L2-Traditional Finance VS Behavioral Finance

Behavioral Finance

• understanding how people make decisions, both individually & collectively

• by understanding how investors and markets behave, it may be possible to modify or adapt to their behaviors in order to improve economic outcomes

• may entail identifying a behavior & then modifying the behavior so it more closely matches that assumed under the traditional finance models

• may be necessary to adapt to an identified behavior & to make decisions that adjust for the behavior

Integration of Behavioral & Traditional Finance

• has the potential to produce a superior economic outcome

• resulting financial decision may produce an economic outcome closer to the optimal outcome of traditional finance, while being easier for an investor to adhere to in practice

Howard Raiffa

• decision theorist, 1997

• provide a framework for understanding the implications of the decision-making process for financial market practitioners

• discusses 3 approaches to the analysis of decisions that provide a more accurate view of a “real” person’s thought process

• Normative, Descriptive, Prescriptive

Normative Analysis

• concerned with the rational solution to the problem at hand

• defines an ideal that actual decisions should strive to approximate

• Traditional Finance Assumptions about Behavior

Descriptive Analysis

• concerned with the manner in which real people actually make decisions

• Behavioral Finance Explanations of Behaviors

Prescriptive Analysis

• concerned with practical advice & tools that might help people achieve results more closely approximating those of normative analysis

• Efforts to use Behavioral Finance in Practice

Traditional Finance

• gained wide acceptance among academics & investment professionals as a guide to financial decision making with its simplifying assumption of rational investors & efficient markets

• limitations of traditional finance have become increasingly apparent

• individual decision making is not nearly as objective & intellectually rigorous, & financial markets are not always as rational & efficiently priced as traditional finance assumes

• to bridge this gap between theory & practice, behavioral finance approaches decision making from an empirical perspective

• identifies patterns of individual behavior without trying to justify or rationalize them

Practical Integration of Behavioral and Traditional Finance

• lead to a better outcome than either approach used in isolation

• by knowing how investors should behave & how investors are likely to behave, it may be possible to construct investment solutions that are both more rational from a traditional perspective

• because of adjustments reflecting behavioral insights, easier to accept & remain committed to

• hoped that they will help many improve their investment approach & enhance risk management

Points from Traditional Finance

• assumes that investors are rational; investors are risk-averse, self- interested utility-maximizers who process available information in an unbiased way

• assumes that investors construct & hold optimal portfolios; optimal portfolios are mean–variance efficient

• hypothesizes that markets are efficient; market prices incorporate & reflect all available and relevant information

• there is the assumption that the investor & the market are rational

• gather or receive all the information they need & their decisionsn are based on that data

• simply states that investors do not make the financial decisions on emotions

Points from Behavioral Finance

• makes different (non-normative) assumptions about investor & market behaviors

• attempts to understand & explain observed investor & market behaviors; observed behaviors often differ from the idealized behaviors assumed under traditional finance

• observed to affect the financial decisions of individuals

• theories & models based on behavioral perspectives have been advanced to explain observed market behavior & portfolio construction

• one behavioral approach to asset pricing suggests that the discount rate used to value an asset should include a sentiment risk premium

• psychology has our role in how people make financial decisions or investments

• explains that people are irrational & our emotions & bias have a role to play when making investment decisions

• this happens because investors might base their decisions on fear, over confidence, gut feeling, what others are doing there by following the crowd and past experiences

Bounded Rationality

• proposed as an alternative to assuming perfect information & perfect rationality on the part of individuals

• individuals are acknowledged to have informational, intellectual, and computational limitations

• as a result, may satisfice rather than optimize when making decisions

Prospect Theory

• proposed as an alternative to expected utility theory

• loss aversion is proposed as an alternative to risk aversion

Markets are not always observed to be efficient

anomalous markets are observed

Behavioral Portfolio Theory

portfolios are constructed in layers to satisfy investor goals rather than to be mean–variance efficient.

Behavioral Life-Cycle Hypothesis

people classify their assets into non- fungible mental accounts & develop spending (current consumption) & savings (future consumption) plans that, although not optimal, achieve some balance between short-term gratification & long-term goals

Adaptive Markets Hypothesis

• based on some principles of evolutionary biology

• degree of market efficiency is related to environmental factors characterizing market ecology

• factors include the number of competitors in the market, the magnitude of profit opportunities available, & the adaptability of the market participants

By understanding investor behavior

it may be possible to construct investment solutions that will be closer to the rational solution of traditional finance and because of adjustments reflecting behavioral insights easier to accept and remain committed to

Investing in anything from properties, stocks, or an essay writing website

• this is a bold and risky move

• but what most people do not know is that the decision to invest in those stocks is influenced by traditional and behavioral finance

3 Main Differences of Traditional

1. Assumes that an investor is a rational person who can process all information unbiased

2. Investors receive unlimited knowledge, data, & information that are perfect, investors carefully processes this information, therefore there's complete rationality

3. States that the market is efficient & is a representation of the financial market’s true value based on the fact that traditional finance believes that investors have self-control

3 Main Differences of Behavioral

1. Draws from real-world experience stating that an investor has biases, it is irrational, and his emotions do play a role in the kind of investments undertaken

2. Investors have bounded rationality so the investor does not process all information regardless of how accurate information is investors are still bound to make an error in judgment

3. Believes that the market is volatile & that is why there are market anomalies. Investors don't have perfect self-control, so limitations exist. Volatility of the markets leads to the rising and falling of stock prices, so an inconsistent market investors. Investors have to realize that a rational financial decisions can be made, but they should not fall into the trap of using emotions or urges to make an investment

Traditional Financial Theory

• Both the market and investors are perfectly rational

• Investors truly care about utilitarian characteristics

• Investors have perfect self-control

• They are not confused by cognitive errors or information processing errors

Behavioral Finance Theory

• Investors are treated as normal not rational

• They actually have limits to their self-control

• Investors are influenced by their own biases

• Who invent stores make cognitive errors that can lead the wrong decisions

Investor Behavior