Importance of Behavioral Finance
YUEN Wai Pong Raymond
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.
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).
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.
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