Traditional Finance vs. Behavioral Finance: An Introduction
The term finance can be described as the management of money and other assets. Finance includes all the sectors like, banking, investments, and credits, and so on. Traditional finance is a type of financing that is used when we take the comparison of expected risk with our expected rate of return. It can also be defined as a ratio of risk and return in investment. If the concept of traditional finance is clearly observed then it is concluded that traditional finance is concerned with the risk factor and finding out that what kind of risk can occur for any type of investment. The relationship between the risk and return becomes clear from the study of traditional finance. Quantitative measures are provided by traditional finance for the measurement of a risk that can be faced by all the members involved in the financial activities. In other words, traditional finance includes businesses, and organizations raise, allocate, and use monetary resources over time – considering the risks entailed in their projects. In traditional finance, the long term funds are provided by the ownership equity – the long-term credit is often in the form of bonds. The balance between them forms a company’s capital investment structure. In the short-term funding, the working capital is mostly provided by banks; they analyze the risks before extending a line of credit. Traditional financing encourages savings so that this saving can be used in the future – a sense of security is also obtained thru this way. Traditional financing contains every aspect that makes the financial future strong like, retirement, insurance – it also provides capital growth solutions. (Ricciardi, 2008).
On the other hand, behavioral finance integrates the concepts of psychology and economics. Behavioral finance does not deal with the quantitative measures of risks rather it deals with the qualitative aspects of risk. It finds out that what effects the risks can have over the psychological and emotional human elements. It can be simply said that behavioral finance depends on the decisions made by the investors. Sometimes, these decisions prove to be the profitable ones, at times these decisions are contradictory. The relationship between the expected risk and return in behavioral finance is nonlinear. (Ricciardi, 2008).
NOTE: You will see that I specifically mentioned to the writer that the correct term is ‘traditional finance’ and not ‘traditional finance.’ He/She has ignored this comment throughout the paper.
Introduction to Behavioral Finance
Behavioral finance basically depends on the psychological impacts on the behavior of the investor. The topic of behavioral finance is very interesting to explore as this study finds out the reasons that are responsible for affecting the efficiency of markets, behavior of investors and the affects of the behavior of investors over the market efficiency. In behavioral finance, investors make decisions depending on their psychology. In this situation, sometimes the decisions that are made by the investors end up in a positive result, but at time the decisions seem to be quite inconsistent; hence, the result is negative. Behavioral finance is used to apply psychological theories that try to define anomalies of stock markets (Stock market anomaly is the state, when the market deviates from its regular position). In the context of behavioral finance, it is considered that the psychology of the participants of the market can influence the investment decisions and also the result of the market. (Behavioral finance, n.d).
Investors do have biased expectations which are sometimes beneficial for them, but at times they also have to face huge losses as without having adequate information, the investors got confident and made investments. Another characteristic of behavioral finance investors is the asset segregation as the investors do not take a complete profile where they are making investments. Behavioral finance is quite different from traditional finance approach, which is based on characteristics like, risk aversion, rational expectations and asset integration. Behavioral finance is not concerned with the quantitative measurement of the risks, but it is basically concerned with the quantitative measures, which include the affects of risks over the emotions of the investors. (Minute-class, 2009).
Behavioral finance primarily consists of two major parts: cognitive psychology and limits to arbitrage. Cognitive psychology is one of the many branches of psychology; it deals with the thinking, perception and other mental capabilities. On the other hand, the limits to arbitrage deals with planning that in what conditions the arbitrage forces will be helpful and efficient and when theses forces would not be effective. The models that are being used in behavioral finance involve agents. These agents are not completely balanced because of the unbalanced nature – perhaps due to the preferences or due to the misconceptions of investors. Behavioral finance is supposed to be loss aversion, which means that the investors in behavioral finance do not look at the amount of risk while making any investment. The investors in behavioral finance go for large losses as they had not made having proper decisions while making the investment. The result in behavioral finance is always unpredictable, till the very end there are the chances of gain or loss.
