CEEC0936 Behavioral Finance

Finance writing assignment about all the bad things of behavioral finance.

Introduction:

Behavioral finance is the combination of cognitive and behavioral psychological theory with traditional finance for proving explanations concerning making financial decisions that are irrational. People at times make irrational financial decisions along with making unethical decisions. Financial investing are sometimes governed by irrationalities that prompts people to behave unethically. Some of the bad things involves in behavioral finance involves ignorance, weakness of will, arrogance, slippery slopes, docility and rationalization. With the impression of behavioral finance, the study of finance is flourishing that intends to identify and resolution of difference between irrational market pricing and rational valuation (Bird et al., 2017).

Discussion:

Eugene Fama is one of the most noteworthy opponent of behavioral finance. manifestation of regular anomalies in conventional economic theory is considered as big contributor in the formation of behavioral finance. This is so because modern finance theories is not capable of explaining some anomalies and it is not necessary to totally abandon market theory. There are systematic patterns of bias regarding decisions and views of people that helps in inflecting decisions about investment. Using the information generated from information processing makes individual making decisions that are less rational (Statman, 2014). Financial decisions of people are driven by many factor such as human unconsciousness needs, emotions of people, psychological and fear traits. Bias becomes fundamental part of human nature that is considered as bad thing in behavioral finance. The biases deals with fundamental part of nature and sit deep within psyche. Biases can be divided into framing, heuristics and some other biases. Individual tends to utilize limited number of heuristics for reducing decision to simpler task when they are faced with complex judgment, statistically probability and incomplete information. Decision-making can be affected by psychological biases (Hirshleifer, 2015).  

Decision-making is a complex process that is done by choosing particular number of alternative course of actions after making careful evaluation. Making investment decisions is the most crucial part to investors because of difference in profiles of individual like socio-economic factors, gender, age, race and educational levels. Behavioral finance influences the mutual funds and investment stock market performance. This is regarded as critical part of process of decision-making process. One of the most critical issue is participant cannot behave irrationally. Overconfidence in making investment decisions stems partly from knowledge illusion. Making investment with overconfidence would lead to risky or inappropriate investments. Overconfidence leads to underestimation of risks, exaggeration of knowledge and ability of control events. In this regard, it is essential to note the difference between social bias and individual bias. Market can average out individual bias, feedback loops are created by social bias, and this make market further from equilibrium fair price (Statman, 2014).

Supporter of standard finance theory and theory of effective market hypothesis criticizes the approach of behavioral finance. Equity premium puzzle is another bad thing or topic for argument. Entry barriers is the main reason of puzzle by which entries have been impeded by individual’s entry into stock market. Moreover, it has been found by Eugene Fama that behavioral finance is itself an assortment of incongruities explained by market. Behavior finance theory does not completely unrestraint the market efficiency . One of the main fundamental flaw in theory of behavioral finance is the conflict of representativeness bias with conservatism bias (Burton & Shah, 2013).

Behavioral finance undermine the purpose of gaining enhance understanding of investor behavior and financial market. The concept remains stuck at individual level of analysis, pointing of failures of calculation and recognition is limited, and it does not acknowledge distortion in financial decisions making. It does not take into consideration and explains how individual act and produce decisions of aggregate outcomes. It avoids the interactive and social aspect of economic activities. Decisions aggregate and act of individual are not addressed using behavioral finance, as it does not have theoretical means to address the mechanisms. It is indicative of the fact that manifestation of collective behavior and institutions are not explained by theory. Behavioral finance cannot grow into robust theoretical realms, as it is dependent on traditional finance and economics. It also faces the challenges of efficient market hypothesis and investors behavior biases (Duxbury, 2015).

Conclusion:

Psychological perspectives in the event of market turbulence invariably influence the decisions about investment. Behavioral finance can be helpful in making financial decisions by knowing inherent psychological tendencies. However, it does not acknowledge the findings of allied socials science. Behavioral finance is reluctant to many knowledge derived from various studies and invest the rational decisions of investors.

References:

Bailey, W. (2016). Behavioral finance and me, or how I came to see the light. The European Journal of Finance, 22(8-9), 627-636.

Bird, G., Du, W., & Willett, T. (2017). Behavioral Finance and Efficient Markets: What does the Euro Crisis Tell us?. Open Economies Review, 2(28), 273-295.

Burton, E., & Shah, S. (2013). Behavioral finance: understanding the social, cognitive, and economic debates. John Wiley & Sons.

Duxbury, D. (2015). Behavioral finance: insights from experiments II: biases, moods and emotions. Review of Behavioral Finance, 7(2), 151-175.

Hirshleifer, D. (2015). Behavioral finance. Annual Review of Financial Economics, 7, 133-159.

Statman, M. (2014). Behavioral finance: Finance with normal people. Borsa Istanbul Review, 14(2), 65-73.