Behavioural Issues in Finance

Introduction

This paper explores behavioural issues in finance by reviewing key concepts and theories associated with financial market assessments. Key tenets of this essay contain discussions about the role of the modern portfolio theory, asset valuation metrics, and the efficient market hypothesis (EMH) in behavioural finance, including a review of the challenges of the capital asset pricing model in pricing stock returns or portfolio returns. The last part of this paper highlights the differences between behavioural and standard finance and explains the role of investor confidence in risk assessment processes.

Review of Modern Portfolio Theory, Asset Valuation, and EMH

Proposed by Harry Markowitz, the modern portfolio theory posits that investors could segment their risks into different portfolios to maximize their returns on investment.¹ This risk management philosophy premises on the understanding that risk is an inherent component of high rewards. Therefore, proponents of the theory believe that it is wrong to rely on one stock for investment because of its poor risk-reward ratio; instead, they argue that investors should diversify their risks by investing in different stocks to minimize their risk exposure.² While some investors religiously abide by this principle to protect their portfolios, some of them believe it is not a reliable framework for making the right investment decisions because it does not focus on the value of stocks purchased.³ Furthermore, they believe it does not consider market structures and their frameworks. Based on these inherent weaknesses, some financial market analysts propose the use of the asset valuation model to guide investment decisions.

The asset valuation model is preoccupied with the need to determine the fair value of stocks. The common principle of the concept is that the value of an asset is hinged on the current cash flow of the same. This principle applies to all types of assets, regardless of the typology. Based on its tenets, the valuation of a financial asset follows three key steps. The first one is the estimation of future cash flows. The second one is an evaluation of the interest rate that should be used to discount the projected cash flow numbers and the final one is an estimation of the cash flow, based on the established interest rates. Value investing has been highlighted as a unique concept in asset valuation because it helps investors to only buy stocks that are undervalued and sell them to make a profit.⁴ Investors who follow this principle argue that there is no other way for them to make a profit. Additionally, pundits posit that making a profit only depends on the experience and skills of investors to do something different from the majority.⁵ Based on this concept, the logical approach to use in making a profit is abiding by the principles of value investing, but this does not often happen because the judgment of investors is often clouded by institutional biases and irrational behaviour. Furthermore, investors are often prone to “herd mentality” when making investment decisions, thereby missing the point of the asset valuation model, which would have helped them to better estimate the value of their investments. Such irrational behaviours contradict one principle of the EMH, which states that asset prices often reflect the true value of all the information in the market.

The main assumption of the EMH is the improbability of “beating the market.” This principle premised on the view that investors are rational people and would logically use the information they have to make sensible investments. Relative to this discussion, Fama said there are three different levels of strengths for the EHM.⁶ The first one is the strong form EMH where all information relating to investment is freely available in the market and all investors can make their judgments or investment choices on the same. The second level of strength is the semi-strong form EMH that assumes that all relevant information relating to a stock price quickly reflects on it. The weak form of EMH is denoted by the availability of historical data relating to stock prices and investments.⁷ The basic assumption behind this principle is that future prices of stocks cannot be reliably predicted from an assessment of past or historical prices. It stems from the assumption that prices will always adjust to new information. Several researchers have disputed the application of this theory in contemporary finance. Some of their concerns will be highlighted in subsequent sections of this paper.

Challenges of the Capital Asset Pricing Model (CAPM) in Pricing Stock Returns or Portfolio Returns

Researchers have used the CAPM to estimate stock prices and portfolio returns. It suggests that risk and investment returns share a linear relationship. This model also advocates for a relationship between the return on investment, risk-free rate, and an asset’s beta.⁸ At the center of the model’s operations are several assumptions, which have been criticized by some economists as unrealistic. For example, the theory uses backwards returns to assess investment options, but this method is difficult to rely on because it does not represent future stock market returns.⁹ Another assumption underlying the CAPM is the ability of investors to borrow at a risk-free rate. In reality, it is difficult for investors to borrow money at no risk. Furthermore, it is difficult for individual investors to borrow at the same rate as governments would. Therefore, it is improbable to conceptualize a situation where the returns on investments would have a steep linear gain as the model proposes.

