Behavioral finance examines investor behavior to understand how people make decisions, individually and collectively. Behavioral finance does not assume that investors always act rationally, but instead that people can be negatively affected by behavioral biases. Market efficiency does not require all market participants to act rationally as long as the market acts rationally in aggregate. If the market is able to quickly adjust for irrationality, then behavioral finance does not necessarily contradict market efficiency. However, if the market allows its participants to earn abnormal returns from the irrationality of others, then the market cannot be efficient.
Loss Aversion Bias
People have a tendency to dislike losses more than they like comparable gains. This may help to explain under-reaction and overreaction market anomalies.
Market participants tend to trade along with other investors, while potentially ignoring their own private information or analysis. This bias may also serve as a possible explanation for the under-reaction and overreaction market anomalies.
People tend to overestimate their ability to accurately determine intrinsic values, and may not process information appropriately as a result, which ultimately leads to mispriced securities. This mispricing has been shown to mainly take place in higher-growth companies, whose prices react slowly to new information.
Similar to herding, information cascade is the transmission of information from those participants who act first and whose decisions influence the decisions of others. As investors base the decisions on the actions of other investors acting before them, stock returns may be serially correlated and lead to over-reaction anomalies. Research has shown information cascades to be greater for companies with poor quality information.
Other biases include representativeness (overweighting current situation in making decisions), mental accounting (separately accounting for different investments and individual security gains/losses), conservatism (maintain prior views or forecasts despite new information), and narrow framing (viewing issues in isolation and responding based on how issues are posed).
A scientist runs a series of unweighted coin-flipping experiments with Bob, Bill, and Jane as test subjects. The scientist first invites Bob to wager $1 on the result of the coin flip, offering $3 if Bob is correct. Bob refuses. Bill, however, is willing to pay $1 for the chance to win $1.50 ($0.50 profit) on correctly calling heads or tails because he recently lost $5 in the casino and it is important that he break even on gambles for the day. Finally, the scientist does not ask Jane to wager money but instead offers her a choice of taking $0.50 or winning $1.00 if the next coin flip comes up heads. Jane takes the $0.50.
Which investor has acted rationally?
The correct answer is C.
Bob is likely affected by loss aversion as a 50% chance to win $3 is worth $1.50, but he wasn’t willing to wager $1. On the other hand, Bill is likely doing mental accounting because his previous losses are sunk costs and shouldn’t motivate him to make bets with a negative expected value (a 50% chance to win $1.50 is only worth $0.75). Jane would have made a perfectly rational decision as she should be indifferent between the two options. By taking the sure $0.50, she may have acted out of risk aversion, which is often accounted for in standard financial models and not irrational behavior.
Reading 46 LOS 46g:
Describe behavioral finance and its potential relevance to understanding market anomalies