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Classical Finance vs Behavoiral Finance

Classical Finance vs Behavoiral Finance

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Published by Purnendu Singh

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Published by: Purnendu Singh on Mar 16, 2011
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Classical Finance vs. Behavioral Finance
 
Prakant Sood, Raju Bhadrish
 
Classical Finance
 
Efficient Market Hypothesis
 
Consider the example of a student and his professor who are walking down Wall Street. Thestudent spots a 100$ bill on the pavement and stoops down to pick it up. The professor thentells him not to waste his time for ³Had the bill actually been there, it would have beenpicked up´ 
 
That, in essence, is the concept of the ³Efficient Market Hypothesis.´ Whenever any newinformation arises, it spreads so rapidly that stock prices almost instantaneously reflect thechange. Thus, no study of stocks and careful stock selection should help over random stockselection. This is because all the effects of data being studied are already reflected in theinformation.
 
Also, at any time, stock price movements would be totally random, as is explained by theRandom Walk Theory. It stated that since stock prices reflect all current information, today¶sstock prices reflect fully today¶s information and tomorrow¶s prices would fully reflecttomorrow¶s information. Then the only new factor in determining the stock price movementsis the new information of tomorrow i.e. tomorrow¶s news, which is completely random, thusimplying that the stock price movements are also totally random.
 
3
types of Efficient Market Hypothesis:
 
 
W
eak:
In this type of a market, all past data and prices are reflected in the currentprices. Thus, Technical Analysis is not of any use.
 
 
S
emi strong:
In this type of a market, all public information is reflected in thecurrent stock prices. Thus, here, even Fundamental Analysis is of no use.
 
 
S
trong:
In this type of market, all information is reflected in the current stockprices. Thus, not only is any kind of analysis useless, even insider information isuseless for predicting future stock market prices.
 
Fundamental Analysis:
This type of analysis involves detailed study and analyzing thecurrent stock prices and trying to logically analyze company information and predict futurestock prices.
 
T
echnical Analysis:
This type of analysis involves statistical correlation of previous stockprices to establish some kind of relation between stock price movements.
 
S
ome studies to prove the feasibility of 
T
echnical Analysis.
 
D
ata Mining:
In this modern age, there is truckload of information at one¶sfingertips due to the extensive reach of the internet. Data mining techniques arethen used to sift through the information and gather relevant correlation betweendata/past stock prices and try and find out patterns.
 
 
 
W
eakness:
Statisticians themselves admit that extensive manipulation of data willyield some results. Taking a simple example, it is possible to visualize why that is soand one can actually see that checking for correlation X, X
2
et cetera one will finallyend up getting a good correlation between the variables in question. However, thesignificance of the result obtained can rarely be ascertained. For example, themaximum correlation was found to between S&P 500 and butter prices inBangladesh.
 
S
ome contradictory theories of EMH
 
S
hort Run Correlation (Bandwagon Effect):
When there is sudden good news or badnews, anticipating future returns or losses, people all panic and follow the bandwagoneffect, all buying or selling stocks. This causes stock prices to move non-randomly for ashort period at least and thus nullifies the random walk theory. This has been observedby carrying out Technical Analysis.
 
N
ullification:
However, this theory goes against the basic assumption of any investorthat he buys low and sells high. Also, statistical returns do not point towards actualeconomic returns as it does not factor in the transaction costs and the small statisticalprobability of returns and correlation (similar to the bandwagon effect).
 
S
ize Effect:
Statistically, through historical data and otherwise, it has been seen thatsmaller stocks perform better as opposed to larger stocks. This refutes the EMH theoryin providing some guidelines for stock portfolio management.
 
N
ullification:
There were some indices problems earlier on leading to somemisrepresentation of figures. Also, a repeat of this experiment in the late 90s showedthat stocks of small companies in 1980s and 1990s did not outperform stocks of largercompanies. This trend could be because it is easier to liquidate cash from largercompanies. Also, the earlier trend could be because only those small companies whichdid not fail were computerized so, in essence, the figures could be unfavorably biased orfalse.
 
There are several other theories trying to explain the fallacies of EMH theory however it canbe easily seen that none of them are perfect. Also, once they are publicly known thechances of returns diminishes greatly.
 
Conclusion
 
In reality, markets are neither perfectly efficient nor perfectly inefficient. All markets areefficient to a certain extent, some more so than others. Rather than being an issue of blackor white, market efficiency is more a matter of shades of gray. In markets with substantialimpairments of efficiency, more knowledgeable investors can strive to outperform lessknowledgeable ones.
 
Yet certain known events can never be understood by the EMH theory for example the stockmarket crashes, dot com burst et cetera and this is why a new theory was needed and thusthe concept of investor psychology and Behavioral Finance came into being.
 
 
Behavioral Finance
 
Most classical investment theories are based on one assumption - investors always act in amanner that maximizes their returns. Yet volumes of research show that investors aren¶talways so rational. Psychological studies, for example, have repeatedly demonstrated thatthe pain of losing money from investments is nearly three times greater than the joy of earning money. Small market corrections have often disintegrated into full-scale crashes asa result, fueled by panicked investors who made rash decisions to avoid losing money in theshort-term rather than focusing on an investment¶s long-term potential. Hence, not everychoice investors make is in their best interests. Emotions such as fear and greed often playa pivotal role in investor decisions; there are also other causes of irrational behavior.Behavioral Finance is the study of how these emotions and mental errors can cause stocksand bonds to be overvalued or undervalued. The claim of Behavioral Finance is: People¶sdeviations from rationality are often
systematic 
. These systematic biases have their originsin human psychology. This has led to the creation of investment strategies that capitalizeon this irrational investor behavior. While investment strategies that exploit emotions haveexisted for centuries, Behavioral Finance focuses on identifying mental mistakes
regularly 
 made by investors. These strategies do more than just examine the fundamentals of companies or the feelings of investors. They incorporate how the brain solves problems and,in certain instances, might be most prone to making a mistake.
 
Psychological research has shown that the human brain often uses ³
 p
erce
 p
tual shortcuts
´ tosolve complex problems. Rather than fully digesting all information before producing anexact answer, the brain sometimes uses tools to quickly generate an estimate. Theseestimates, however, aren¶t always accurate.
O
ptical illusions are good examples of how the use of shortcuts can lead to mental mistakes.Vision is a very complex problem that requires the brain to process a lot of data: colors,depths and shapes. A set of tools enables the brain to make rapid estimates. While theseestimates are usually accurate, there are occasions when these tools cause the brain toincorrectly process information and produce an optical illusion.Vision is not the only complex problem that the brain solves by using shortcuts. Studies inBehavioral Finance have shown that the brain has similar tools for processing financial dataand producing estimates when making investment decisions. And, similar to optical illusions,there are certain instances when these tools can cause mistakes. The primary mentalmistakes made by investors are overreacting or under reacting to new information about acompany.Some of the most common perceptual shortcuts are described below:
Representativeness
 
Representativeness is a tool that the brain uses to classify things rapidly. The brain assumesthat items - plants, people, stocks, etc. - with a few similar traits are likely to be identicaleven though they may be quite different in reality. While representativeness helps the brainorganize and quickly process large amounts of data, it is a shortcut that can cause investorsto overreact to old information. For example say a company A is a small family managedbusiness. Based on this information investors would typically classify A as slow to respondto change, unprofessional, un-transparent etc. while the reality might be just the opposite.
 

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