Behavioural Finance Issues in Risk Assessment Processes Essay

Introduction

The theory of behavioural finance seeks answers to explain why individuals often make useless or even irrational choices when buying stocks or investing their financial means in other actives. Also, individuals who are involved in this sphere of research want to understand what psychological motives influence a consumer’s decision to buy any item, regardless of the fact whether it was necessary for this individual or not. To make appropriate and logical studies in the sphere of behavioural finance, some scholars invented several theories that helped them to find sound justifications of certain behaviours observed among people who purchase stocks regularly. The main elements that have to be considered in the given paper include the modern portfolio theory, asset valuation, and EMH (efficient market hypothesis). The following content will present a literature review that is intended to discuss certain issues of financial models and theories in behavioural finance.

Modern Portfolio Theory

Modern portfolio theory is described by Ricciardi and Simon as “an inclusive investment approach that assumes that all investors are risk-averse, and seeks to create an optimal portfolio in consideration of the relationship between risk and reward as measured by alpha, beta and R-squared”¹. It is necessary to mention that the given theory was invented and popularised by an American economist, Harry Max Markowitz. Ricciardi and Simon² also observe such phenomena that appear in financial markets as correlation, crash, efficient frontier, January effect, and others. All these theories are crucial for investors who seek profitable deals. Moreover, the article by these authors accents on the fact that the modern portfolio theory is intended to analyze the possible return on investments as it requires making a graph to identify the average growth of stocks and their current prices. Moreover, every element of a person’s portfolio must be compared and chosen about other valuable papers purchased by this particular investor.³

Asset Valuation

Asset valuation can be interpreted as a process of assessment of any company’s or non-profitable organization’s financial statement that includes its property, investments, actives, expensive items, and other elements that produce cash flows for it.⁴ Usually, the services of people who specialize in asset valuation are used when something is being put up on sale. It may be a stock of a corporation, it’s building, transport means, and so on. Statman⁵ discusses the subject of asset valuation as a pricing model that will be reviewed in detail in the following context. Statman⁶ also emphasizes on the fact that asset valuation differs from arbitrage pricing theory as the latter is beneficial only for utilitarian benefits. In turn, a behavioural asset is used by professionals for emotional, significant, and expressive benefits. It is necessary to mention that the article by the author mentioned in the given paragraph discussed a wide range of strategies used by Warren Buffet and other notable investors when they made decisions regarding their next stock purchases. In general, Statman⁷ observes various methods used by professionals in the sphere of behavioural finance and points out some outcomes that become possible with the use of models described in the article.

EMH

As mentioned in the introduction section, EMH is an abbreviation for the efficient market hypothesis. According to the standards and premises of the given hypothesis, all the valuable and important information regarding financial changes in a company’s environment is immediately included in the organization’s stocks. It is obvious that the price of these valuable papers also varies regularly. It appears that the majority of companies in the world have some changes in their financial statements that are updated almost every day. EMH was initially invented by an American economist, Eugene Fama⁸. Ricciardi and Simon⁹ describe EMH in their work and say that investors should own the entire market, instead of making multiple attempts to out-perform it. The authors support this statement by claiming that “stocks are considered to be at their fair value, but proponents argue that active traders or portfolio managers cannot produce a superior return over time that beat the market”¹⁰. It would be proper to mention that the stock under the name of S&P 500 beats the entire market environment the major part of the time that amounts to 70%.

Another article was written by Titan¹¹ explains the topic of EMH in detail. The author states that this element has three forms that will be discussed below:

• Weak-Form of effectiveness can be determined if the price of any market’s active reflects the previous information regarding this position, which can be interpreted as the available data about the previous state of the market that can be observed at the present moment.¹²
• Semi-strong Form of EMH appears when the price of any markets active accurately reflects not only the previous, but also the popular data (that can be accessed by any interested person at the present moment and that is popularised by mass media, politicians, and other instances or important figures.
• A strong Form of market effectiveness implies the situation when the price of markets active precisely reflects all the necessary data, including previous information, popular materials, and a corporation’s insights (the information that is only known by a limited number of people who have contact or access to the primary source of it).

