Behavior Finance

im going to discuss about the financial market and show how behavior finance provide explanations why people make irrational financial decisions.

According to Fama, the efficient-market hypothesis (EMH) asserts that financial markets are "informationally efficient", so security prices always fully reflect the available information in this situation investors are rational and they value each security for its foundamental value and they quickly respond to new information by bidding up prices when the new is good and bidding down prices when the new is bad.

But we know it's not like this.... Investors are not fully rational. Many investors react to irrelevant information in forming their demand for securities, they trade on noise rather than information!!

So if we take in consideration the behavior finance... we can see that the imperfections of financial markets depends on

- Limits to arbitrate: many securities do not have perfect or even good substitutes, making arbitrage risky;

- Psychology: explains the kinds of deviations from full rationality.

If we consider the psychology point of view , we can find some possible explanations such as:

- regret theory, according to this theory investors avoid selling the security as a way to avoid the regret of having made a bad investment

- Over /under reacting: investors get optimistic when the market goes up, conversely, investors become extremely pessimistic during downturns; so this can create buying or selling panic

- Overconfidence: people generally rate themselves as being above average in their abilities. Many investors think they can consistently time the market;

- Herd behavior: the tendency for individuals to mimic the actions (rational or irrational) of a larger group;

- loss aversion: refers to people's tendency to strongly prefer avoiding losses to acquiring gains. This explains also why investors hold on to losing stocks because people often take more risks to avoid losses than to realize gains. For this reason, investors willingly remain in a risky stock position, hoping the price will bounce back.