Subject 4. Behavioral Finance

Some investors behave highly irrationally and make predictable errors. Behavior finance is a field of finance that proposes psychology-based theories to explain stock market anomalies. Within behavioral finance, it is assumed that the information structure and the characteristics of market participants systematically influence individuals' investment decisions as well as market outcomes. There have been many studies that have documented long-term historical phenomena in securities markets that contradict the efficient market hypothesis and cannot be captured plausibly in models based on perfect investor rationality. Behavioral finance attempts to fill the void.

Loss Aversion

This is a theory that people value gains and losses differently and, asa result, will base decisions on perceived losses rather than perceived gains. Thus, if people were given two equal choices, one expressed in terms of possible losses and the other in possible gains, they would choose the former.

Overconfidence

Most people consider themselves to be better than average in most things they do. For example, 80% of drivers contend that they are better than "average" drivers. Is that really possible? Studies show that money managers, advisors, and investors are consistently overconfident in their ability to outperform the market. Most fail to do so, however.

Other behavior theories include representativeness, gambler's fallacy, mental accounting, etc.

Information Cascades

Information cascading is defined as a situation in which an individual imitates the trades of other market participants and completely disregards his or her own private information. A related concept is herding, which is clustered trading that may or may not be based on information. Some researchers argue that institutional investors trade together because they receive correlated private information or infer private information from previous trades, and institutional herding helps prices more quickly reflect market information and improve market efficiency. The result is that trading does not incorporate information and prices can move away from fundamentals.

Some researchers argue that information cascades help promote market efficiency.

User Contributed Comments 7

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johntan1979: Good example of herding: Toxic CDOs
jonan203: herding = treasuries
ldfrench: herding = for sheepdogs
CFAToad: Herding = making a comment because others made a comment. ; )
farhan92: wouldn't information cascading violate the code and standards?! diligence and reasonable bias
Kiniry: In the words of R.E.M- Everybody Herds
zriddle: Herding = The Craft Bee