Topic: Behavioural Finance Name Professor Institution Course Date Many studies in the area of behavioural finance suggest that individual investors make systematic errors due to behavioural biases. Do you believe that more sophisticated investors (e.g. equity fund managers) can capitalize on such individual investors’ errors and consistently outperform the market on a risk-adjusted basis?…
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It is very clear that some of the participants in the market do not make rational decisions which translate to mistakes. However, astute market players get the chance to capitalize on such mistakes. For instance, a rational investor can take the decision to buy when there is market crash resulting from speculative behavior (Mussweiller & Schneller, 2003, p. 124). Given a risk-adjusted basis, rational investors can beat market performance in a consistent manner. According to the perfect market hypothesis, prices reflect the full information about the market. This has the implication that an investor cannot beat the market unless he or she has inside information. A number of indices have been created with the aim of mimicking market performance. Research studies indicate that index funds account for almost 10 percent of the U.S. stock market capitalization and 60 percent of the money flowing into mutual funds. Despite the increasing euphoria towards passive management, there is active management which has enabled investors beat market bearing returns. Behavioral finance insists that investors are irrational in their decisions and that it is easy to partly predict future performance of stocks using their past performance. Careful analysis of the past trends of the tocks has the advantage of making it possible to outperform the market (Mulino, Scheelings, Brooks & Faff, 2009, p. 50). Rational investors can outperform because there exists inefficiencies in the capital market which create investment opportunities. Rational investors outperform the market because irrational investors often find themselves in the bottom part of the distribution pattern. There is some level of disconnection between stock performance and stock market valuation. The existence of irrational investors has resulted in the markets being driven by emotions rather than logic (Dreman, Johnson, MacGregor & Slovic, 2001, p. 127). However, research studies indicate that logic often triumphs over emotions. Irrational investors tend to lose while logic investors record gains. Most of the investors in the market do not bother to look at the fine details of their investment portfolios. Instead they look for information such as who are investing in the same portfolio and this has the negative effect of encouraging wrong decisions. There are a number of situations that a rational investor can exploit and record superior performance that the market. Theoretically, this is possible even though no investor has ever recorded consistent returns above market expectations (Statman, Fisher & Anginer, 2008). First, a rational investor can do a comprehensive homework and identify small cap stocks that in most cases are not well followed. Such stocks are often ignored by equity funds because of the fear of high risks associated with small companies. Furthermore, such companies are not well known in Wall Street and this makes it possible for most of the investors to ignore them (Caginalp, 2002, p. 73). A rational investor can identify such companies and analyze their prospects for superior returns. The small cap firms have a potential of recording higher returns than the market because their true value has not been influenced by speculations. Second, the market sometimes overdoes its pessimism for a number of individual companies as well as certain sectors (Bruce, 2003, p. 125). The situation
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The researcher states that behavioral finance examines how the human animal reacts in a financial system theoretically devoid of any emotions. This has been referred to in the past as ‘open-minded finance’ which is a generous expression implying that many investors often behave in a quite contradictory manner to the advice given them by their financial advisors. ‘Proponents of behavioral finance contend that people may not always be “rational,” but they are always “human.” Thus, behavioral finance exposes the irrationality of investors in general and shows human fallibility in competitive markets.’ To many, the idea of market effi...
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...Topic The Foundations of the Revealed Preference Theory There is growing tendency of greater rigor in modern economic theory in Formulationof its assumptions
2) Standards of proof on which assumptions imply
The use of rigor is commendable because it:
1) Assures that conclusions are incurred by hypotheses
2) Spares us with unrealistic economic assumptions (perfect competition, divisibility, and restrictive mathematical conditions)
3) Leads to more precise theory and greater realism
However, its dedication to rigor can lead to indiscriminate application, formalism, and a level of abstraction that makes it difficult for economists. However, this unfamiliarity does not validate the objection to its implementation. Newman (1955... The Foundations ...
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Economics is a science due to the complications in the subject matter and complications, in the mechanism of prices and production.
There has been an analysis of the behaviour of individuals constituting the economic community to illustrate the development of...
..., from this article, readers can comprehend the following.
The concept of behaviouralfinance that has a fundamental application in the field of economics.
Understand the Brownian model, which is widely used in finance and physics.
The book gives the background information of the model in that, it outlines how Louis Bachelier it in 1900 with an aim of understanding modeling fluctuations of prices in financial markets.
It makes readers to articulate Albert Einstein contribution in mathematical model, which was first established by Robert Brown in 1827.
Chaos and Order in the Capital Market by Edgar Peters
This is a book by Peter (1996), who in great thoughts outlines facts of...
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Reference List 12
The literature emphasises on the need for a new economic paradigm. Economic paradigm is required for facilitating development of the global economy. This need is realised by every country around the world, but the government and higher authorities are reluctant to fulfil the same as it entails a huge investment. Hence, it is not plausible for the poor countries to incorporate and encourage the change. The environmental changes are frequent and unavoidable, but economic model change is rare and difficult to attain...
12 Pages(3000 words)Literature review
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