Behavioral Finance and Modern Financial Economics - Assignment Example

?BEHAVIORAL FINANCE PART Section A Behavioral finance refers to the study of the influence of psychology on people in the financial sector and its perceived overall influence on financial markets. This in essence means it is a combination of finance and psychology to determine and explain how and why people tend to make illogical and inherent decisions when it comes down to saving, spending money. In investigating these unique phenomena, there arise two key challenges. One is whether the phenomenon exists at all in the first place and two, even if it did, will a radical paradigm shift in behavior be the proposed solution? Psychology therefore becomes a key component when it comes to dissecting and understanding human judgment, behavior and general well-being. Modern financial economics are pegged on the assumption that financial practitioners act both meticulously and with rationale. However as evidenced and earlier stated, this is not always the case. These deviations from the norm are not rampant and inherent but follow a systematic chain of events. With this information in mind it is possible to incorporate these systematic human deviations into the standard model of financial markets (Rutledge 264). In so doing, two commonly overlooked mistakes come to the foreground: Financial practitioners tend to indulge in excessive trading with belief that the next trade will rake in more lucrative returns. This is irrational trading and is propelled by emotion rather than rational thinking. The human trait of being too overconfident or corky in this case is the key driving motivation behind this bias. Some financial practitioners are also in the habit of holding on to losing stocks while at the same selling their winning stocks. This again is instigated by lack of confidence and the need to avoid both failure and regrets coupled with poor judgments. Behavioral finance contributes to asset pricing in two major dimensions. These dimensions are reached upon by use of agents which may in them are not completely rational. These are: I. Limits to arbitrage This argues that the damage caused by irrational traders in their irrational deviations may be difficult, if not impossible to be undone by the more rational trades. The traditional asset-pricing model does not factor in market frictions and greatly undermined trading frictions like transaction cost, bid spread, ask spread etc. These forces have a great impact on asset returns and therefore should not be ignored. The limits to arbitrage create a model where mispricing exist for the simple reason that risk adverse arbitragers are not concerned mainly with the riskless values of an asset, but about the price of assets in periods following these irrational traders. This model considers the cost of arbitrage more so the volatility returns and states that the habit of mispricing will inevitably dominate markets especially in the cases of highly volatile stocks whereby arbitragers may avoid the risky volatile position. Finding mispricing is a tasking affair and may involve institutional laws that should regulate the type of trade to be done. For instance short selling which is essential to effective arbitrage including cost of borrowing, legal fees and liquidity risk is not allowed in mutual and pension funds. Therefore there should exist a cap on the limits to arbitrage. II. Psychology: This helps in creating a continuum of deviations spurning from full rationality to completely irrational. The known concept of asset pricing therefore is in a very vibrant flux whereby there is a slow paradigm shift from the completely irrational approach to a more accommodating broader outlook based on the psychology of investors. Risk and misevaluations are therefore the two main determinants of the security expected returns. This is roughly based on a concept by Savage (183) which is a decision making method with imminent or existing risks in consideration. This concept is known as the Subjective Expected Utility whereby it is widely expected that the rational agent will always seek self-interest. Consumers are always rational in that they will consume goods with the highest utility. Furthermore, research has shown that human beings are adept to using heuristics while making decisions and forming beliefs. This creates the irrational deviations alluded to as these heuristics do not allow for critical and logical thinking but rather depend heavily on emotions and experiences. With experience, consumers always learn what is best for them and what is not. As mentioned above, human beings a rational and will tend to choose the goods and services with the highest utility and leave out those with the least utility. Section B The study of behavioral finance cannot be complete without studying behavior traits that affect the mindset of people when it comes to finances. These traits include: I. Overconfidence II. Optimism III. Self attribution bias IV. Mental accounting I. Overconfidence and Optimism Optimism is defined as having a positive outlook of the future in believing in the success of something .It is an essential trait in financial world whereby a positive outlook boosts morale and performance.However; there is always a tendency of financial traders to be too optimistic and harboring great expectations. People tend to exaggerate their abilities and when done in the financial, this can be detrimental. The risk here is that too much confidence and optimism creates a very high expectation of returns on investment. If this fails to happen, it may trigger an intense psychological reaction that may be hard to overcome. Optimism is a key ingredient in success as it increases confidence that in turn increases persistence, resilience and determination towards achieving specific goals. Overconfidence and cockiness seem to arise from an array of psychological biases, including the perceived illusion of control and