CAPM and Returns

CAPM (capital asset pricing model) is a model of financial actives assessment that is used to identify a required level of their profits that is intended to be added to a diversified portfolio considering a market risk of this particular element. The problems of the CAPM in pricing stock or portfolio returns can be formulated as the fact that all the profits and risks are equivalent to the price of any purchased valuable note.¹³ However, the main cash flow can be identified with the help of its exchange rate. It is necessary to state that CAPM is an advanced approach to the problem as it explores the balance between a market and its rates that are set according to the modern portfolio theory by all investors involved in a particular sphere.

Ricciardi and Simon¹⁴ claim that the pricing of one stock and changes in it make a significant impact on the same factor of identical ones. In such cases, equal prices must be achieved simultaneously and automatically. It appears that similar values are important to identify additional payments for risk if:

• They are used to determine capital investments during the process of an organization’s value assessment. Usually, the objectivity can be reached with the help of market price identification.
• The risk management allows one to evaluate stock fond using equal prices.

Size Effect Against EMH

The article was written by Fama and French¹⁵ discusses various risks and elements used to identify international stock returns, including momentum, value, and size. To begin with, it is necessary to state that the authors of the article interpret such a phenomenon as size effect as the strategy of one company that has several small firms. According to the academic source, such a methodology of development appears to be more efficient than that of companies with large market capitalization. Fama and French¹⁶ state that the manipulation described above is one of the most important factors used to explain and evaluate the Three-Factor Model developed by these scholars.

The article by Fama and French¹⁷ then gives a description of the Three-Factor Model, which can be referred to as another asset pricing model that includes the use of CAPM. Moreover, it adds both value and size factors to evaluate the possible risk factors. This model presents competition to EMH that was described above. Although the article by Fama and French¹⁸ outlines only advantages of the model, many investors debate about its efficiency and compare it to EMH. Individuals try to understand which model appears to be more efficient in the international financial market.

In his other paper, Fama¹⁹ observes this question and gives a more detailed comparison of the pricing models mentioned above. It is necessary to mention that the efficiency also implies more investments in several financial means in one stock, and hence an increased risk of such operations. In turn, the inefficient approach to the problem can be explained as setting the wrong values of certain businesses, which might lead to a long-term investment that will be paid off for decades.²⁰ In this relation, EMH seems to be more beneficial than the Three-Factor Model as the majority of successful investors choose this variant when making their final decisions.

Behavioural and Standard Finance Differences

In this paragraph, the literature review of two articles will be made. The first article by DeBondt, Muradoglu, Shefrin, and Staikouras²¹ gives the definitions of both behavioural and standard finances. In turn, the academic source developed by Statman²² focuses a reader’s attention only on behavioural finance. While the latter author prefers to describe the mentioned phenomenon and relates it with other theories assessed in previous paragraphs of the paper, DeBondt et al.²³ interpret their methodology as “normal” and claim that it is for “normal people”. In turn, the overview of different errors and benefits that people experience when using their suggested method.

According to Statman²⁴, investors who follow the theory of standard finance are more likely to be rational as they do not have any limitations in their decisions. In contrast, it would be proper to state that other investors who prefer to follow the behavioural finance model seem to be irrational in their preferences.²⁵ “Normal people” can be seen to get upset, stressed, and regretting their cognitive mistakes. While reading the article by DeBondt et al.²⁶, it is possible to note that the model of behavioural finance reflects all issues of human conduct. In conclusion, it is essential to claim that spontaneous decisions made by “normal people” bring them more profits and benefits than to their colleagues who follow the standard finance model.

Overconfidence’s Influence on Investors

The article was written by Barber and Odean²⁷ provides an excessive explanation of what overconfidence is. The authors claim that this factor increases the levels of trading in financial markets. “Human beings are overconfident about their abilities, their knowledge, and their prospect”²⁸. Unfortunately, investors overestimate their knowledge and make an inappropriate decision regarding their financial means and investments of other resources. The authors’ paper offers its readers to become familiar with the research of psychologists who were participating in the study. It is necessary to state that the professionals’ conclusions reflect that the majority of men fail to estimate their abilities and all the possible risks appropriately. In turn, women are not likely to think more about themselves than they can. This theory was not suggested by scholars. Instead, they organized a study to check the reaction of both genders to the same items or events. It appeared that men got more excited and emotional than females. As the text continues, Barber and Odean²⁹ use examples from previous studies of their colleagues in the discussed field. According to the survey, “overconfident investors believe more strongly in their valuations, and concern themselves less about the beliefs of others.”³⁰

Conclusion

All the articles given and described above explain various phenomena in financial markets. The literature review performed above was designed to explain some terms related to investments and people’s decisions regarding the allocation of their financial means. It would be proper to state that some people have behavioural issues that hurt their decisions made when investing money. The given work offers some theories that explain individuals’ motives in such instances. Another interesting fact discovered during the literature review is that the use of both EMH and the theory of size-effect vary in different parts of the world. Therefore, it may be essential to consider national preferences when analyzing investors’ choices.