Cognitive Psychology
Cognitive psychology is a branch of psychology that deals with the neural processes and activities people use to perceive situations and circumstances, how people learn, remember and determine what actions to take. It is a vast field of science that is connected to many different fields like, neurology, linguistic and philosophy. Basically, cognitive psychology deals with the aspects of how people access, process and then retain the information. Cognitive psychology has very wide range of applications or methods for improving the perception and memory, enhancing the ability to learn or methods to take quick and accurate decisions. This is the field of psychology that relates with concepts like, decision making, thinking and perception and all these factors are closely related with almost every field of life. (Wagner, n.d).
When it comes to behavioral finance then there are many different aspects that are given by various cognitive psychologists. They believe that there are many elements that are related to the mental processes such as, heuristics, confidence, decision making, mental accounting, framing, representativeness, conservatism, dispositions effect, memory and perception and many other such elements.
Information Processing Critiques
Cognitive psychology plays its role when an investor is making an investment in the form of information processing. The information processing process has got positive and negative aspects. It is not possible that every time when the information is being processed, the result is positive – or in the form of profits. The information processing also has got some negative facets and these are discussed as given below:
Forecasting Errors
In behavioral finance, errors can be forecasted at the time of information processing. When traders feel that this is a good time for the market, they increase the prices of their commodities. But when the result comes out, it is totally opposite and then they don’t have any other option but to decrease the prices. Likewise, when traders belive that the market is slow, they drop down the prices, but when the result comes out, they have bear losses. Thus, it can be stated that the incorrect predictions of traders about the market thru information procession can create forecasting errors.
Overconfidence
The overconfidence is another problem that can occur while processing the information – it also results in huge losses. The problem of overconfidence takes place when investors are very much sure of their information and they underestimate the risks by overestimating their information about the market.
Conservatism
It is a common trend that when any new information or announcement is made in the market, then the traders and investors take time in adapting the new strategy or information. The investors take a lot of time in observing the new trends and information and as a result they react very slowly in changing their beliefs.
Sample Size Neglects and Representativeness
The problem of sample size neglects occurs when a sample which was selected for developing the information is not of the appropriate size. The correct sample size counts a lot at the time of gathering the market information and predicting the market conditions.
In the 1960s, psychologists described the human brain as a device that is used for processing information. Psychologists in the field of cognitive psychology, such as, Ward Edwards, Amos Tversky and many others related the field with behavioral finance. Psychologists started comparing the different models of the cognitive psychology, like, the decision making model under the risk with the models related to economics (such as rational behavior). The comparison was made for making the interrelation between these two fields. (Behavioral finance, n.d).
Prospect theory
The prospect theory is also an essential element for behavioral finance. The theory deals with how people can manage the risks and uncertainties. The theory was established by Kahneman and Tversky over a period of 30 years – the theory is not only essential for the field of economics, but it is also relevant in the discussion of the financial investing.
The prospect theory looks for the behavior of people when they are facing risks or uncertainties. It judges what will be the reaction of people when they will be facing a risk and having a loss. It further observes the reaction when a risk is end up with a gain. As behavioral finance involves a great deal of risk and uncertainty, this theory is vital for the field of behavioral finance. The reaction of people while facing a risk is very much closely related to their decision making capability. The theory basically shows a risk seeking behavior. It counts a lot in the field of behavioral finance as in economics, good prediction of human behavior is vital. (Watkens, 1996)
Behavioral Biases
The behavioral biases can be defined as the wrong actions or results that are faced because of making any error based decision. The behavioral biases occur because of incorrect decisions and unreasonable mental processes.
Framing
Framing shows that how a problem, question, situation, condition and option are presented in front of the decision maker. Different decision makers can take different decision for the similar problem. As prospect theory deals with how people manage the risks and problems, so this theory can handle the affects of framing.
Mental Accounting
Mental accounting can be termed as a process by which people prepare the problem in decision making. In mental accounting the investors possess flexibility and they set apart money in to different mental accounts reserved for different purposes. While performing these tasks sometimes improper decisions are made. Mental accounting can be termed as gambling where people continue to make investments by using their previously earned profits and without taking risks under consideration.
Regret Avoidance
A feeling after a post decision that may lead to unavoidable circumstances which an individual experiences failing to choose a better alternative is regret. To avoid these regrets, people make a more conventional decision. People make these decisions to avoid loss from their investments that may lead to financial crisis or psychological pain, which means, to admit a wrong investment strategy. In short, we can say that regret avoidance is like admitting a mistake by wrong investments, which finally results in a financial loss.