Is the Size Effect against EMH?

The size effect contradicts the principles of the EMH because when it is analyzed on a risk-adjusted basis, smaller companies would have greater returns compared to larger organizations.¹⁰ In other words, companies that have a smaller market capitalization value tend to yield better returns to their investors compared to those that have bigger market capitalization. Eugene Fama and Kenneth French espouse this view after demonstrating that companies, which have small capitalization levels in the bottom 30% of companies, outperformed their counterparts in the large 30% of capitalization by up to 4%.¹¹ The same trend was witnessed in stock market performance because small stocks had an average annual return of more than 15%, while large stocks had an average return of only 10%.¹² These statistics show that smaller stocks outperformed larger stocks by up to 50%. However, this finding is not absolute because studies have also shown that large stocks also outperform smaller ones. Here, the general understanding is that outperformance is volatile. Nonetheless, the effect size proved in the analysis shows that it is against EMH principles.

Differences between Behavioural and Standard Finance

Behavioural finance differs from standard finance on various metrics. The differences can be seen in their applications because investment and hedge fund managers use behavioural finance to understand their clients’ needs and investor behaviour, while standard finance is mostly applied to generic financial investment processes.¹³ Based on their various applications, it is essential to understand the main difference between both types of finance.

The first difference is the subject matter. Standard finance mostly focuses on how rational investors behave, while behavioural finance focuses on normal people. Behavioural finance is cognizant of how information is conveyed to investors because it recognises how it could lead to cognitive biases and emotional investment decisions. In this regard, this type of finance focuses on understanding why investors behave the way they do. Since some decisions made by investors are suboptimal, behavioural finance helps to explain the link between such decisions and inefficient markets. This difference partly explains why some markets are deemed a reflection of all available information relating to them. Comparatively, traditional finance differs from behavioural finance because it considers investors as rational people. Its tenets are largely explained in neoclassical economics.¹⁴ This field of finance aims to maximize the personal utility function of investment and premises on the need for rational investors to create efficient markets.

Based on the above-mentioned differences, standard finance and behavioural finance are premised on two different sets of principles and assumptions. Behavioural finance acknowledges capacity limitations to knowledge processing, limitations to decision-making; and the existence of bounded rationality and prospect theory. Comparatively, standard finance assumes that there is unlimited perfect knowledge in the market; utility could be maximized; decision-making could be fully rational, and risk aversion is an inherent part of economics. The influence of behavioural finance in investment relations seems to be dominating more debates about financial market analysis today. Multiple moderating factors, such as investor overconfidence, have been highlighted as possible influences on investment outcomes.

Does Overconfidence Cause Investors to Overestimate Their Knowledge and Underestimate Risks in Making Investment Decisions?

A study conducted by James Montier titled, “Behaving Badly” demonstrated that more than 70% of investors were overconfident about their financial decisions.¹⁵ About 26% of the same respondents believed that their performance was average, although only 50% of them could be above average. This analysis means that most of the investors were irrationally overconfident. This finding shows that most investors overestimate their knowledge of the markets and underestimate the risks associated with making investment decisions. This is a problem in investment analysis and it is partly explained by behavioural finance.

In terms of investing, overconfidence could lead traders to overestimate their knowledge of the markets – a process that could be detrimental to their stock-picking abilities in the long-run. Barber and Odean support this view by contending that many overconfident investors conduct more trades than their rational counterparts.¹⁶ This behaviour spills over into their investment actions because overconfident investors always believe that they know which stocks to buy or sell, and at which points they should exit and enter their trades. Nonetheless, Janovec says that evidence proves that their actions are wrong because overconfident investors who conduct more trades usually earn less than the markets.¹⁷ Based on these outcomes, researchers have associated overconfidence with several negative financial outcomes, including underinvestment, overinvestment, capital losses, and low investment returns.¹⁸ Nonetheless, the link between overconfidence and investment decisions is useful in this analysis to the extent that it could help people to understand individual risk aversion behaviour. It has also been used to comprehend the riskiness of investment decisions and articulate changes in the investment structure of organizations and investment firms.

