Critical analysis of the behavioural finance as a theory

Term Paper 2015 16 Pages

Economics - Finance


Table of contents

List of abbreviations

List of figures

1. Introduction
1.1. Problem description
1.2. Structure and boundaries

2. Modern and Traditional Finance Theory
2.1. Basic Classification
2.2. Emergence of Behavioural Finance
2.3. Anomalies on financial markets

3. Factors of Behavioural Finance
3.1. Overconfidence
3.2. Prospect Theory
3.3. Heuristics
3.4. Comfort of Crowds

4. Criticism of Behavioural Finance

5. Conclusion

I. Monographic
II. Essays/Articles in Miscellanies, Commentary
III. Articles in Newspapers or FACH Magazines
IV. Internet Sources

List of abbreviations

Abbildung in dieser Leseprobe nicht enthalten

List of figures

Fig. 1 Average annual returns loser vs. winner portfolio

Fig. 2 Prospect Theory Model

1. Introduction

1.1. Problem description

The process of making decisions on the financial market is influenced by various factors and involves a relatively complex behaviour. In general two factors drive the process, one the financial model, that represents the correlation of risk and return and second the internal factors determined by skill level, investment portfolio and education.1 This work at hand distinguishes between traditional and modern theory of financial markets. The Efficient Market Hypothesis (EMH) explains that investors act rationally and make economic decisions on a rational basis. These process of decision making is explained in the Expected Utility Theory and assumes that investors are doing everything to optimize their performances, which correlates with the term `homo oeconomicus`.2 The behavioural financial theory, taken as the modern theory, basically handles individual circumstances that result in decision makings on the market.3 This work at hand will work out the changes that proceeded over the years and try to explain which way is more sufficient for analysing and understanding occasions on the financial market. The aim is to impart, how behavioural finance tries to explain the financial market with help of models. Furthermore possible shortcoming or critics of these models shall be shown.

1.2. Structure and boundaries

In the beginning the theory of traditional and modern finance will be described. Then the text continues with the emergence of behavioural finance and points out the significance today. In the third part behavioural factors that have influence on decision making processes according to behavioural finance are presented. Afterwards a critical analysis of behavioural finance will follow and give pros and cons regarding modern and traditional theories. In the end the assignment will end with a conclusion. Due to the scale of the thesis, it will focus on behavioural finance aspects and cannot describe traditional finance theory in detail.

2. Modern and Traditional Finance Theory

2.1. Basic Classification

In the recent past modern finance assumed that individual on the stock markets act predictable, unbiased and especially rational, who are looking to optimise their benefits. In order to handle their jobs, investors have special economic knowledge and are skilled in calculation and analysis tools for wide understanding of the market. In theory, markets work efficiently and assets have a calculable fair value, which can be considered by on concept,” price equals expected discounted payoff”.4 That means that an asset´s market price is the one particular price and includes all accessible information. Regarding this theory there are two influential persons, Harry Markowitz with his work about diversifying risks on capital and money markets in year 1952 and the other was William Shape with his Capital Asset Pricing Model (CAPM) in year 1964.5 For decades financial market participants committed fully to this theory and thought that this reflects the current situation, irrational occurrences were ignored. The idea of rational behaviour on markets is based on EMH and has been used to formulate economic models and theories, but with gaining significance of psychological and behavioural science this way of thinking was challenged.6

2.2. Emergence of Behavioural Finance

The first occasion was dated in year 1900 when Louis Bachelier stated that stock prices take course in a random way. But with the publication of the prospect theory in year 1979 by psychologists Kahnemann, D. and Tversky, A. the first components of behavioural finance was published and the former assumptions of then modern finance were questioned.7 Thaler, R. gives the following definition of behavioural finance,” a new approach to financial markets … has emerged at least in part in response to difficulties faced by the traditional paradigm. In broad terms, it argues that some financial phenomena can be better understood using models in which some agents are not fully rational.”8 As it got more complicated to explain the various situations, like occasions as price bubbles or currency under-valuation, behavioural finance got more popular at stock markets by using approved methods. In the year 2002, Kahnemann was honoured by the Nobel Prize for his Research in this certain field (Tversky died in 1996).9

2.3. Anomalies on financial markets

There are different anomalies on financial markets, in the following three of them will be presented. At first, the size effect was documented by Banz, R. in year 1981 and in literature it is often called “the size premium” or “small firm effect”.10 The size effect describes the difference of return between portfolios of so called small caps and large caps. Large-cap portfolios include stocks from companies with a higher market value, companies with a market capitalisation of more than two billion Euros, small-cap portfolios include stocks form companies with a market capitalisation below 500 million Euros.11 The observation Banz, R. made was that small caps make an averagely higher return than large caps.12

The next anomaly can be explained by referring to a study by De Bondt, W. and Thaler, R. in year 1985. In this study, all stocks traded between year 1926 and 1982 on the NYSE were ordered every three years on their cumulative three year interest rate and then formed into two different portfolios. One was a “winner” portfolio with the top 35 stocks and a “loser” portfolio with the 35 worst performing stocks.13 With regard of the average return of these two portfolios, they observed that the loser portfolio performed better than the market by 19,6% after a holding it the period of 36 months, while the winner portfolio made shares of 5% below the market value. Thus, it showed a difference of 24.6% in total.14 This is shown in the following figure.