Bibliography

Barber, B., and Odean, T., ‘Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment’, Quarterly Journal of Economics, vol. 116, no. 1, 2001, pp. 261–292.

Beck, T., and Demirguc-Kunt, A., ‘Small and Medium-Size Enterprises: Access to Finance as a Growth Constraint’, Journal of Banking & Finance, vol. 30, no. 11, 2006, pp. 2931–2943.

Brown, W., and Cliff, T., ‘Investor Sentiment and Asset Valuation’, The Journal of Business, vol. 78, no. 2, 2005, pp. 405–440.

DeBondt, W., Muradoglu, G., Shefrin, H., and Staikouras, K., ‘Behavioural Finance: Quo Vadis?’, Journal of Applied Finance, vol. 18, no. 2, 2008, pp.7-21.

Elton, J., and Gruber, J., ‘Modern Portfolio Theory, 1950 to Date’, Journal of Banking & Finance, vol. 2, no. 11-12, 1997, pp. 1743–1759.

Fama, E., ‘Market Efficiency, Long-Term Returns, and Behavioral Finance’, Journal of Financial Economics, vol. 49, no. 1, 1998, pp. 283–306.

Fama, E., and French, K., ‘The Capital Asset Pricing Model: Theory and Evidence’, Journal of Economic Perspectives, vol. 105, no. 1, 2004, pp. 457–472.

Jagannathan, R., and Wang, Z., ‘The Conditional CAPM and the Cross-Section of Expected Returns’, The Journal of Finance, vol. 51, no. 1, 1996, pp. 3–53.

Olsen, R., ‘Toward a Theory of Behavioral Finance: Implications from the Natural Sciences’, Qualitative Research in Financial Markets, vol. 2, no. 2, 2010, pp. 100–128.

Ricciardi, V., and Simon, H., ‘What Is Behavioral Finance?’, Business, Education and Technology Journal, vol. 1, no. 1, 2000, pp. 1-9

Statman, M., ‘Behavioral Finance vs. Standard Finance, Behavioral Finance and Decision Theory in Investment Management’, Borsa Istanbul Review, vol. 14, no. 1, 1995, pp. 14-22.

Titan, G., ‘The Efficient Hypothesis: Review of Specialized Literature and Empirical Research’, Procedia Economics and Finance, vol. 32, no. 1, 2015, pp. 442-449

Yen, G., and Lee, C., ‘Efficient Market Hypothesis (EMH): Past, Present and Future’, Review of Pacific Basin Financial Markets and Policies, vol. 11, no. 2, 2008, pp. 305–329.