Limits to Arbitrage and Market Efficiency
In simplest words, the term arbitrage can be defined as a transaction to gain a profit in a very short span of time – usually by taking an advantage of a price differential between two or more than two markets. For example, an asset is bought at a comparatively lower price and immediately sold in a different market at a higher rate. If there are no arbitrage chances in any market then it is known as the arbitrage free market.
On the other hand, the market efficiency is a concept that is essential for finding out the conditions of the market. The term efficient market describes a market where the information is impounded into the price of financial possessions; the term is used to show the operational effectiveness and efficiency of the market. A very well known hypothesis regarding the market efficiency is known as the Efficient Market Hypothesis (EMH). According to EMH, at any instance of time, the price value of assets totally reflects all the available and related information. In this section of the paper, we are going to discuss the limitations attached to arbitrage and the market efficiency. (Dimson, 1998).
- Fundamental risk – while the price may be low such that you expect a higher return, the actuality is that it may be less than that. While the risk is not correctly priced it is still risk.
- Implementation costs – it may take a lot of risky traders to push the price to equilibrium, it may not be possible.
- Model risk – there is the issue of uncertainty in the model itself, ie. CAMP, 3-Factor, etc. non of which represent the true, underlining, actual fact return process.
- Equity carve-outs
- Closed-end funds
It is a common act that financial assets are often misevaluated and it is difficult to achieve profits out of these misevaluations. There can be two types of misevaluations: one is those that are regular or arbitrage able and the second one is those which are not repeating and are long term in their nature. If the regular misevaluations are taken then the strategies for trading can be profitable and because of this reason evade funds and others controls them from getting too large. So for such assets it can be noticed that market seem to be very efficient and effective. But for the misevaluations that are long term and no repeating it seems to be quite an impossible task to predict the ups and downs of the market as long as they face it and early risks can be faced which can even clean up the capital. Another inferior situation can be if the partners are limited and the investors that are providing the money then the extraction of capital after a losing line can basically end up in the pressure of buying and selling that can in the return result in to the inefficiency. It is never known which investors can make the market efficient and profitable, but there is a group of investors that always struggle to make profit and money by finding out those misevaluations are prevaricative funds. Big and small positions can be taken by the relative value hedge fund, devalued securities can be taken and then high valued securities can be found and can be made short valued. But in contrast, macro hedge funds can take positions that cannot be hedged simply. It is a fact that if the arbitrageurs try and put efforts for making money then the markets can get better and efficient. It happens in the market that large companies do make profits in the long run but sometimes can get failure just in a single season. The companies value gets so much down that they have to liquefy themselves. The companies usually merge together and it is a fact that when the 60-40 is not the ratio of the stock prices then the chances of arbitrage profit exists. Let us take an example for making it clearer; Long Term Capital Management (LTCM) is a very big hedge fund and was established around 9 years ago. Initially, LTCM appeared to be very successful, but after few years, LTCM faced a bad part in which it faced a loss of 4 billion dollars. This huge loss forced LTCM to liquidate – the equity capital of LTCM was washed out. Still in the long run, LTCM proved to be right; LTCM used to make trade in the fixed income and derivative market. LTCM lost money on the Royal Dutch/ Shell equity arbitrage trade. The interests of the Royal Dutch from the Netherland and Shell from the UK were merged on 60-40 bases and the dividends were paid on these bases. Simply, it seems that the profit opportunity existed when stock prices were not in 60-40 ratio. In the year 1998, LTCM bought cheap stocks and lost money because of a diversion of the prices. In order to fulfill the liquidity requirements, LTCM along with many other hedge funds sell out their positions – this step also made the markets inefficient. In the year 2002, the Royal Dutch was also dropped from the S&P 500 because of eliminating on American companies.
