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YUEN is a finance professional with over 20 years practical experience in financial accounting, financial management and investment. He is a freelance trainer and grader. He also holds a PhD(Management) with research interest in market crash and Fractal Theory. He served Qualification Program of... More
  • Importance Of Behavioral Finance 0 comments
    Oct 11, 2013 2:44 AM

    Importance of Behavioral Finance

    YUEN Wai Pong Raymond

    Abstract

    This paper discusses the importance of behavioral finance in filling the gap that modern portfolio theory left exemplified by the existence of a lot of investment sagas.

    Body

    Behavioral Finance - A More and More Important Research Subject in Finance

    Behavioral finance is getting more and more attention for the understanding of behavior of investing public in the current capitalist world. A lot of investing paradoxes cannot be explained by the modern portfolio theory which is based on the cornerstone assumptions that all investors are rational and independent. Under the modern portfolio theory (Markowitz, 1952) followed by development of CAPM Model and APT Model, investors are assumed to be rational and independent and, as a result, it is very difficult to get alpha return from the market, i.e. efficient market hypothesis (Fama, 1970). The only important investment decision under the modern financial theory is to decide the allocation of investment between the efficient market frontier and risk free interest rate.

    The implication of efficient market hypothesis is that nobody can consistently beat the market and get a superior return in the long run. However, we see a lot of investment sagas such as Mr. Warren Buffett (Buffett and Clark, 2001), Mr. Peter Lynch (Lynch and Rothchild, 2000), Sir John Mark Templeton (Templeton and Scott, 2008) , Mr. Ginzo Korekawa (Ginzo, 1991), Mr. Andre Kostolany (Kostolany, 1996), Mr. Jim Slater (Slater, 2000), Mr. Jim Rogers (Rogers, 2004), Mr. George Soros (Soros and Volcker, 2003) , Mr. Philip Fisher (Fisher, 1997), using investment methods mentioned in the quoted books generating large extent of alphas… The list of these investment sagas is just too long to name all. If the modern portfolio theory is valid and the market is efficient to eliminate for all alphas within the stock market, what is the reason that there are so many superb investors in the market?

    As a result, a different school of finance theory known as behavioral finance was developed to explain this with leading scholars such as Kahneman, Daniel, and Amos Tversky in research on decision under uncertainty (Tversky and Kahneman, 1974) and Prospect Theory (Kahneman and Tversky, 1979).

    Conclusion

    In a nutshell, the behavioral finance espouses that investors are not always rational and sometime they are irrational. Under behavioral finance, there are a good number of theories developed including: prospect theory, loss aversion, disappointment, status quo bias, gambler's fallacy, self-serving bias, money illusion, cognitive framing, mental accounting, anchoring, disposition effect, endowment effect, inequity aversion, reciprocity, intertemporal consumption, present-biased preferences, momentum investing, greed and fear, herd behavior, and sunk-cost fallacy.(Wikipedia:Behavior Economics 25 Apr 2012).

    It seems that behavioral finance is a promising theory to fill the gap that left by modern portfolio theory in explaining the existence of so many investment sagas, and challenges whether the market is efficient.

    Bibliography

    Books

    • Buffett, Mary and Clark, David, The Buffettology Workbook: Value Investing The Warren Buffett Way (Chinese Translation Version), 2001
    • Fisher, Philip A., Common Stocks and Uncommon Profits (Wiley Investment Classics), 1997
    • Graham, Benjamin and Buffett, E. Warren , The Intelligent Investor: A Book of Practical Counsel, 1986
    • Kindleberger, Charles P., Aliber, Robert and Solow, Robert, "Manias, Panics, and Crashes: A History of Financial Crises (Wiley Investment Classics)", 2005
    • Kostolany, Andre, Weisheit eines Spekulanten - German (Chinese Translation Version) ,1996
    • Korekawa, Ginzo, Jiden haran o ikiru: Soba o kaketa rokujunen - Japanese (Chinese Translation Version), 1991
    • Lynch, Peter and Rothchild, John, One Up on Wall Street, 2000
    • Mackay, Charles, Extraordinary Popular Delusions, 2003
    • Rogers, Jim, Hot Commodities: How Anyone Can Invest Profitably in the World's Best Market (Chinese Translation Version), 2004
    • Slater, Jim, Zulu Principle (Chinese Translation Version), 2000
    • Soros, George and Volcker, Paul A., The Alchemy of Finance (Wiley Investment Classics) (Chinese Translation Version), 2003
    • Templeton, Lauren and Phillips, Scott, Investing the Templeton Way: The Market-Beating Strategies of Value Investing's Legendary Bargain Hunter (Chinese Translation Version), 2008
    • Train, John, The New Money Masters (Chinese Translation Version, 1994
    • Vega, Joseph de la, Confusion de Confusiones (Chinese Translation Version),1688

    Journals / Articles / Thesis / Papers

    • Barberis, Nicholas, Andrei Shleifer, and Robert Vishny (1998), A Model of Investor Sentiment, Journal of Financial Economics, 1998.
    • Fama, Eugene (1970), Efficient Capital Markets: A Review of Theory and Empirical Work, Journal of Finance, May 1970
    • Kahneman, Daniel, and Amos Tversky (1979) "Prospect Theory: An Analysis of Decision under Risk", Econometrica, XLVII (1979). (Paper is for download at www.princeton.edu/~kahneman/docs/Publications/prospect_theory.pdf)
    • Markowitz, H. M. (1952), Portfolio Selection, Journal of Finance, Mar 1952
    • Robert J. Shiller (2001), Bubbles, Human Judgment, and Expert Opinion, Yale University - Cowles Foundation ; National Bureau of Economic Research (NBER) ; Yale University - International Center for Finance, May 2001 (Paper for download at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=275515&download=yes)
    • Tversky, Amos, and Daniel Kahneman, "Judgment under Uncertainty: Heuristics and Biases," Science, 1974.
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