A survey of behavioural finance
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A survey of behavioural finance
A Survey of Behavioral FinanceNicholas Barberis and Richard ThalerSeptember 2002*AbstractBehavioral finance argues that some financial phenomena can p A survey of behavioural finance plausibly he understood using models in which some agents are not fully rational. The field has two building blocks: limits to arbitrage, which argues that it can be difficult, for rational trailers to undo the dislocations causer! by less rational traders: and psychology. which catalogues the kinds A survey of behavioural finance of deviations from full rationality we might expect to set'. We discuss these two topics, and then present a number of behavioral finance applicationA survey of behavioural finance
s: to the aggregate stock market, to the cross-section of average returns, to individual trading behavior, and to corporate finance. We close by assesA Survey of Behavioral FinanceNicholas Barberis and Richard ThalerSeptember 2002*AbstractBehavioral finance argues that some financial phenomena can p A survey of behavioural finance inides. Milt Harris and Rene Stnlz. We are very grateful to Markus Brunnenneier, George Constantinides, Kent Daniel, Milt Hanis. Ming Huang, Owen Lamont, Jay Ritter. Andrei Shleifer. Jeremy Stein and Tuoino Vuoltccnaho for extensive comments.I1 IntroductionThe traditional finance paradigm, which und A survey of behavioural finance erlies many of the other articles in this handbook. seeks to understand financial markets using models in which agents are “rational”. Rationality meaA survey of behavioural finance
ns two things. First, when they receive new information, agents update their beliefs correctly, in the manner described by Bayes' law. Second, given tA Survey of Behavioral FinanceNicholas Barberis and Richard ThalerSeptember 2002*AbstractBehavioral finance argues that some financial phenomena can p A survey of behavioural finance tility (SEU).This traditional framework is appealingly simple, and it would be very satisfying if its predictions were confirmed in the data. Unfortunately, after years of effort, it has become clear that basic facts about the aggregate stock market, the cross-section of average returns and individu A survey of behavioural finance al trading behavior are not easily understood in this framework.Behavioral finance is a new approach to financial markets that has emerged, at least iA survey of behavioural finance
n part, in response to the difficulties faced by the traditional paradigm. In broad terms, it argues that some financial phenomena can be better underA Survey of Behavioral FinanceNicholas Barberis and Richard ThalerSeptember 2002*AbstractBehavioral finance argues that some financial phenomena can p A survey of behavioural finance nets that underlie individual rationality. In some behavioral finance models, agents fail to update their beliefs correctly. In other models, agents apply Bayes' law properly but make choices that are normatively questionable, in that they are incompatible with SEU.1This review essay evaluates recen A survey of behavioural finance t work in this rapidly growing field. In Section 2. we consider the classic objection to behavioral finance, namely that even if some agents in the ecA survey of behavioural finance
onomy are less than fully rational, rational agents will prevent them from influencing security prices for very long, through a process known as arbitA Survey of Behavioral FinanceNicholas Barberis and Richard ThalerSeptember 2002*AbstractBehavioral finance argues that some financial phenomena can p A survey of behavioural finance aders interact, irrationality can have a substantial and long-lived impact on prices. These papers, known as the literature on ‘"limits to arbitrage,” form'It is important to note that most models of asset pricing use the Rational Expectations Equilibrium framework (REE), which assumes not only indi A survey of behavioural finance vidual rationality but also consistent. beliefs (Sargent, 1993). Consistent beliefs means that agents’ beliefs are correct: the subjective distributioA survey of behavioural finance
n they use to forecast future realizations of unknown variables is indeed the distribution that those realizations art* drawn from. This requires not A Survey of Behavioral FinanceNicholas Barberis and Richard ThalerSeptember 2002*AbstractBehavioral finance argues that some financial phenomena can p A survey of behavioural finance the correct distribution for the variables of interest.Behavioral finance departs from REE by relaxing the assumption of individual rationality. An alternative departure is to retain individual rationality but to relax the consistent, beliefs assumption: while investors apply Bayes’ law correctly, t A survey of behavioural finance hey lack the information required to know the actual distribution variables arc drawn from. This line of research is sometimes referred to as the liteA survey of behavioural finance
