This topic is pretty fresh. It represents an area not yet fully explored. Therefore, to say that this is the point and you can be sure of the information received is not yet possible. Why? What is this direction? What books can be read on the topic?
Introductory information
The difference between behavioral and traditional finance is:
- The objective perception of information.
- Adequacy of the approach to forecasts.
Simply put, some economists use specific indicators, while others believe that forecasting cannot be avoided. The second opinion belongs to proponents of behavioral economics. They believe that this is due to the ability to make mistakes when it is people who make forecasts. After all, in this case you have to use your memory and, reproducing the adoption of certain decisions, rely on its data.
At the same time, people do not really like to apply a logical analysis of the information that is available. This situation leads to errors. To minimize them by accounting, the theory of behavioral finance was invented. People are more often driven by emotions rather than logic. Thus, the psychology of investors has a greater influence on the price of stocks than fundamental indicators.
The study of Amos Tversky and Daniel Kahneman should be taken as the basis for considering this topic. Their insights and arguments appealed to a large number of behavioral economists. These colleagues have repeatedly proved that a person processes data inefficiently. People tend to make ridiculous and quick decisions. This occurs much more often than unhurried and logical conclusions based on adequacy and objectivity. So, among traders more often there is an understanding of the market through faith in the best. In conjunction with the memory of the past and drawing parallels, taking into account signals, which are not a guarantee of the implementation of the forecast expected by the trader.
About models used in forecasting
It is not surprising that attempts to foresee the future are not without difficulties. Indeed, between behavior and movements there is an extremely close relationship. Predicting the psychology of the crowd is not easy. This issue began to be studied since the 40s of the last century. Nobody could achieve significant results in predicting the behavior of financial markets. But the attempts do not stop. To this day, enthusiasts are trying to achieve success in creating complex mathematical models that make it possible to accurately predict situations. Many people believe in the reality of this approach. In this case, psychology is relegated to the background.
So how does our brain make a decision? Behavioral finance, although it is known for skepticism, still deserves attention. As one interesting point, there is a desire to bring a small fact: the previously mentioned cognitive psychologist and physiologist Daniel Kahneman received the Nobel Prize in the economic field in 2002. Moreover, he seriously stands out among all who had the honor of being honored with her specialization alone. Of course, having a prize cannot prove that the theory is genuine. But this was the first step towards world recognition. But in general, this topic dates back to 1985, when behavioral finance arose as a science.
It is assumed that the use of its information makes it possible to take into account the irrational nature of investor activity in market conditions, explaining the behavior of objects in situations where classical dogmas cannot provide a clear explanation. And as a result, it will be possible to cope with the negative results of erroneous judgments, as well as illusions of perception. It is also possible with some success to anticipate the actions of other market participants, develop an effective investment strategy and achieve maximum effect on the directed and invested capital.
Subsequent development
It is not necessary to think that if the first article was published, then immediately behavioral finance on the stock exchange began to quickly raise activity for itself. Many experts met with the impossibility of explaining many phenomena that occur in the financial markets. Classical theories simply did not allow them to fit into the existing framework. At the same time, the idea expressed about the behavioral aspect attracted many. Therefore, a more detailed study of the relationship between the effectiveness of financial and economic activities and the personal characteristics of people began.
At the moment, more than one theory of behavioral finance has been created. They aim to clarify numerous facts when classical approaches diverge from practice. Among all the diversity, it should be noted that the following theories are considered the most promising:
- Perspective.
- Behavior of investors in the stock market.
- Noise trading.
- The influence of the psychological qualities of the trader on the effectiveness of operations.
These are worth considering theories and authors. Behavioral finance is not limited to them. But, nevertheless, they are the most interesting and complete formations. Although some thinkers deserve mention, for example, G. Simon. Behavioral finances and investors were of considerable interest to him, although during the years of his work they still had little idea about this, because they, as a separate science, had not yet taken shape. But, nevertheless, he was awarded the Nobel Prize for his research.