self-attribution bias. In financial economics overconfidence and over optimism is seen as an overestimation of private information with regard to trading. Therefore, to be successful in any business dealing, one has to be optimistic and positive about things. It is a common knowledge to all that in business, one has to be a risk taker and not risk averse. To be a risk taker, one has to be optimistic that what he risks will bring positive returns. Without being optimistic one cannot risk. On the other hand, it is wise not to be overconfident as this might lead one into making irrational decisions which will bring losses. A business person should have just the right mount of confidence that will guide him in good business deals. II. Self Attribution Bias Self-attribution bias is defined as the tendency of people to favor them by putting themselves in positions of bias. This self-serving bias leads financial practitioners to disregard or demean information that contradicts their own core beliefs and sometimes even proven facts. Self-attribution manifests itself with people praising themselves for past successes while blaming others for their failures. This can be viewed as an extension of overconfidence and overoptimistic. Generally financial traders with this trait gain more confidence when his beliefs tally with those of public opinion but does not get affected when he is on the wrong instead tends to shift blame to others or bad luck absolving themselves. III. Mental Accounting Mental accounting can be defined as a set of cognitive operations which human being employs to code, categorize and evaluate financial activities. This can be on the basis whereby people tend to separate the money into different accounts based on an array of subjective criteria, like the source of the money and intent for each account. Clearly it is an illogical perspective to view financial matters as it overlooks many factors. For example a person may have an account set up for holidays and vacations while at the same time struggling with credit debts. Some individuals who have no problem paying for a beer at $ 5 but refuse to pay $ 2.50 at the local grocery because his reference price is much lower can compound the absurdity of this ideology further. Mental accounting has three components that are vital and essential behavioral finance: The perceived outcome which is influenced by the making and (or the lack of) evaluating of decision. Assigning specific activities to different account. Ability to determine the periods and the relation of these mental accounts. Mental accounting has the implication that costs seen and analyzed subjectively and tend to relate to their intended purpose. This is irrational in the fact that different tasks are allocated the same amount. People tend to represent expenditures as costs provided they are able to include expenditure related benefits in their mental accounts, which in the real sense are actual losses. Section C Empirical Formula for Investigating Daniel et al Behavioral model Daniel, Hirshleifer, and Subramanian proposed a behavioral model that sought to further explain behavioral finance. In this model, there are two judgment biases i.e. overconfidence and self-attribution. Investors are also classified into two categories, informed and uninformed investors. According to them, informed investors tend to be overconfident and are adept to ignore rational public signals, pointers and trends. They produce an overreaction to personal private signals and end up producing reversals in terms stock returns. Self-attribution on the other hand is said to momentum in earnings. This model was put to test empirically to ascertain its accuracy. The hypothesis being tested here was that informed investors tend to be overconfident and end up making mistakes. The method of choice was he world renowned and acclaimed Over-Claiming Questionnaire. The OCQ as is commonly known was developed by Paulhus and colleagues and is well validated. It is basically a list of famous names, towns, people, dishes etc. some items in this list are foils, in that they do not actually exist in real life. People who tend to choose these nonexistent foils are most likely to be overconfident in that they try to be a cut above the rest by exaggerating their knowledge level while they fall prey to the method. This measure accurately measures the extent to which individual claims knowledge of these nonexistent items is said to have departed from reality and is overconfidence. This method is ideal in that it assesses overconfidence using operation criteria that is simple and workable. In this model, individual difference tends to be the depended variables. Due to differences between one individual to another, it is important to consider third party variable that may influence overconfidence. Human traits such as optimism, extraversion, trait dominance and lowered neurotic levels can alter the outcome of the OCQ depending on the most dominant of these. PART 2 Section A The Von Neumann-Morgenstern Utility Theory The theory states that a utility function is only fully satisfied by an agent if they satisfy the four axioms exhibited in the theorem. Finalized in 1947, it proved that an agent can only be rational if the real valued function of u is defined on possible outcomes and probabilities. For instance, take possibilities A and B; If L= 0.35A +0.65B, it is definite that one of the events must take place, one more than the other, of course. It can therefore be expressed as; L= SUM of PiAi or L= SUM of PiBi, in general terms. The theorem is based on four major axioms which include the continuity (If, then there exists a probability such that . ), completeness (For any lotteries L, M, exactly one of the following holds: , or (either L is preferred, M is preferred, or there is no preference.), Transitivity assumes that preference is consistent across any three options: If and, then and the Archimedean property which assumes that L Read More