The Improvement of the Standard Economic Model by Psychological Factors

The Improvement of the Standard Economic Model by Psychological Factors

1. Introduction

During the past years the financial markets have been characterized by increasing volatility and fluctuations. The standard economic model which makes efficient market hypothesis and the rational man hypothesis as precondition regards the financial investment process as a dynamic equilibrium process, according to the balance principle derived the equilibrium model of investment market. But more and more data show that its theories are incomplete and unrealistic. The over-idealistic assumptions have been constantly questioned with the increasingly complex investment market environment. The behavioral finance which carries out theoretical analysis through the behavior of approaching true market utilizes psychological factors of individuals to bring challenges to the standard economic model. It indicates neither those investors are rational nor that markets are effective. And point out that due to the deviation of the cognitive processes, emotions, feelings, preferences and other psychological reasons, investors cannot make unbiased estimates in a rational manner. The importance of psychosocial factors in economic interactions is also revealed in the experimental economists' work on financial markets. This paper will through the behavioral finance's empirical and experimental research findings to discuss the influences of investment behavior's psychological factors to the standard economic model's assumptions.

2. The main assumptions of the standard economic model and their defects

Standard economic model is the body of knowledge built on the pillars of the arbitrage principles, the portfolio principles, the capital asset pricing theory and the option-pricing theory (Statman, M. 1999). These approaches consider markets to be efficient, highly analytical and normative.

Modern financial economic theory is based on the assumption that the representative market actor in the economy is rational in two ways: the market actor makes decisions according to the axioms of expected utility theory and makes unbiased forecasts about the future. In the expected utility theory, a person under the conditions of uncertainty are rational decision-making, risk averse and the utility function of a person is concave, such as the marginal utility of wealth decreases. Assets price are set by rational investors and consequently rationality based market equilibrium is achieved.

2.1 Hypothesis of rational man

The standard economic model thinks that investors are rational. They are full of wisdom, neither sentimental nor blindly. They have stable preferences, and their forecasts about the future are unbiased. Rational man hypothesis thinks that every person engaged in economic activities are self-serving, they try to use minimal economic costs of their own to get maximization of their own economic interests.

2.2 The efficient market hypothesis

According to the efficient market hypothesis (EMH), financial prices incorporate all available information and prices can be regarded as optimal estimates of true investment value at all times. In other words, the investment market can make quick and reasonable reaction for the continuous and unpredictable information flow.

This hypothesis is based on the notion that people behave rationally, maximize expected utility accurately and process all available information (Shiller, R. 1998). Financial assets are always priced rationally, given what is publicly known. Stock prices approximately describe random walks through time: the price changes are unpredictable since they occur only in response to genuinely new information, which by the very fact that it is new, is unpredictable (Shiller, R. J. 2000). Due to the fact that all information is contained in stock prices it is impossible to make an above average profit and beat the market over time without taking excess risk. EHM mainly depends on three basic assumptions. ○1 all investors of capital market are rational, they can evaluate the securities in rationality and the market is effective. ○2 even if there are irrational investors in the investment market, the trading behavior will be offset each other due to they are random, and thus will not form a systematic price deviations. ○3 even if the behavior of irrational investor does not offset each other, they will also be correct because of the investment behavior of rational arbitrageurs, so that asset prices return to fundamental value and will not have a material impact on the market.

2.3 Defects

Stringent conditions on these assumptions often have greater discrepancy to the actual situation. They are not actively guide people's behavior. EMH requires people to do nothing, as in the case of effective market everything is futile. But in this case, how information responded in the price and how the market to be effective?

There have been a number of studies pointing to market anomalies that cannot be explained with the help of standard financial theory, such as abnormal price movements in connection with mergers, stock splits and spin-offs. According to the efficient market hypothesis, stock price fluctuations cannot have obvious regularity and it impossibly appear huge fluctuations in the short term in the case of without a major announcement, so the EMH is flawed. In addition, rational arbitrage model utilizes the incorrect views of irrational speculators, through the "buy low and sell high" to keep stock price and base value consistent. It believed that rational arbitrageurs must prevail in the market, so that prices can fall to the base value quickly. However, many investors in the condition of incomplete information and knowledge and limited rationality, the assumption is clearly not true.

Facing to these shortcomings, economists introduce many psychological factors to the economic analysis and develop more sophisticated financial market theory.

3. The amendment for the standard economic model based on psychological factors of behavioral finance

Based on the above discussion, psychological factors have become the important factors of researching economic behavior, which is effectively put forward in behavioral finance. Behavioral finance is a new paradigm of finance, which seeks to supplement the standard theories of finance by introducing psychological aspects to the decision-making process. Contrary to the traditional economic theory, behavioral finance deals with individuals and ways of gathering and using information and seeks to understand and predict systematic financial