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. The
student spots a 100$ bill on the pavement and stoops down to pick it up. The professor then
tells him not to waste his time for “Had the bill actually been there, it would have been
picked up”

That, in essence, is the concept of the “Efficient Market Hypothesis.” Whenever any new
information arises, it spreads so rapidly that stock prices almost instantaneously reflect the
change. Thus, no study of stocks and careful stock selection should help over random stock
selection. This is because all the effects of data being studied are already reflected in the
information.

Also, at any time, stock price movements would be totally random, as is explained by the
Random Walk Theory. It stated that since stock prices reflect all current information, today’s
stock prices reflect fully today’s information and tomorrow’s prices would fully reflect
tomorrow’s information. Then the only new factor in determining the stock price movements
is the new information of tomorrow i.e. tomorrow’s news, which is completely random, thus
implying that the stock price movements are also totally random.

3 types of Efficient Market Hypothesis:

 Weak: In this type of a market, all past data and prices are reflected in the current
prices. Thus, Technical Analysis is not of any use.
 Semi strong: In this type of a market, all public information is reflected in the
current stock prices. Thus, here, even Fundamental Analysis is of no use.
 Strong: In this type of market, all information is reflected in the current stock
prices. Thus, not only is any kind of analysis useless, even insider information is
useless for predicting future stock market prices.

Fundamental Analysis: This type of analysis involves detailed study and analyzing the
current stock prices and trying to logically analyze company information and predict future
stock prices.

Technical Analysis: This type of analysis involves statistical correlation of previous stock
prices to establish some kind of relation between stock price movements.

Some studies to prove the feasibility of Technical Analysis.

 Data Mining: In this modern age, there is truckload of information at one’s

fingertips due to the extensive reach of the internet. Data mining techniques are
then used to sift through the information and gather relevant correlation between
data/past stock prices and try and find out patterns.
  Weakness: Statisticians themselves admit that extensive manipulation of data will
yield some results. Taking a simple example, it is possible to visualize why that is so
and one can actually see that checking for correlation X, X 2 et cetera one will finally
end up getting a good correlation between the variables in question. However, the
significance of the result obtained can rarely be ascertained. For example, the
maximum correlation was found to between S&P 500 and butter prices in
Bangladesh.

Some contradictory theories of EMH 

Short Run Correlation (Bandwagon Effect): When there is sudden good news or bad
news, anticipating future returns or losses, people all panic and follow the bandwagon
effect, all buying or selling stocks. This causes stock prices to move non-randomly for a
short period at least and thus nullifies the random walk theory. This has been observed
by carrying out Technical Analysis.

Nullification: However, this theory goes against the basic assumption of any investor
that he buys low and sells high. Also, statistical returns do not point towards actual
economic returns as it does not factor in the transaction costs and the small statistical
probability of returns and correlation (similar to the bandwagon effect).

Size Effect: Statistically, through historical data and otherwise, it has been seen that
smaller stocks perform better as opposed to larger stocks. This refutes the EMH theory
in providing some guidelines for stock portfolio management.

Nullification: There were some indices problems earlier on leading to some

misrepresentation of figures. Also, a repeat of this experiment in the late 90s showed
that stocks of small companies in 1980s and 1990s did not outperform stocks of larger
companies. This trend could be because it is easier to liquidate cash from larger
companies. Also, the earlier trend could be because only those small companies which
did not fail were computerized so, in essence, the figures could be unfavorably biased or
false.

There are several other theories trying to explain the fallacies of EMH theory however it can
be easily seen that none of them are perfect. Also, once they are publicly known the
chances of returns diminishes greatly.

Conclusion

In reality, markets are neither perfectly efficient nor perfectly inefficient. All markets are
efficient to a certain extent, some more so than others. Rather than being an issue of black
or white, market efficiency is more a matter of shades of gray. In markets with substantial
impairments of efficiency, more knowledgeable investors can strive to outperform less
knowledgeable ones.

Yet certain known events can never be understood by the EMH theory for example the stock
market crashes, dot com burst et cetera and this is why a new theory was needed and thus
the 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 a
manner that maximizes their returns.  Yet volumes of research show that investors aren’t
always so rational. Psychological studies, for example, have repeatedly demonstrated that
the 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 as
a result, fueled by panicked investors who made rash decisions to avoid losing money in the
short-term rather than focusing on an investment’s long-term potential. Hence, not every
choice investors make is in their best interests. Emotions such as fear and greed often play
a 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 stocks
and bonds to be overvalued or undervalued. The claim of Behavioral Finance is: People’s
deviations from rationality are often systematic. These systematic biases have their origins
in human psychology.  This has led to the creation of investment strategies that capitalize
on this irrational investor behavior. While investment strategies that exploit emotions have
existed 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 “perceptual shortcuts” to
solve complex problems. Rather than fully digesting all information before producing an
exact answer, the brain sometimes uses tools to quickly generate an estimate. These
estimates, however, aren’t always accurate.

Optical 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 these
estimates are usually accurate, there are occasions when these tools cause the brain to
incorrectly process information and produce an optical illusion.