Prospect theory
The foundation was laid by Morgenstern and Neumann in 1944. Then they formulated the theory of expected utility. She is now the basis of a large number of financial models. But for traders, it is not she who is of primary interest. Within the framework of the topic, the theory of rational expectations is of greatest importance, which is an addition that explains the behavior of economic entities at the macro level.
According to the above hypotheses, the formation of people's expectations is carried out not on their own experience, but on the use of the information provided. For example, the government says it will take all measures necessary to combat inflation. At the same time, people should transform their own expectations according to the information received. Almost immediately, a lot of criticism arose that called into question the universality of such assumptions.
The most influential in this regard is the theory of perspectives, which was prepared by Kahneman and Tverki and presented to the public in 1979. It is used to explain and predict investor behavior in conditions of risk and uncertainty. The theory of prospects believes that market participants do not have rational behavior. It is an example of descriptive rather than normative analysis. At the same time, the fact that it is based on the results obtained during hundreds of experiments does not allow us to abandon it.
About research results
What conclusions did Kahneman and Tverka come to after work? They found that the sensations of individuals from acquisitions and losses of monetary sums, equal in absolute value, are asymmetrical. What does it mean? The pleasure of a person from acquiring a thousand dollars is much less than the frustration of losing it. And at the same time, the desire to avoid losses is weakly associated with the desire to shun risk. This leads to an interesting result.
So, avoiding losses in real life, people risk much less than if the activities were carried out in a strictly rational framework and sought to maximize utility in the implementation of actions. Also, the theory of perspectives promotes the point of view that it is not typical for people to evaluate probabilities. As a result, behavioral finance and bonds do not have a rational value. For example, the probability of events whose presence in the future is practically guaranteed or vice versa is underestimated. A situation is also possible when something is considered such that it never happens. Although there is a probability of their implementation (albeit small). All this contributed to the formation of the main provisions:
- The usefulness of each result should include an estimate of the corresponding probability. In this case, it is necessary to make an adjustment for the attitude of people to risk.
- Introduction of cost function. It is determined not by the total well-being of the subject, but by the values, which in a particular case are “losses” and “wins”, which are separated by “points of indifference”.
Prospect theory is used to explain the large number of anomalies that can be found on the market. The most illustrative examples include:
- The effect of predisposition.
- Increased risk premium.
- Asymmetry of price elasticity coefficients of demand.
Theory of behavior of investors in the stock market
We proceed to the next development. Its formation began with Schleifer's work “Ineffective Markets: An Introduction to Behavioral Finance”. It analyzes a lot of evidence of both inadequate and excessive reaction of investors to new data. When can it be?
An insufficient reaction is observed in cases of obtaining negative data, when quotes are reduced less than they should. In other words, the company's shares are overvalued. Their acquisition brings the investor a loss. An overreaction occurs when, after a series of positive data flows, the price rises excessively. And the object is overrated. At the same time, it brings losses to its owners. Changes occur under the influence of publicly available information.
Evidence of an inadequate or overreaction was obtained through numerous observations, which have been conducted since 1970 by a number of experts. For example, to refute or confirm the hypothesis of an effective market, they were received by Logran, Cutler, Poterb, Summers and many others. Schleifer proposed a model according to which it is possible to describe the process of forming an opinion among investors regarding the shares of certain companies. It is based on two factors:
- Conservatism of thinking.
- Misuse of probability theory models in practice.
How are they manifested? The effect of conservatism is an insufficient reaction of investors to the receipt of negative information, which should lead to a revaluation of shares. Behavioral supervision in the financial market has shown that bad news that does not correspond to prevailing beliefs is poorly perceived. Therefore, the reaction occurs late or limited. The improper use of probability theory models in practice is that, having a series of good news about the company, investors think that the positive trend will continue in the future. But if conviction is supported only by this, then the result is only a revaluation of assets and lower incomes of their owners.
