Learn what behavioural finance is all about

Finance and investment management are not like physics. In finance, there are very few systematic “laws of nature” to be observed. We instead observe the effects of compounded human behaviour on asset prices in an open environment where exogenous shocks take place on a continuous basis.

Standard finance theory tackles this complexity through some rather extreme shortcuts. These include, for example, the assumption that the dynamics of asset prices are random and that the distribution of possible outcomes follows a Gaussian law. Further embedded within standard finance is the concept of “Homo economicus” being the idea that humans make perfectly rational economic decisions at all times. These shortcuts make it much easier to build elegant theories, but, after all in practice, the assumptions did not hold true.

Behavioural finance puts a human face on the financial markets

So what is the alternative? Behavioural finance may be part of the solution, with its emphasis on the numerous biases and heuristics (i.e. deviations from rationality) attached to the otherwise exemplary rational “Homo economicus” individual assumed in standard finance. Anomalies have been accumulating that are difficult to explain in terms of the standard rational paradigm, many of which interestingly are consistent with recent findings from psychology.

Behavioural finance makes this connection, applying insights from psychology to financial economics. It puts a human face on the financial markets, recognising that market participants are subject to biases that have predictable effects on prices. It, thus, provides a powerful new tool for understanding financial markets and one that complements, rather than replaces, the standard rational paradigm.

From standard finance to behavioural finance?

According to the efficient market hypothesis, financial prices incorporate all available information and prices can be regarded as optimal estimates of true investment value at all times. The efficient market hypothesis is based on the notion that people behave rationally, maximise expected utility accurately and process all available information. In other words, financial assets are always priced rationally, given what is publicly known.

Stock prices approximately describe random walks through time, i.e. price changes are unpredictable since they occur only in response to genuinely new information, which by the very fact that it is new, is unpredictable. Due to the fact that all information is contained in stock prices it is impossible to make an above average profit and beat the market over time without taking excess risk.

Eugene Fama has provided a careful description of an efficient market that has had a lasting influence on practitioners and academics in finance. According to Fama (1965), an efficient market is:

“…a market where there are large numbers of rational profit maximisers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, on the average, competition will cause the full effects of new information on intrinsic values to be reflected “instantaneously” in actual prices. A market in which prices always “fully reflect” all available information is called “efficient”.

Behavioural finance

For a while, theoretical and empirical evidence suggested that the capital asset pricing model, the efficient market hypothesis and other rational financial theories did a respectable job of predicting and explaining certain events. However, as time went on, academics in both finance and economics started to find anomalies and behaviours that couldn’t be explained by theories available at the time. While these theories could explain certain “idealised” events, the real world proved to be a very messy place in which market participants often behaved very unpredictably.

Behavioural finance is an add-on paradigm of finance, which seeks to supplement the standard theories of finance by introducing behavioural aspects to the decision-making process. Contrary to the Markowitz and Sharp approach, behavioural finance deals with individuals and ways of gathering and using information. At its core, behavioural finance analyses the ways that people make financial decisions. Behavioural finance seeks to understand and predicts systematic financial market implications of psychological decision processes. In addition, it focussed on the application of psychological and economic principles for the improvement of financial decision-making.

Challenging the efficient market hypothesis

Market efficiency, in the sense that market prices reflect fundamental market characteristics and that excess returns on the average are levelled out in the long run, has been challenged by behavioural finance. There have been a number of studies pointing to market anomalies that cannot be explained with the help of standard financial theory, such as abnormal prices movements in connection with initial public offerings (IPOs), mergers, stock splits, and spin-offs.

Throughout the 1990s and 2000s statistical anomalies have continued to appear which suggests that the existing standard finance models are, if not wrong, probably incomplete. Investors have been shown not to react “logically” to new information, but to be overconfident and to alter their choices when given superficial changes in the presentation of investment information. During the past few years there has, for example, been a media interest in social media stocks, as with Facebook IPO’s recently. Most of the time, as we know in retrospect, there was a positive bias in media assessments, which might have led investors in making incorrect investment decisions.

These anomalies suggest that the underlying principles of rational behaviour, underlying the efficient market hypothesis, are not entirely correct and that we need to look, as well, at other models of human behaviour, as have been studied in other social sciences. The following sections introduce some of the basic findings and principal theories within behavioural finance that often contradict the basic assumption of standard financial theory.

If you want to learn more about the modern approaches to finance, then download and read “Behavioural Finance” written by Peter Dybdahl Hede.