Vision is not the only complex problem that the brain solves by using shortcuts. Studies in
Behavioral Finance have shown that the brain has similar tools for processing financial data
and producing estimates when making investment decisions. And, similar to optical illusions,
there are certain instances when these tools can cause mistakes. The primary mental
mistakes made by investors are overreacting or under reacting to new information about a
company.

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 assumes
that items - plants, people, stocks, etc. - with a few similar traits are likely to be identical
even though they may be quite different in reality. While representativeness helps the brain
organize and quickly process large amounts of data, it is a shortcut that can cause investors
to overreact to old information. For example say a company A is a small family managed
business. Based on this information investors would typically classify A as slow to respond
to change, unprofessional, un-transparent etc. while the reality might be just the opposite.
Representativeness can cause investors to make errors in financial markets. If a company
has repeatedly delivered poor results, investors will sometimes become disillusioned with it.
In their minds, the company has the traits of a lousy company and, like most lousy
companies, it will continue to deliver poor results in the future. Investors in these instances
overreact to the past, negative information and ignore valid signs of improvement. Although
it may be poised to deliver good results, the company is overlooked and its stock
undervalued.

This is not to say investors won’t ever change their view. If the company continues its
improvement over time, investors will eventually overcome their representativeness error.
And the company will start to look like a potentially attractive investment.

Anchoring

Mental mistakes can also cause investors to underreact to new, positive information about a
company. One shortcut that causes this is anchoring - a tool the brain uses to solve
complex problems by selecting an initial reference point and slowly adjusting to the correct
answer as it receives additional information. Bargaining is a good example of how anchoring
works. A well-trained car salesman negotiates with potential customers by starting at a high
price and slowly reducing the price over time. His goal is to anchor the customer to the high
price (regardless of the actual value of the car) and let the customer feel he negotiated a
good deal by getting a lower price. Anchoring also can cause securities to be mispriced. For
example, should a company suddenly report substantially higher earnings, the market will
on occasion underreact to this change. Although the company is making more money, its
stock price does not rise because investors assume that the change in earnings is only
temporary. They remain anchored to their previous view of the company’s potential
profitability because they have underreacted to the new, positive information. This does not
mean that investors will never move away from their initial reference point, or anchor.
Similar to representativeness, as investors get better information about the company over
time, they will eventually overcome mental mistakes caused by anchoring. They will realize
that the company is likely to continue to be more profitable in the future and that its stock
is probably an attractive potential investment.

Some other key theories in Behavioral Finance are:

Prospect theory

Prospect theory suggests that people respond differently to equivalent situations depending
on whether it is presented in the context of a loss or a gain. Typically, they become
considerably more distressed at the prospect of losses than they are made happy by
equivalent gains. This 'loss aversion' means that people are willing to take more risks to
avoid losses than to realize gains: even faced with sure gain, most investors are risk-
averse; but faced with sure loss, they become risk-takers. Hence small market corrections
may lead to full scale crashes.

According to the related 'endowment effect', people set a higher price on something they
own than they would be prepared to pay to acquire it.

Regret theory
Regret theory is about people's emotional reaction to having made an error of judgment,
whether buying a stock that has gone down or not buying one they considered and which
has subsequently gone up. Investors may avoid selling stocks that have gone down in order
to avoid the regret of having made a bad investment and the embarrassment of reporting
the loss. They may also find it easier to follow the crowd and buy a popular stock: if it
subsequently goes down, it can be rationalized as everyone else owned it. Going against
conventional wisdom is harder since it raises the possibility of feeling regret if decisions
prove incorrect.

Over- and Under-reaction 

The consequence of investors putting too much weight on recent news at the expense of
other data is market over- or under-reaction. People show overconfidence. They tend to
become more optimistic when the market goes up and more pessimistic when the market
goes down. Hence, prices fall too much on bad news and rise too much on good news. And
in certain circumstances, this can lead to extreme events.

Behavioral Finance seeks to identify market conditions in which investors are likely to
overreact or underreact to new information. These mistakes can cause mispriced securities.
And the goal of Behavioral Finance strategies is to invest in these securities before most
investors recognize their error - and to benefit from the subsequent jump in price once they
do.

Of course it is more likely that some combination of the above is behind a investor reaction
for example stock market crashes may be explained using prospect theory and investor
over-reaction.

The attractive feature of Behavioral Finance investment strategies is that they have an
advantage over most traditional approaches to investing. Most investors use information-
based strategies. They try to generate good returns by acquiring better information about
companies or by processing information better than their peers through a unique,
quantitative strategy. But gaining advantages through these methods is becoming
increasingly difficult. A combination of the Internet and the increasing power of
microprocessors is making information more readily available and easier to process for all
investors.

Behavioral Finance strategies, however, take advantage of human behavior – and human
behavior changes very slowly. The brain has evolved over centuries, its approach to solving
complex problems, and the tools it uses to solve them, are unlikely to change in the near
future. And Behavioral Finance investors will be waiting to take advantage when mistakes
are made.