Behavioral Finance Heuristic and Judgment, a literature review - Essay Example

In subsequent studies, Fama (1998; with French 1992/1993/1996) and Malkiel (1995) showed empirical evidence proving these conclusions and the observation that in efficient markets, only those that arrive first can earn above average returns. This logic that consistently beating the market is impossible (returns are so low that most will go to trading fees and commissions) led to the creation of index funds that mimic market performance. On the other side are the behavioral finance academics who claim that capital markets are inefficient, citing observable market anomalies showing that stock price behavior is predictable, that investors are irrational, and that many can earn above average returns or beat the market (Shiller 1981/1990/2000).

Barberis, Shleifer and Vishny (1998) claim that in the ongoing battle between rational and irrational traders in the market the irrational ones are dominating. The systematic errors that irrational investors make when they use public information to form expectations of future cash flows overwhelm the efforts of rational traders to undo the former's market dislocating effects. Daniel, Hirshleifer, and Subrahmanyam (1998) state that irrational traders' overconfidence in interpreting private information pushes up prices above rational fundamentals and increases market inefficiency.

Behavioural finance studies are backed by empirical evidence showing market inefficiency caused by limits to arbitrage (Shleifer and Vishny 1997) and behavioral psychology, both individual (Shleifer 2000) and collective (Hirshleifer and Teoh 2003), as factors that explain inefficient market behaviour. One stock anomaly cited as proof of market inefficiency is the so-called January effect that can be stated simply as "stock prices tend to go up in January" (Gultekin and Gultekin 1983). Thaler (1987) and Shiller (1997) attributed this to psychological factors as investors are influenced by their own mental compartments.

Fama (1998) claims that conclusions based on market anomalies discovered by behavioral finance are due to poorly done statistical work and amateurish techniques. He cited above average returns as the result of chance, that behavioral finance models are loaded with judgmental biases making it predictably easy to justify any hypothesis proposed, and that the efficient market hypothesis can explain all forms of market behaviour to date. Nevertheless, despite the voluminous literature on the topic, both efficient markets and behavioral finance proponents agree that their models have not managed to fully explain capital markets behavior.

Sharpe, a 1990 Nobel Prize winner who supports both theories said that "as a practical matter it is prudent to assume the market is pretty close to efficient in terms of pricing and risk and return On the other hand, we have learned from cognitive psychology that ordinary human beings needalternatives