Noise Trading Theory
It was first proposed to the world in 1968. Its main provisions were formulated in Black's work “Noise”. Further development of the theory involved Summers, Bradford, Schleifer, De Long. What is its essence?
Work in the stock market, when noise (rumors, unverified information, etc.) is used as the basis for making a decision, is opposed to an approach that is based on reliable and timely information. What does it look like in practice? When market participants are guided in their actions by unverified data and rumors, use the advice of pseudo experts, this means that they are noise traders. They carry out transactions. In this case, noise is taken as accurate data, although it is not. In other words, their behavior is not rational.
Often activities are carried out because, as Black said, “they like to trade.” It is this factor that contributes to an increase in activity. After all, if market prices would always be the result of adequate and reliable information, then in this case, obtaining additional profit is a difficult task. And stock trading in the form in which it is would lose all meaning.
But the effects in question do not end there. Behavioral finance within the framework of this theory suggests that there must also be rational participants. For their designation, the phrase "information traders" is used. As a rule, the former are at a loss, while the latter make a profit. At the same time, information traders take into account the behavior of their “noisy” colleagues and seek to interact more with them than with their rational competitors. This theory contradicts almost all the most important provisions of classical finance. But stock practice calmly fits into its framework, although the very behavior of the market is unpredictable.
Theory of the influence of psychological qualities of a trader on the effectiveness of operations
When conducting research in the markets of Canada and the United States, a statistically significant correlation was established between the positive set of psychological qualities of a person and the success of his professional activities.
In accordance with this theory, success accompanies those who have a set of the following qualities:
- There is no desire to control the market and subordinate it to yourself.
- He feels an individual risk barrier - the limit values that he can take on. That is, the maximum amount of capital that can be put on the line without fatal consequences.
- They make thoughtful and adequate decisions, even in cases where the situation does not develop as planned.
- It takes into account the selectivity (selectivity) of memory and perception.
- It can recognize the state of stress and develop protective mechanisms against rash actions that can be taken in it.
- It has adequate self-esteem.
- May take into account the influence of negative tendencies, dispositions and attitudes.
- Avoids psychological attachment to the use of specific financial instruments.
- May give up instant profit to win in the long run.
- He has endurance and patience.
- He can plan the development of several, often opposite options for the development of events in the stock market.
- Able to focus on the goal and constantly act to achieve it on the basis of the decision.
- He has the skills to work with large amounts of information to avoid psychological overload.
- There is no psychological dependence on trade.
For acquaintance: the choice of literature
Behavioral finance, despite its relative novelty, is a fairly broad topic. And to fit absolutely everything within the framework of one article is a complicated matter.
And for those who want to know more, a full-fledged textbook is suitable. Behavioral finance has been well studied. They are well considered in the following works:
- Nikolay Rudyk: “Behavioral finance, or Between fear and greed.” This book shows very well how the irrational nature of man influences the decision-making process. It is considered how illusions affect the process of thinking and lead to systematic errors. Rudyk in Behavioral Finance pays attention to excessive self-confidence. As well as the delusion of a "hot hand", the effect of disposition and many other factors that only create problems.
- Sergey Filin: “Behavioral finance. Investors, companies, markets. ” This is an extensive work, which outlines the theme of evolution of views, the psychology of risk, the problem of inefficiency, asset pricing mechanisms, and much more. This will help lay a solid foundation for success if you learn and apply the material in the book. Behavioral finance and material from this work will be of interest to traders. Especially for those who have to work with assets and influence legislative and regulatory support.
- Semen Bogatyrev: “Behavioral finance. Tutorial". This book discusses the process of the emergence of this sphere, differences from the traditional direction, describes the tools used and shows how it can be used in practice in valuation, accounting, budgeting and trading.
But behavioral finance is not limited to this. The book can give a basic theoretical idea of the situation, but only practice will help to fully learn everything in the smallest details.
Criticism of theses under consideration
Considering everything exclusively in a positive way, you can not notice the negative aspects. ? : . , , . .
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