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Economic Psychology » Finance Topics
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Key observations made the behavioral finance literature include
the lack of symmetry between decisions to acquire or keep resources,
called colloquially the "bird in the bush" paradox, and
the strong loss aversion or regret attached to any decision where
some emotionally valued resources (e.g. a home) might be totally
lost. Loss aversion appears to manifest itself in investor behavior
as an unwillingness to sell shares or other equity, if doing so
would force the trader to realise a nominal loss (Genesove &
Mayer, 2001). It may also help explain why housing market prices
do not adjust downwards to market clearing levels during periods
of low demand.
Applying a version of prospect theory, Benartzi and Thaler (1995)
claim to have solved the equity premium puzzle, something conventional
finance models have been unable to do.
Behavioral finance models
- Some financial models used in money management and asset valuation
use behavioral finance parameters.
- Thaler's model of price reactions to information, with three
phases, underreaction - adjustment - overreaction, creating a
price trend
- The stock image coefficient
Criticisms of behavioral finance:
Critics of behavioral finance, such as Eugene Fama, typically
support the efficient market theory. They contend that behavioral
finance is more a collection of anomalies than a true branch of
finance and that these anomalies will eventually be priced out of
the market or explained by appeal to market microstructure arguments.
However, a distinction should be noted between individual biases
and social biases; the former can be averaged out by the market,
while the other can create feedback loops that drive the market
further and further from the equilibrium of the "fair price".
A specific example of this criticism is found in some attempted
explanations of the equity premium puzzle. It is argued that the
puzzle simply arises due to entry barriers (both practical and psychological)
which have traditionally impeded entry by individuals into the stock
market, and that returns between stocks and bonds should stabilize
as electronic resources open up the stock market to a greater number
of traders. In reply, others contend that most personal investment funds are managed through superannuation
funds, so the effect of these putative barriers to entry would be
minimal. In addition, professional investors and fund managers seem
to hold more bonds than one would would expect given return differentials.
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