rature on bounded rationality, or on structural uncertainty. For example, a model in which investors do not know the growth rate of an asset’s cash HoA Survey of Behavioral FinanceNicholas Barberis and Richard ThalerSeptember 2002*AbstractBehavioral finance argues that some financial phenomena can p A survey of behavioural finance ionality, the approach is quite different.2one of the two buildings blocks of behavioral finance.To make sharp predictions, behavioral models often need to specify the form of agents’ irrationality. How exactly do people misapply Bayes law or deviate from SEE? For guidance on this, behavioral econom A survey of behavioural finance ists typically turn to the extensive experimental evidence compiled by cognitive psychologists on the blast's that arise whim people form beliefs, andA survey of behavioural finance
on people s preferences, or on how they make decisions, given their beliefs. Psychology is therefore the second building block of behavioral finance,A Survey of Behavioral FinanceNicholas Barberis and Richard ThalerSeptember 2002*AbstractBehavioral finance argues that some financial phenomena can p A survey of behavioural finance nance: to understanding the aggregate stock market, the cross-section of average returns, and the pricing of closed-end funds ill Sections I, 5 and 6 respectively: to understanding how particular groups of investors choose their portfolios and trade over time in Section 7: and to understanding the f A survey of behavioural finance inancing and investment decisions of firms in Section 8. Section 9 takes stock and suggests directions for future research.32 Limits to Arbitrage2.1 MA survey of behavioural finance
arket EfficiencyIII (he traditional framework where agents are rational and there are no frictions, a security's price equals its “fundamental value.”A Survey of Behavioral FinanceNicholas Barberis and Richard ThalerSeptember 2002*AbstractBehavioral finance argues that some financial phenomena can p A survey of behavioural finance here the discount rate is consistent with a normatively acceptable preference specification. The hypothesis that actual prices reflect fundamental values is the Efficient Markets Hypothesis (EMH). Pul simply, under this hypothesis, “prices are right,” in that they are set by agents who understand Ba A survey of behavioural finance yes’ law and have sensible preferences. In an efficient market. there is “no free lunch": no investment strategy can earn excess risk-adjusted averageA survey of behavioural finance
returns, or average returns greater than are warranted for its risk.Behavioral finance argues I fiat some features of asset prices are most plausiblyA Survey of Behavioral FinanceNicholas Barberis and Richard ThalerSeptember 2002*AbstractBehavioral finance argues that some financial phenomena can p A survey of behavioural finance A long-standing objection to this view that goes back to Friedman (1953) is that rational trailers will quickly undo any dislocations?Thc idea, now widely adopted, that behavioral linance rests Oil the two pillars of limits to arbitrage arid investor psychology is originally due tn Shleifer and Summ A survey of behavioural finance ers (1990).'We draw readers' attention to two other recent surveys of behavioral finance. Shleifer (2000) provides a particularly derailed discussionA survey of behavioural finance
of the theoretical and empirical work on limits to arbitrage, which we summarize in Section 2. Ilirshleifer's (2001) survey is doser to ours in terms A Survey of Behavioral FinanceNicholas Barberis and Richard ThalerSeptember 2002*AbstractBehavioral finance argues that some financial phenomena can p A survey of behavioural finance the material somewhat differently.3caused by irrational traders. To illustrate the argument, suppose that the fundamental value of a share of Ford is $20. Imagine that a group of irrational traders becomes excessively pessimistic about Ford’s future prospects and through its selling, pushes the pric A survey of behavioural finance e Io $15. Defenders of the EMH argue chat rational traders, sensing an attractive opportunity, will buy the security at its bargain price and at the sA survey of behavioural finance
ame time, hedge their bet by shorting a “substitute" security, such as General Motors, that has similar cash flows to Ford in future states of the worA Survey of Behavioral FinanceNicholas Barberis and Richard ThalerSeptember 2002*AbstractBehavioral finance argues that some financial phenomena can p A survey of behavioural finance it has not survived careful theoretical scrutiny. In essence, it is bast'd on two assertions. First, as soon as there is a deviation from fundamental value in short, a mispricing an attractive investment opportunity is created. Second, rational traders will immediately snap up the opportunity, there A survey of behavioural finance by correcting the mispricing. Behavioral finance does not take issue with the second step in this argument: when attractive investment opportunities cA survey of behavioural finance
ome to light, it is hard to believe that they are not quickly exploited. Bather, it disputes the first step. The argument, which we elaborate on in SeGọi ngay
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