It proves that in case of losses, the selling pressure that has been caused by the market forces the companies to sell out their assets, thus, the market becomes more inefficient – these factors make the limitations for the arbitrage. Although, arbitrage can keep the market quite efficient, but the problem is that the arbitrages are not always powerful. There are many traders that are able to misprice and they do this mispricing to the level of variance. In such situations, obviously the arbitrageurs will observe that they are on the negative side of the market and they will be pressurized to end up their positions as soon as misprices are corrected. It is also not possible to find out two mispriced properties having the same level of risk. In majority of the cases, in order to make the arbitrageurs to take benefit from the mispricing with out having any risk but for this the assets should be at the risk that can at least be compared. If this is not the case then it would not be possible to correct the mispricing without any risk. Finally, it is a concept that arbitrageurs do have access to money but this is not the true statement. They actually have got the capital which they are not allowed to use. Mostly the arbitrageurs are the people that are responsible for managing and administering the money of other people so they are restricted by the people who own these capitals. (Ivkovic, 2007).
Like arbitrage, there are some limitations for the market efficiency. There are basically two types of events that usually take place in the market. One is high frequency events and the others are low frequency events. The high frequency events take place often as the name itself shows and the low frequency events occur rarely, but such low frequency events take a long time to get a recovery from them. The high frequency events are supportive for the efficiency of the market as these events take place often, but they are tend to cause less affects to the market; thus, the efficiency is not disturbed to the large extent. It is very much difficult to look for any strategy that can assure only profitability as if there was any such strategy then all investors should have applied that strategy. The low frequency events take long time to get recovered – sometimes these events give huge losses to companies; hence, these events are definitely not suitable for the efficiency of the market. The low frequency events are the ones that are unusual and results in huge losses and for this reason it takes a long time to recover from these events because it is not easy to recover the huge losses that have been made to the company. In a sentence, there are some limitations of the market efficiency and arbitrage; nevertheless, there could be many other reasons but these are the major ones. (Ritter, 2003).
Important Heuristics
Heuristics are the rules which are also known as the rules of thumb. The use of heuristics is common in many psychological fields. In behavioral finance, it is used for the decision making purpose. There are many heuristics that have been used in behavioral finance as this field requires a great deal of decision making process. To understand it clearly, we divide it into six general purpose heuristics which are as follows: affect; availability; similarity; causality; fluency; and surprise.
There are also six special purpose heuristics which are as follows: attribution; substitution; outrage; prototype; recognition; and choosing. Some of the most important heuristics of behavioral finance are as follows:
- Affect: This heuristics is based on how quickly the feeling of goodness and badness can be sensed.
- Availability: It deals with observing that whether the available information is enough or other options should be looked for the process of decision making.
- Similarity: It is based on observing the recent situations and the working models of those situations. It basically finds out the similarity between the appearance and reality. (Sewell, 2008).
Do Investor Biases Affect Asset Prices?
Normally, investors are reluctant to invest in an unstable market. This occurs due to biased behavior of investors that creates differences in a market. It creates differences between the risk seeking trade and informed trade. When an investor is going to invest some capital in a product that has a less value, the investor remains bias with the market condition and sells that product at a higher price than its actual value.
Usually, the result of this type of biasness is a nightmare for the investor as he suffers from heavy losses. This attitude further leads to reduce the prices of higher value commodities; thus, the prices change because of these reluctant investors rather than the unbiased investors. The behavior has a very deep impact over the position and price of an asset so it can be said that an investor biases can affect the price value of any asset. (Coval, 2005).
Patterns in the Trade of Individual Investors
Individual investors are basically the people who are able to buy small amount of assets or security for their own sake. Individual investors are opposite to institutional investors. As the name is suggests, in an individual investment, a single person makes an investment, whereas, the institutional investors are the organizations that invest huge amount of money. So, in this sense, it can be said that individual investors are opposite to the institutional investors. It is always recommended by financial experts that individual investors should avoid trading as they can face many huge losses when they trade on their own – as they are individuals so all the losses have to be faced by a single person and cannot be divided as in the case of the institutional investment. There are four types of institutional investors: corporations, dealers, foreigners and mutual funds. It has been observed many times that individual investors fail in front of institutional investors. Institutional investors are more compact with their investments as their investments are in companies which are providing them with fixed profits or pre-decided profit percentagea. In contrast, individual investors are bound to lose money because of their scattered investments. [NOTE: explain more clearly] There can be two types of trade transactions: aggressive trades and passive trades. The type of trade depends on the order that is beneath this trade. There are three steps for the aggressive and passive trade. In the first step, for every supply, a time sequence for clearing prices is established. The data is compiled and brought into the desired order and then put in front of the people in the market. In the second step, all the orders that have been placed are classified as aggressive or passive orders. This classification is done by comparing the prices of the orders. In the third and final step, all the orders are matched for the trade. (Barber, 2006).
