TABLE OF CONTENTS
II. Modern Finance
III. Emergence of Behavioural Finance
IV. Behavioural Factors
V. Criticism of Behavioural Finance
Shortly after Nokia announced that earnings and growth will be lower for one quarter due to its product cycles, the market responded (July 27, 2000) by trading nearly 3% of the companies entire cap and thereby erasing nearly $70 billion in market capitalisation. That means that although the company’s earnings per share where up 77% over the previous year, the share price went down 27% on 121 million shares traded, because of one single announcement. How is this to explain?
First the theory of modern finance will be described. Then the text continues with the mergence of behavioural finance and the third part presents some of the behavioural factors that influence decision making according to behavioural finance. Criticism of behavioural finance will follow and the assignment will end with my conclusion.
II. MODERN FINANCE
Over the last decades, the modern finance acted on the assumption that the stock market consists of strictly rational, predictable and unbiased operating individuals, who seek to maximise returns. Specialised economic knowledge is indispensable for the investors and calculation as well as analysis are their most important tools. Moreover, markets are efficient and all financial values have a clearly calculable fair value. This way, the market price of an item is the only possible price and reflects exactly and fully all available information. Two influential thinkers regarding this theory are Harry Markowitz with his fundamental work on diversifying risks in money and capital markets (1952) and William Shape, who introduced the Capital Asset Pricing Model (1964).
Over the years, investors working at the stock market agreed that the theory idealises the “true world” by ignoring irrational occurrences. Furthermore, investors are relying on a set of asset pricing models, for which little support and theory exists.
III. EMERGENCE OF BEHAVIORAL FINANCE
Already 1900 Louis Bachelier claimed that stock prices follow a random walk. But it was not before 1972 that the first seminal paper was published by Slovic and Baumann, supported in 1979 by Kahnemann and Tversky’s (both psychologists) publication of the prospect theory definitely questioning the assumptions of the modern finance theory.
Thaler (1993) describes behavioural finance as “simply open-minded finance” claiming that “sometimes in order to find a solution to an [financial] empirical puzzle it is necessary to entertain the possibility that some of the agents in the economy behave less than fully rational some of the time”.
Behavioral finance got more and more popular as it got more complicated to explain the real situation (currency under-valuation, price bubbles etc.) at the stock market using approved methods. In 2002, Kahnemann (Tversky already died) received the Nobel Price for economy for his long-time research in this particular field.
Research in behavioural finance, as the application of psychology to finance, has shown that markets are not completely efficient and people are often not behaving rationally. It studies and tries to understand the behavioural factors that impact the decision making process of individuals as well as groups, and contribute to market anomalies for possibly using them in investment strategies.
 Behavioral Finance – Theory and Practical Application, Hubert Fromlet, Business Economics 2001, Vol.36, No.3
 Corporate Finance, Michael Keaney, Course Material, Mercuria Business School