Behavioural Finance

The content of this book has become ever more relevant after the recent 2007-2009 and 2011 financial crises, one consequence of which was greatly increased scepticism among investment professionals about the received wisdom drawn from standard finance, modern portfolio theory and its later developments. Modern portfolio theory suddenly appeared terribly old-fashioned and out of date for a very simple and straightforward reason: It did not work! So what is the alternative? Behavioural finance may be part of the solution, with its emphasis on the numerous biases and heuristics (i.e. deviations from rationality) attached to the otherwise exemplary rational “Homo economicus” individual assumed in standard finance. It puts a human face on the financial markets, recognising that market participants are subject to biases that have predictable effects on prices.

Preface

The content of this book has become ever more relevant after the recent 2007–2009 and 2011 financial crises, one consequence of which was greatly increased scepticism among investment professionals about the received wisdom drawn from standard finance, modern portfolio theory and its later developments. The combined collapse of Goldman Sachs Asset Management quantitative funds during the summer of 2008 and then the formal academic recognition in 2009 that an equally divided asset-allocation strategy performed better than any statically optimised portfolio strategy cast serious doubts on the capability of modern standard finance, relying as it does on quantitative analytics, to provide value to investors. Modern portfolio theory suddenly appeared terribly old-fashioned and out of date for a very simple and straightforward reason: It did not work!

Finance and investment management are not like physics. In finance, there are very few systematic “laws of nature” to be observed. We instead observe the effects of compounded human behaviour on asset prices in an open environment where exogenous shocks take place on a continuous basis. Standard finance theory tackles this complexity through some rather extreme shortcuts. These include, for example, the assumption that the dynamics of asset prices are random and that the distribution of possible outcomes follows a Gaussian law. Further embedded within standard finance is the concept of “Homo economicus” being the idea that humans make perfectly rational economic decisions at all times. These shortcuts make it much easier to build elegant theories, but, after all in practice, the assumptions did not hold true.

So what is the alternative? Behavioural finance may be part of the solution, with its emphasis on the numerous biases and heuristics (i.e. deviations from rationality) attached to the otherwise exemplary rational “Homo economicus” individual assumed in standard finance. Anomalies have been accumulating that are difficult to explain in terms of the standard rational paradigm, many of which interestingly are consistent with recent findings from psychology. Behavioural finance makes this connection, applying insights from psychology to financial economics. It puts a human face on the financial markets, recognising that market participants are subject to biases that have predictable effects on prices. It, thus, provides a powerful new tool for understanding financial markets and one that complements, rather than replaces, the standard rational paradigm.

At its core, behavioural finance analyses the ways that people make financial decisions. Besides the impact on financial markets, this also has relevance to corporate decision making, investor behaviour, and personal financial planning. Our psychological biases and heuristics have real financial effects, whether we are corporate manager, professional investors, or personal financial planners. When we understand these human psychological phenomena and biases, we can make better investment decisions ourselves, and better understand the behaviours of others and of markets.

Content

• Preface

1. Outlining the structure of the book
2. Acknowledgements and author’s foreword

• From standard finance to behavioural finance?

1. The efficient market hypothesis
2. Behavioural Finance
3. Prospect theory

• Heuristics and biases related to financial investments

1. Financial behaviour stemming from familiarity
2. Financial behaviour stemming from representativeness
3. Anchoring
4. Overconfidence and excessive trading
5. Path-dependent behaviour

• Financial anomalies – Do behavioural factors explain stock market puzzles?

1. The January effect & Small-firm effect
2. The winner’s curse
3. The equity premium puzzle
4. Value premium puzzle
5. Other anomalies

• Behavioural investing

1. Points to consider for the behavioural investor

• List of references
• Endnotes