Patterns in Stock Return
The term stock return is also known as the return on investment or the rate of return. It is actually the division of money that has been gained or lost over the life of the investment. It shows how much cash has flown out from the investment or how much profit has been made. Many views have been made in order to explain the patterns in the stock returns. These views include:
- Daniel, Hirshleifer and Subrahmanyam (19988, 2001): In this paper, the patterns of the stock return were described using the attributes of over confidence and the self attribution. The attribute of over confidence creates over the reaction – it enhances the phenomena of the long run and the book market. The attribute of self attribution strongly supports the over confidence, which made the prices to continue overacting.
- Barberis, Shleifer and Vishnay (1998): According to this theory, the extrapolation creates sequences that are random in nature; on the other hand, agents continue to expect the patterns in small samples. And because of this, the over reaction is created.
- Hong and Stein (1999): According to this theory the slow diffusion of news can cause momentum. In the return the traders who purchase depending on the past output establishes the overreaction and the reason for this is that they trait the actions of precedent momentum traders to news and so they do not buy more stocks. (Subrahmanyam, n.d).
Objections to Behavioral Finance
Behavioral finance has already been faced many critics, and still has been criticized by saying that biases do exist in almost every field of economics. There should be a limit to the affects and importance of these biases. The market prices also show huge biases – the process can bring back to the rational levels. This theory has said to be a non rigorous theory. The methodologies that have been used in behavioral finance are irrelevant. Many different methodological problems have been indicated by a critic Gregory Curtis in behavioral finance. Behavioral finance is very much criticized by Eugene Fama, who supports the efficient market theory in comparison to behavioral finance. According to critics, behavioral finance does not have any supportive evidence that can make it a true branch of finance. They argue that behavioral finance is just a collection of many different anomalies and that these anomalies can be priced out of the market easily. According to Fama, the anomalies that are being used by behavioral finance and have been established by the advocates of behavioral finance are nothing, but just a chance, and there is no rule or methodology lying behind these anomalies.
As discussed earlier, behavioral finance is based on cognitive psychology and it depends on the perception of a person that how does he take the things; thus, critics consider behavioral finance as it has no grounds – the results are just considered as by chance results. (What are the critics saying? n.d).
Conclusion
The paper has provided an in-depth analysis of and idear related to behavioral finance. Firstly, the comparison between behavioral and traditional finance has been made. Thru this comparison, it has been found that traditional finance provides the quantitative measures of risks that how much loss will be suffered in case of a problem; whereas, behavioral finance provides the qualitative measures of the risk which means that what psychological affects will be caused by a risk or a problem.
Traditional finance gives a linear relation between the expected risk and return, whereas, behavioral finance gives a non-linear relationship between the expected risk and the return on it. Behavioral finance depends on the psychological impacts over the behavior of an investor. It involves cognitive psychology to a great extent as cognitive psychology deals with the thinking, opinions and perception of a human being.
It can be stated that cognitive psychology plays a great role in the decision making and information processing operations of behavioral finance. In behavioral financing, investors make decisions that are totally based on their own perceptions and information which were gathered by them.
Moreover, there are some information processing inadequacies exist, like, forecasting error, overconfidence, conservatism and sample size neglect. It is not necessary that any decision made by an investor in behavioral finance tends to be right. At times, the decisions are quite inconsistent. Many theories like the prospect theory and heuristics such as affect, availability and similarity and so on are involved in behavioral finance which was widely used for making decisions. The paper also discussed about an individual investment and concludes that an institutional investment is far better than an individual investment as any loss can affect an individual greatly as compared to an institution. The criticism on behavioral finance has also been discussed in the paper. The critics believe that behavioral finance does not have any solid ground. Thus, the results of the investments made in behavioral finance are quite inconsistent and very risky.
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