Footnotes

1. V. Ricciardi and H. Simon, ‘What Is Behavioral Finance?’, Business, Education and Technology Journal, vol. 1, no. 1, 2000, p. 3.
2. V. Ricciardi and H. Simon, ‘What Is Behavioral Finance?’, Business, Education and Technology Journal, vol. 1, no. 1, 2000, p. 2.
3. J. Elton and J. Gruber, ‘Modern Portfolio Theory, 1950 to Date’, Journal of Banking & Finance, vol. 2, no. 11-12, 1997, p. 1750.
4. W. Brown and T. Cliff, ‘Investor Sentiment and Asset Valuation’, The Journal of Business, vol. 78, no. 2, 2005, p. 423.
5. M. Statman, ‘Behavioral Finance vs. Standard Finance, Behavioral Finance and Decision Theory in Investment Management’, Borsa Istanbul Review, vol. 14, no. 1, 1995, p. 14.
6. M. Statman, ‘Behavioral Finance vs. Standard Finance, Behavioral Finance and Decision Theory in Investment Management’, Borsa Istanbul Review, vol. 14, no. 1, 1995, p. 16.
7. M. Statman, ‘Behavioral Finance vs. Standard Finance, Behavioral Finance and Decision Theory in Investment Management’, Borsa Istanbul Review, vol. 14, no. 1, 1995, p 17.
8. E. Fama, ‘Market Efficiency, Long-Term Returns, and Behavioral Finance’, Journal of Financial Economics, vol. 49, no. 1, 1998, p. 286.
9. V. Ricciardi and H. Simon, ‘What Is Behavioral Finance?’, Business, Education and Technology Journal, vol. 1, no. 1, 2000, p. 6.
10. V. Ricciardi and H. Simon, ‘What Is Behavioral Finance?’, Business, Education and Technology Journal, vol. 1, no. 1, 2000, p. 3.
11. G. Titan, ‘The Efficient Hypothesis: Review of Specialized Literature and Empirical Research’, Procedia Economics and Finance, vol. 32, no. 1, 2015, p. 445.
12. G, Yen and C. Lee, ‘Efficient Market Hypothesis (EMH): Past, Present, and Future’, Review of Pacific Basin Financial Markets and Policies, vol. 11, no. 2, 2008, p. 306.
13. R. Jagannathan and Z. Wang, ‘The Conditional CAPM and the Cross-Section of Expected Returns’, The Journal of Finance, vol. 51, no. 1, 1996, p. 19.
14. V. Ricciardi and H. Simon, ‘What Is Behavioral Finance?’, Business, Education and Technology Journal, vol. 1, no. 1, 2000, p. 4.
15. E. Fama and K. French, ‘The Capital Asset Pricing Model: Theory and Evidence’, Journal of Economic perspectives, vol. 105, no. 1, 2004, p. 457.
16. E. Fama and K. French, ‘The Capital Asset Pricing Model: Theory and Evidence’, Journal of Economic perspectives, vol. 105, no. 1, 2004, p. 463.
17. E. Fama and K. French, ‘The Capital Asset Pricing Model: Theory and Evidence’, Journal of Economic perspectives, vol. 105, no. 1, 2004, p. 459.
18. E. Fama and K. French, ‘The Capital Asset Pricing Model: Theory and Evidence’, Journal of Economic perspectives, vol. 105, no. 1, 2004, p. 464.
19. E. Fama, ‘Market Efficiency, Long-Term Returns, and Behavioral Finance’, Journal of Financial Economics, vol. 49, no. 1, 1998, p. 288.
20. T. Beck and A. Demirguc-Kunt, ‘Small and Medium-Size Enterprises: Access to Finance as a Growth Constraint’, Journal of Banking & Finance, vol. 30, no. 11, 2006, p. 2935.
21. W. DeBondt, G. Muradoglu, H. Shefrin, and K. Staikouras, K, ‘Behavioural Finance: Quo Vadis?’, Journal of Applied Finance, vol. 18, no. 2, 2008, p. 7.
22. M. Statman, ‘Behavioral Finance vs. Standard Finance, Behavioral Finance and Decision Theory in Investment Management’, Borsa Istanbul Review, vol. 14, no. 1, 1995, p 14.
23. W. DeBondt, G. Muradoglu, H. Shefrin, and K. Staikouras, K, ‘Behavioural Finance: Quo Vadis?’, Journal of Applied Finance, vol. 18, no. 2, 2008, p.10.
24. M. Statman, ‘Behavioral Finance vs. Standard Finance, Behavioral Finance and Decision Theory in Investment Management’, Borsa Istanbul Review, vol. 14, no. 1, 1995, p 14.
25. R. Olsen, ‘Toward a Theory of Behavioral Finance: Implications from the Natural Sciences’, Qualitative Research in Financial Markets, vol. 2, no. 2, 2010, p. 113.
26. W. DeBondt, G. Muradoglu, H. Shefrin, and K. Staikouras, K, ‘Behavioural Finance: Quo Vadis?’, Journal of Applied Finance, vol. 18, no. 2, 2008, p.13.
27. B. Barber and T, Odean, ‘Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment’, Quarterly Journal of Economics, vol. 116 no. 1, 2001, p. 273.
28. B. Barber and T, Odean, ‘Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment’, Quarterly Journal of Economics, vol. 116 no. 1, 2001, p. 261.
29. B. Barber and T, Odean, ‘Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment’, Quarterly Journal of Economics, vol. 116 no. 1, 2001, p. 281.
30. B. Barber and T, Odean, ‘Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment’, Quarterly Journal of Economics, vol. 116 no. 1, 2001, p. 286.