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  1. Behavioral Finance: Introduction
  2. Behavioral Finance: Background
  3. Behavioral Finance: Anomalies
  4. Behavioral Finance: Key Concepts - Anchoring
  5. Behavioral Finance: Key Concepts - Mental Accounting
  6. Behavioral Finance: Key Concepts - Confirmation and Hindsight Bias
  7. Behavioral Finance: Key Concepts - Gambler's Fallacy
  8. Behavioral Finance: Key Concepts - Herd Behavior
  9. Behavioral Finance: Key Concepts - Overconfidence
  10. Behavioral Finance: Key Concepts - Overreaction and Availability Bias
  11. Behavioral Finance: Key Concepts - Prospect Theory
  12. Behavioral Finance: Conclusion

By Nathan Reiff

The fact that regularly occurring anomalies in conventional economic theories exist helped to prompt the development of behavioral finance. These anomalies seem to directly violate modern financial and economic theories that assume rational and logical behavior among participants. In this chapter, we’ll explore some of the anomalies in these theories.

January Effect
The January effect is so named because the average monthly return for small firms is consistently higher in January than for any other month in the year. This phenomenon goes against the efficient market hypothesis, which predicts that stocks should move at a "random walk." (For related reading, see the Financial Concepts tutorial.)

One of the major departure points from which the January effect theory was established was a 1976 case study by Michael S. Rozeff and William R. Kinney. Rozeff and Kinney found that between 1904 and 1974, the average January returns for small firms was roughly 3.5%, while returns for all other months was closer to 0.5%. They reported their findings in a paper called “Capital Market Seasonality: The Case of Stock Returns.” Their findings suggest that the monthly performance of small stocks actually follows a relatively consistent pattern (even if the returns themselves are not necessarily consistent between January and other months). This consistency is contrary to the predictions made by conventional financial theory. Therefore, Rozeff and Kinney believed that an unconventional factor was at play and helped to contribute to the above-average January returns year after year.

There are a few possible explanations for a surge in January. One holds that this boost comes as a result of investors who sell off dead-end stocks in December in order to achieve tax losses. This may lead to returns bouncing back up in January, while investors have less of an incentive to sell. This may be an important factor, but it’s not the only one: indeed, the phenomenon still exists in places where capital gains taxes do not occur. (To read more, see A Long-Term Mindset Meets Dreaded Capital Gains Tax.)

The Winner’s Curse
Conventional financial theory assumes that investors are rational enough to individually assess the true value of an asset and that they will then bid or pay accordingly. However, anomalies in these theories suggest that this may not always be the case. The so-called “winner’s curse” is one of them.

The winner’s curse is a tendency for the winning bid in an auction setting to actually exceed the intrinsic value of the item purchased. Obviously, this flies in the face of the assumption that investors will only pay the true value for an asset.

Conventional theories assume that all participants taking part in the bidding process will have access to all of the relevant information and that they will also all come to the same valuation for the item in question. This means that any differences in the pricing of the item would suggest some other factor which is not directly tied to the item itself is exerting an effect on the bidding.

Richard Thaler, behavioral finance pioneer, wrote a 1988 article on the winner’s curse in which he proposed two primary factors which undermine the rationality of the bidding process: the number of bidders and the aggressiveness of the bidding itself. As an example, the more bidders involved in the process, the more aggressively each bidder must act in order to dissuade others from bidding. As a corollary, increasing the aggressiveness with which you place bids will also increase the likelihood that a winning bid will ultimately exceed the value of the asset in question.

A real-life example of the winner’s curse can be seen in the case of prospective homebuyers bidding for a house. While it’s possible that all parties involved are rational, and that each knows the home’s true value based on studies of recent sales of comparable homes in the area, valuation error can still occur. A number of variables, including aggressive bidding and the presence of multiple bidders, can contribute to this effect. The result is that the sale price of a home is regularly 25% or more above the true value of the home. In this example, the curse manifests in two ways: not only has the winning bidder actually overpaid considerably, but now that buyer may have a more difficult time securing financing. (For related reading, see Shopping For A Mortgage.)

Equity Premium Puzzle
One of the most confounding anomalies to conventional financial theory is the equity premium puzzle. According to the capital asset pricing model (CAPM), investors holding riskier financial assets should be compensated with higher rates of returns. (For more insight, see Determining Risk And The Risk Pyramid.)

Long-term studies have revealed that, over a 70-year period, stock yields are, on average, in excess of government bond returns by 6-7%. Stock real returns are 10%, while bond real returns are about 3%. However, academics hold that an equity premium of 6% is extremely large and would imply that stocks are considerably risky to hold in comparison with bonds. According to conventional economic models, this premium should actually be much lower. The disconnect between theoretical models and empirical results is a major puzzle, and it confounds academics to this day.

Behavioral finance has proposed a solution to the equity premium puzzle. This answer suggests that the tendency for people to have “myopic loss aversion,” a situation in which investors who are overly preoccupied by the negative effects of losses in comparison to an equivalent amount of gains, tend to take a short-term view on an investment. This results in those investors paying far too much attention to the short-term volatility of their stock portfolios. Thus, a myopic (i.e., shortsighted) investor might react negatively to downside changes, even though it’s common for average stocks to fluctuate by several percentage points in either direction over a very short span of time. Because of this, behavioral finance theorists believe that equities must yield a high-enough premium in order to compensate for the investor’s outsized aversion to loss. In this way, the equity premium is seen as an incentive for market participants to invest in stocks instead of somewhat safer government bonds.

The above anomalies are just a few of the real-world situations that behavioral finance has attempted to explain. There are many other similar irrational or unpredictable phenomena which behavioral finance has so far not attempted to address. None of this is to say, of course, that conventional financial theory is not valuable; rather, the addition of behavioral financial theory can help to provide additional clarification as to how investor behavior plays out in the real world.

Behavioral Finance: Key Concepts - Anchoring
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