Berkshire Ruminations

Monday, June 12, 2006

What is behavioral finance?

Efficient market theory has been around since the 1960s and gained considerable steam during the long bear market in the 1970s. It was standard dogma in universities for several decades and was never directly challenged. Meanwhile various professors began publishing papers that documented real-world anomalies, phenomena that seemed to be impossible under the assumptions of EMT. That is, they found cracks in the efficient market foundation. As more and more anomalies were documented, more and more doubts grew about the validity of the theory and an alternative notion, behavioral finance, was born.

EMT was never that popular on Wall Street anyway, of course. If EMT held, a good portion of those whose livelihood was made there would be out of business, an unattractive notion for sure. It was much more appealing to them to go about their lives assuming that, at least, it was possible to beat the market, even if they weren’t beating the market themselves. Ironically, this sort of self-denial, whether it was true or not, is a great example of the type of bias that plays a role in behavioral finance.

Behavioral finance has been around now for about twenty years, but only widely accepted recently. As I see it, it is the natural evolution of academic finance generally. Indeed, Professor Richard Thaler – the most prominent name in behavioral finance – even authored a paper entitled “The End of Behavioral Finance,” (Financial Analysts Journal, Nov/Dec 1999 – a great summary which I highly recommend) suggesting that eventually the modifier “behavioral” won’t even be needed.

Traditional theory assumes that decision makers act rationally, that the make unbiased judgments and that they always act in a way to maximize their individual well-being. Most psychologists will tell you this is an unrealistic assumption to make about human behavior, and so a great deal of behavioral finance research has been done in conjunction with psychologists.

Two psychologists, Amos Tversky and Daniel Kahneman, set the stage in the late 70s with “Prospect Theory” which examines how individuals make decisions. Within this framework, they developed the notion of “loss aversion.” Individuals aren’t afraid of risk, they are just afraid of the risk of losing. When confronted with gains, people are more likely to seek risk than when confronted with equally probable losses. That is, investors aren’t risk-averse, they are loss-averse. Thaler later performed an experiment that demonstrates this tendency. Students were told to assume they had just won $30 and were offered a coin-flip upon which they would win or lose $9. Seventy percent of the students opted for the coin-flip. When other students were offered $30 for certain versus a coin-flip in which they got either $21 or $39 a much smaller proportion, 43%, opted for the coin-flip. EMT holds that individuals weigh these probabilities without bias, and under such assumptions results like this would not occur.

There are two key points to the idea of behavioral finance: 1) investor irrationality/psychology and 2) limits to arbitrage. EMT does not rule out the possibility that investors act irrationally, but only that if they do their actions will be exploited by rational investors and arbitraged away. For example, in the case of Palm/3Com, where Palm shares were dramatically overpriced, EMT proponents would have expected short sellers to continue to sell the shares until they fell in price, making a quick arbitrage profit. But because there were simply not enough shares available to be shorted, the price remained high, as ordinary selling pressure was not enough to offset the irrational optimism of buyers.

If we can assume that there are times when arbitrage opportunities are limited, and that there are times when investors give in to behavioral biases and make irrational decisions, then an entire new world of finance just waits to be explored. How and why do investors make irrational decisions? Are these behaviors predictable? These are the types of questions that are starting to get answered in financial literature today.


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