A Survey of Behavioral Finance

A Survey of Behavioral Finance

By: Nicholas Barberis and Richard Thaler

            Barberis and Thaler discuss the results of the behavioral finance, a fairly new field of finance compared to the traditional finance paradigm.  The key difference between behavioral finance and the traditional finance paradigm is rationality.  The traditional finance paradigm assumes rational individuals.  Rationality means two things.  First, when presented with new information, agents update their beliefs accordingly.  Second, given their beliefs, agents make choices that are normatively acceptable.  Behavioral finance considers when some agents are not rational.  Specifically, when one of the two tenets of rationality are relaxed.

            One of the two building blocks of behavior finance is limits to arbitrage.  A classic objection to behavioral finance is that when some agents don’t act rationally, the agents who do act rationally will prevent them from influencing prices for long due to arbitrage.  A series of theoretical papers suggests otherwise, showing that in an economy where rational and irrational investors interact, irrationality can have a long and substantial impact on prices.  This stands counter to the efficient markets hypothesis (EMH), where put simply, the “prices are right.” Limits to arbitrage suggest that mispricing does occur and can persist.  Some reasons these limits exist are the fundamental risks the arbitrageur faces, noise trader risks, and implementation costs.  Some evidence of the limits to arbitrage are twin shares, index inclusions, and internet carve-outs.

            The other building block of behavior finance is psychology.  The theory of limited arbitrage shows irrational traders can cause deviations from fundamental value, but psychology seeks to tell us why those traders act irrationally.  For guidance, economists consider extensive evidence compiled by cognitive psychologists on the systematic biases that arise when people form beliefs, and on people’s preferences.  Some of these beliefs that are particularly useful to behavioral finance are overconfidence, optimism and wishful thinking, representativeness, conservatism, belief perseverance, and anchoring.  A couple things to focus on when considering preferences are prospect theory and ambiguity aversion.

            Barberis and Thaler follow this overview by explaining some applications of behavioral finance.  The first is the aggregate stock market, where behavioral finance may help solve the equity premium puzzle and the volatility puzzle.  The second is the cross-section of average returns.  Behavioral finance may help explain some anomalies, such as the size premium, long-term reversals, the predictive power of scaled-price ratios, momentum, and event studies of earnings announcements, dividend initiations and omissions, stock repurchases, and primary and secondary offerings.  The third application is closed-end funds and comovement.  The fourth is investor behavior where irrationality and psychology can explain insufficient diversification, naïve diversification, excessive trading, the selling decision, and the buying decision.  The last application mentioned is corporate finance, where behavioral finance can address security issuance, capital structure, investment, and dividends.

            When De Bondt and Thaler (1985) published their paper, many scholars felt the best explanation was programming error.  Since then, most of the empirical facts are agreed upon but the interpretation of those facts in still in dispute.  Behavioral finance has been very helpful in understanding possible limits of arbitrage and bounded rationality.  Barberis and Thaler concede there are numerous degrees of freedom but note that rational modelers have just as many options to choose from.  There is only one scientific way to compare alternative theories, behavioral or rational, and that is with empirical tests.  They say we should be skeptical of theories based on behavior that is undocumented empirically.  Barberis and Thaler conclude by giving two predictions.  First, we will find out that most of our current theories, both rational and behavioral, are wrong.  Second, substantially better theories will emerge.