise trader risk is systematic, or the arbitrage requires specialized skills, or there are costs to learning about such opportunities.

Index inclusions are shown as a good example of evidence supporting limits to arbitrage in the handbook. It almost says that stock prices jups premanantly and gives examples from S&P. The theory of limited arbitrage shows that if irrational traders cause deviations from fundamental value, rational traders will often be powerless to do anything about it. In this part Barberis and Thaler summarize the psychology and summarize what psychologists have learned about how people appear to form beliefs in practice.

Overconfidence, optimism and wishful thinking , representativeness, conservatism, belief perseverance, anchoring, availability biases are some of beliefs that explain in the book. The important thing of all these biases that according to observations when the bias is explained, people often understand it, but then immediately proceed to violate it again. On the other hand, people, through repetition, will learn their way out of biases; that experts in a field, such as traders in an investment bank, will make fewer errors; and that with more powerful incentives, the effects will isappear. Prospect Theory is explained in the book with some examples and formulas. This section of the book gives answers to how prospect theory could explain why people made different choices in situations with identical final wealth levels. Ambigutiy aversion is defines risk as a gamble with known distribution and uncertainty as a gamble with unknown distribution, and suggests that people dislike uncertainty more than risk. The experiments about ambigutiy aversions shows that people do not like sitiuations where they are uncertain.

Aversion changes based on preceived competence at assessing relevant distribution. US stock market is a good research area for the facts about its behaviour. The most three important behaviours are equity premium , high volality and predictable returns. Risk preium seems to high and possible explanations are under prospect theory. Rational approches must focus on changing risk aversion to explain volatility. Volatiliy explanations under beliefs are overreaction to dividend growth, overreaction to returns, confusion between real and nominal rates. All three of these facts are known as eqity puzzles.

Both the rational and behavioral approaches to finance have made progress in understanding the three puzzles singled out at the start of this section. The advances on the rational side are well described in other articles in this handbook. Here, we discuss the behavioral approaches, starting with the equity premium puzzle and then turning to the volatility puzzle. Equity premium puzzle is that even though stocks appear to be an attractive asset investors appear very unwilling to hold them. In particular, they appear to demand a substantial risk premium in order to hold the market supply.

Benartzi and Thaler are one of the earliest papers link prospect theory to the equity Premium. Their study is about how an insvestor allocate his portfolio between T-Bills and the stock market with the prospect theory acknowledge. Prospect theory argues that when choosing between gambles, people compute the gains and losses for each one and select the one with the highest prospective utility. In a financial context, this suggests that people may choose a portfolio allocation by computing, for each allocation, the potential gains and losses in the value of their.

One possible story is that investors believe that the mean dividend growth rate is more variable than it actually is. When they see a surge in dividends, they are too quick to believe that the mean dividend growth rate has increased. Their exuberance pushes prices up relative to dividends, adding to the volatility of returns. holdings, and then taking the allocation with the highest prospective utility. this is a example of representativness. In the handbook they explains the cross-section of average returns.

They document that one group of stocks earns higher average returns than another. These facts have come to be known as “anomalies” because they cannot be explained by the simplest and most intuitive model of risk and return in the financial economist’s toolkit, the Capital Asset Pricing Model, or CAPM. This is explainin by the size Premium, long term reversals, the predictive of scaled ratios, momentum, event studies of earnings announcements,event studies of divident initiations and ommissions, event studies of stock repuchases, event studies of primary and secondary offerings.

Barberis and Thaler clasify the behavioral models on whether their mechanism centers on beliefs or on prefences. the result of systematic errors that investors make when they use public information to form expectations of future cash flows. Conservatism and representativeness cause this. Behavioral finance has also discuss about how certain groups of investors behave, and what kinds of portfolios they choose to hold and how they trade over time. It is simply to explain the actions of certain investors, and these actions also affect prices.

Some of the actions of nvestors and the behavioral ideas are insufficient diversifation, naive diversifation,excessive trading, the selling and buying decision. In the corporate finance part of the hand book; gives opinions to rational managers in a mispricing market and gives examples for “market timing”. On the conclusion of the hand book they mentioned that behavioral finance will be develop on coming years. This handbook publish on 2002 and it is valid nowadays. After I read this book I mentioned how important to analyszing the market as an investor by the view of the behavioural finance.

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