Abbildung in dieser Leseprobe nicht enthalten

Fig. 1 Average annual returns loser vs. winner portfolio15

This observation that the loser had higher average annual returns than the winner, is also called "Long-term reversals" or "winner-loser effect".16

The third anomaly is called momentum and describes the short term development of stock values in the same direction. A study made by Jegadeesh, N. and Titman, S. from 1993, they formed share frequency scale based on their six-month return. Then they calculated the average six-month return based on the portfolio information. The study´s result was that the frequency scale with the highest previous winners surpassed the previous biggest losers on an average higher return of 10% on an annual basis.17

3. Factors of Behavioural Finance

There are different influences on individual decision makings and therefore ensuing behaviour. The whole process of how information is stored, requested and implemented provides enough fragility that problems like manipulation can occur. In theory there are different kinds of errors that describe such a manipulation and its impact on the financial market.

3.1. Overconfidence

Overconfidence describes people that are too confident in judging and self-assurance. There are studies that support this assumption, for example 85% of Frenchmen estimate that they are above-average lovers, and without the overconfidence effect that figure would be exactly 50%.18 Particularly experts overestimate their skills by estimating to have valuable information that provides them advantages over the market and other investors. Investors are more convinced by self-developed information than public information to support their decision making. That means they overestimate their own forecasts, which leads to a selective point of view, which reduces external influence. Additionally it is assumed, that public information change investors´ confidence in an asymmetric way, which is called "self-attribution bias".19 If the public information randomly confirms the analysis of investors, then they trust their own investigations much more. The confidence of investors in their own analyses remains unchanged even when newer public information refutes the results of their own analyses.20

Investors therefore trust only their own analyses. When your own information is positive, then investors the stock price too far in relation to the fundamental values push up. Public information but after a little time Delay correct the course. This development will generate the long-term reversals.21 In addition, the authors assume that public confidence information of investors and in terms of their private information in an asymmetric way Change way. This phenomenon is known as the "self-attribution bias". If the public information (random) confirms the analysis of investors, then trust it their own investigations much more.


1 Cp. Sudarma, M., et al (2014, p. 1.

2 Homo economicus is the figurative human being characterized by the infinite ability to make rational decisions.

3 Cp. Forbes, W. (2009), p. 9.

4 Cp. Celik, S., et al (2012), p. 142.

5 Cp. Fromlet, H. (2001), p. 135-142.

6 Cp. Bikas, E. (2013), p. 870-876.

7 Cp. Wakker, P.P. (2010), p. 231.

8 Thaler, R./ Barberis, N. (2003), p. 1053-1054; Baker, H.K./ Nofsinger, J.R. (2010), p. 192.

9 Frankfurter, G.M. (2003), p. 1-3.

10 Cp. Banz, R. (1981), p. 3-18.

11 Cp. http://www.welt.de/finanzen/vermoegenscheck/anlage-abc/article12999711/Was-Large-von-Small- Caps-unterscheidet.html, accessed on 24/03/2015.

12 Cp. Fama, E./ French, K. (1992), p. 427-465.

13 Cp. Barberis, N./ Thaler, R. (2003), p. 1085 f.

14 Cp. De Bondt, W./ Thaler, R. (1985), p. 800-801.

15 Source: taken from: De Bondt, W.; Thaler, R. (1985), p. 800.

16 Cp. Barberis, N./ Thaler, R. (2003), p. 1087.

17 Cp. Jegadeesh, N./ Titman, S. (1993), p. 65-91.

18 Cp. https://www.psychologytoday.com/blog/the-art-thinking-clearly/201306/the-overconfidence-effect, accessed on 23/03/2015.

19 Cp. http://www.europeanfinancialreview.com/?p=512, accessed on 28/03/2015.

20 Cp. Ackert, L.F./ Deaves, R. (2010), p. 151.

21 Cp. Barberis, N./ Thaler, R. (2003) p. 1085 f.


ISBN (eBook)
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University of Applied Sciences Essen
behavioural finance behavioral finance heuristics prospect theory financial markets Finanzmärkte finanzmarkt Verhalten



Title: Critical analysis of the behavioural finance as a theory