Conclusion

In this paper, the researcher explored behavioural issues in finance by reviewing key concepts and theories associated with financial market assessments. This essay also contained discussions regarding the role of the modern portfolio theory, asset valuation metrics, and the efficient market hypothesis (EMH) in behavioural finance. The three frameworks of investment work towards achieving the same goal of helping investors to make the right decisions, but they differ in terms of principles, methodology, and assumptions. The CAPM also differs from the models mentioned above on the same grounds, but its inherent weaknesses stem from its reliance on risk-free rates to support investment decisions, which have been deemed unrealistic. In this regard, it has some weaknesses in stock pricing and the estimation of portfolio returns.

Broadly, all the financial investment models highlighted in this paper underscore the need to properly manage information and make rational choices when formulating investment decisions. This view explains the role of the EMH and its weaknesses, especially in the prediction of future stock prices. Behavioural finance is at the center of these discussions because, unlike traditional forms of finance, it accounts for human weaknesses in decision-making and highlights institutional biases when investing. Traditional forms of finance are generic and do not seem to consider the role of human behaviour in finance. This difference explains why behavioural issues in finance seem to take center-stage in most discussions that focus on investment analysis today.

Reference List

Athanassakos, G., ‘Value Investing Vs. Modern Portfolio Theory’, Journal of Business & Finance Affairs, vol. 1, no. 110, 2012, pp. 1-10.

Barber, B., and Odean, T., ‘Boys Will be Boys: Gender, Overconfidence, and Common Stock Investment’, The Quarterly Journal of Economics, vol. 116, no. 1, 2001, pp. 261-292.

Fabozzi, F., Gupta, F., & Markowitz, H., ‘The Legacy of Modern Portfolio Theory’, The Journal of Investing Fall, vol. 11, no. 3, 2002, pp. 7-22.

Fama, E., ‘Market Efficiency, Long-Term Returns, and Behavioral Finance’, Journal of Financial Economics, vol. 49, no. 1, 1998, pp. 283– 306.

Fama, E., and French, K., ‘Size, Value, and Momentum in International Stock Returns’, Journa of Financial Economics, vol. 105, no. 1, 2012, pp. 457-472.

French, J., ‘Back to the Future Betas: Empirical Asset Pricing of US and Southeast Asian Markets’, International Journal of Financial Studies, vol. 4, no. 15, 2016, pp. 1-10.

Janovec, M., ‘Integrated Supervision of the Financial Market without the UK’, International Journal of Financial Studies, vol. 6, no. 20, 2018, pp. 1-10.

Lipiec, J., ‘Capital Asset Pricing Model Testing at Warsaw Stock Exchange: Are Family Businesses the Remedy for Economic Recessions’, International Journal of Financial Studies, vol.2, no. 1, 2014, pp. 266-279.

Noddeboe, E., and Faergemann, H., ‘Positive Alpha and Negative Beta (A Strategy for Counteracting Systematic Risk)’, International Journal of Financial Studies, vol. 3, no. 1, 2015, pp. 431-450.

Omisore, I., Yusuf, M., and Christopher, N., ‘The Modern Portfolio Theory as an Investment Decision Tool’, Journal of Accounting and Taxation, vol. 4, no. 2, pp. 19-28.

Ronzani, A., Candido, O., and Maldonado, W., ‘Goodness-of-Fit versus Significance: A CAPM Selection with Dynamic Betas Applied to the Brazilian Stock Market’, International Journal of Financial Studies, vol. 5, no. 33, 2017, pp. 1-10.

Statman, M., ‘Behavioral Finance: Finance with Normal People’, Borsa Istanbul Review, vol. 14, no. 1, 2014, pp. 65-73.

