From Efficient Markets to Behavioral Finance
27 Pages Posted: 3 Feb 2004
Date Written: December 2003
In this paper I point out the role assumed by behavioral finance in order to explain financial market trend in the last few years, which doesn't seem to respect classical financial theory principles: price equals stock fundamental value.
The two approaches make two different assumptions. The efficient market theory assumes that:
a) investors are rational b) they have a complete information c) they maximize expected utility.
Behavioral finance asserts individuals are not always rational, hence it supplies new hypothesis on individuals preferences and it proposes a new expected utility theory (Prospect Theory). Such theory points out as individuals try to obtain the best for themselves and as individuals are characterized by cognitive bias in every decision making step. Therefore, considering human weaknesses, which push an individual into making anomalous selections, behavioral finance seems a more realistic approach.
In conclusion, investor rationality, which was assumed by efficient market hypothesis, just is an illusion, little by little this theory will be supplanted by behavioral finance.
Note: Downloadable document is in Italian.
Keywords: behavioral finance, efficient markets, limited arbritrage, prospect theory, disposition effect
JEL Classification: G10, G11, G12, G30
Suggested Citation: Suggested Citation