Titan, A., ‘The Efficient Market Hypothesis: Review of Specialized Literature and Empirical Research’, Procedia Economics and Finance, vol. 32, no. 1, 2015, pp. 442 – 449.

Footnotes

1. F. Fabozzi, F. Gupta, and H. Markowitz, ‘The Legacy of Modern Portfolio Theory’, The Journal of Investing Fall, vol. 11, no. 3, 2002, pp. 7-22.
2. I. Omisore, M. Yusuf and N. Christopher, ‘The Modern Portfolio Theory as an Investment Decision Tool’, Journal of Accounting and Taxation, vol. 4, no. 2, pp. 19-28.
3. G. Athanassakos, ‘Value Investing Vs. Modern Portfolio Theory’, Journal of Business & Finance Affairs, vol. 1, no. 110, 2012, pp. 1-10.
4. G. Athanassakos, ‘Value Investing Vs. Modern Portfolio Theory’, Journal of Business & Finance Affairs, vol. 1, no. 110, 2012, pp. 1-10.
5. G. Athanassakos, ‘Value Investing Vs. Modern Portfolio Theory’, Journal of Business & Finance Affairs, vol. 1, no. 110, 2012, pp. 1-10.
6. E. Fama, ‘Market Efficiency, Long-Term Returns, and Behavioral Finance’, Journal of Financial Economics, vol. 49, no. 1, 1998, pp. 283– 306.
7. J. French, ‘Back to the Future Betas: Empirical Asset Pricing of US and Southeast Asian Markets’, International Journal of Financial Studies, vol. 4, no. 15, 2016, pp. 1-10.
8. J. Lipiec, ‘Capital Asset Pricing Model Testing at Warsaw Stock Exchange: Are Family Businesses the Remedy for Economic Recessions’, International Journal of Financial Studies, vol.2, no. 1, 2014, pp. 266-279.
9. E. Noddeboe and H. Faergemann, ‘Positive Alpha and Negative Beta (A Strategy for Counteracting Systematic Risk)’, International Journal of Financial Studies, vol. 3, no. 1, 2015, pp. 431-450.
10. E. Fama and K. French, ‘Size, Value, and Momentum in International Stock Returns’, Journal of Financial Economics, vol. 105, no. 1, 2012, pp. 457-472.
11. E. Fama and K. French, ‘Size, Value, and Momentum in International Stock Returns’, Journal of Financial Economics, vol. 105, no. 1, 2012, pp. 457-472.
12. A. Titan, ‘The Efficient Market Hypothesis: Review of Specialized Literature and Empirical Research’, Procedia Economics and Finance, vol. 32, no. 1, 2015, pp. 442 – 449.
13. M. Statman, ‘Behavioral Finance: Finance with Normal People’, Borsa Istanbul Review, vol. 14, no. 1, 2014, pp. 65-73.
14. A. Ronzani, O. Candido and W. Maldonado, ‘Goodness-of-Fit versus Significance: A CAPM Selection with Dynamic Betas Applied to the Brazilian Stock Market’, International Journal of Financial Studies, vol. 5, no. 33, 2017, pp. 1-10.
15. M. Janovec, ‘Integrated Supervision of the Financial Market without the UK’, International Journal of Financial Studies, vol. 6, no. 20, 2018, pp. 1-10.
16. B. Barber and T. Odean, ‘Boys Will be Boys: Gender, Overconfidence, and Common Stock Investment’, The Quarterly Journal of Economics, vol. 116, no. 1, 2001, pp. 261-292.
17. M. Janovec, ‘Integrated Supervision of the Financial Market without the UK’, International Journal of Financial Studies, vol. 6, no. 20, 2018, pp. 1-10.
18. B. Barber and T. Odean, ‘Boys Will be Boys: Gender, Overconfidence, and Common Stock Investment’, The Quarterly Journal of Economics, vol. 116, no. 1, 2001, pp. 261-292.