In the past three decades, there two assumptions were based by the evolving of finance in the world, the first assumption was that people are rational, and they can make rational decisions, the other assumption was that people are unbiased in their predictions about the future (Nofsinger, 2002). Alternatively, compare with the traditional finance, behavioral finance considers that investors can be irrational, the financial decisions, corporations, and the financial markets could be affected by the emotions and cognitive biases from decision-maker (Nofsinger, 2002). Following, first of all, I will give a brief overview of the behavioral approach and the Expected Utility Hypothesis, EUH as well. Secondly, I will discuss the behavioral approach in detail, contrast its success and shortcomings, and show how the behavioral approach may affect the financial decision making.
â…¡.The Expected Utility Hypothesis
As mention above, traditional financial consider that decision-maker are rational and they should behave in order to maximize their wealth. The Effective Utility Hypothesis, which the model refers to the standard finance model, tells us how the rational decision-maker should behave, and it has become a criterion for rational decision making. Under the EUH, probabilities are assigned to states; the investors are assumed to make decisions based on a von Neumann Morgenstern utility function, which dependent only on the outcomes. Nevertheless, the hypothesis assumes that every individual has their unique information set which different from the other investors, and it also assumes that the individual might use the information in a rational way to maximize their utility. There are four axioms of the expected utility hypothesis that define a rational decision maker; they are comparability, transitivity, independence and certainty equivalent (Elton, Gruber, Brown and Goetzmann, 2003). Comparability assumes that an individual has well defined preferences and can always decide between any two alternatives. Transitivity means that if a decision maker decides according to the comparability axiom, this individual might also decides consistently. Independence assumes that two gambles mixed with a third one maintain the same preference order, means the two are independently of the third one. Certainty equivalent means that for every gamble there is a value called certainty equivalent, and the investor might indifferent between the gamble and the certainty equivalent (Elton, Gruber, Brown and Goetzmann, 2003). Levy mentions that there are three various attitudes toward risk, risk neutral, risk averter and risk seeker (2012).
â…¢.Behavioral approach
1. Overview
The expected utility hypothesis announced that people behave as if they are risk aversion. And it considered as the normative behavior for people to value a gamble at its expected value. However, in reality, people are not always risk adverse (Barber and Odean, 1998). In 1979, Daniel Kahneman and Amos Tversky developed an alternative model against the Expected Utility Theory, called prospect theory, and give a series of critiques of the EUH model (Kahneman and Tversky, 1979). In their paper, there three effects that might against the expected utility hypothesis, called the certainty effect, the reflection effect and the isolation effect. These effect also the crucial contradiction between the behavior approach and the EUH model. Except of the prospect theory, Brabazon also considers that human decision processes would affect by several cognitive illusions (Brabazon, 2000). Some illusions due to heuristic decision processes, and some illusions caused by the adoption of mental frames. Heuristic decision processes means that the decision making process is not as strictly rational as the Expected Utility Hypothesis considered. The decision maker takes mental 'short cuts' in the process because the relevant information is not perfectly collected and information can not be objectively evaluated. When there has limited available time for decision making, decision maker might follow Heuristic decision processes, which would result in poorer decision outcome. Generally, illusions that due to the Heuristic decision processes include representativeness, overconfidence, anchoring, gambler's fallacy and availability bias (Brabazon, 2000). Following, I will give a brief overview of the heuristic decision process and discuss the prospect theory in detail.
2. Aspects of Behavioral approach
2.1 Heuristic decision processes
As mention above, 'short cut' allow the decision maker to generate an estimate of the answer with all available information before making decision. Representativeness and familiarity are these kind of 'short cut', it allow investors to organize and quickly process large amounts of information, but whilst, it also make it hard for investor to generate the new information and lead to an incorrect decision (Nofsinger, 2002). Nevertheless, Nofsinger and Brabazon consider that representativeness is based on stereotypes, this means investors tend to assume that recent results will continue into the future. An example enumerated in Nofsinger's book that in financial markets, the stocks of good companies might not be a good investment. Sometimes, investors consider that companies with high levels of earning growth that drive its stock to a high price should be a good investment. However, cause of the representativeness, they ignore the fact that few companies can sustain this high levels of growth rate, so over time, the stock might fall because the investors figure out that they have been too optimistic in predicting future growth of the companies. Different from the representativeness, as the literal meaning, overconfidence means that investors overestimate their knowledge, underestimate the risks in markets, and believe that they can predict and control the market better than what they can do actually (Brabazon, 2000). Nofsinger suggests that there are two aspects to overconfidence. One of them is 'miscalibration', which means people might too certain about their answer, even they have no idea what the questions about. Indeed, it is what we called overconfident. Except of this, the other aspect of the overconfidence is 'better-than-average effect'. It means that people believe that their abilities, knowledge, and skills are better than the average, they have positive views of themselves, but unfortunately it is unrealistic (2000). Anchoring means that a value scale is fixed or anchored by recent observations ((Brabazon, 2000). This can lead to underreaction to trend changes. Gambles' fallacy appears when investors inappropriately predict that a trend will reverse. This bias leads the investors to anticipate the end of a run of market returns. Here is a classic example that, after tossing a coin, the result is head, head and head, people might tend to believe that the result of next toss must be tail, because they consider that there is a greater chance to toss a tail, however, they ignore the fact that the chance of tossing head or tail is the same (Nofsinger, 2000). Availability bias means that people place too much inappropriate weight on the available information that they can receive easily to make a decision. What I mention above give a brief overview of one aspect of the behavioral approach to illustrate how decision maker might act in the real life in a more appropriate way than the expected utility hypothesis. However, it does not mean that investors will suffer from the same illusion although the cognitive illusions above are widely observed ((Brabazon, 2000). Following, I will discuss the most well known theory of the behavioral approach, labeled prospect theory.
2.2 Prospect theory
Nofsinger has a view that many of the behaviors of decision maker in the world are outcomes of prospect theory which developed by the Kahneman and Tversky in 1979 to against the 'normative' model- the Expected Utility Hypothesis. Under prospect theory, people behave as if maximizing an S-shaped value function, different from the standard utility function, this S-shaped value function basis of gains and losses instead of levels of wealth. There are three properties that the value function is defines on deviations from the reference point, it is concave for gains and convex for losses, and it also steeper for losses than for gains (Kahneman and Tversky, 1979). This theory gives us an overview of how people make a decision under uncertainty (2000), and it also present a series of problems in which people's preferences violate the EUH model.
The first problem is called certainty effect; it means that people tend to overweight certainties (Kahneman and Tversky, 1979). However, in the expected utility hypothesis, it suggests that investor will make order of action rationally, and dependent on the outcomes' utility that is weighted by their probabilities. Moreover, there some examples that shown in Kahneman and Tversky's paper, one of them is that there are two options, A offer 2500 with the probability of 0.33, 2400 with probability of 0.66, and 0 with probability of 0.01; B offer 2400 for certainty. With the expected utility hypothesis, a 'rational' investor might order the action of A, because the average payoff of A is higher than B. However, with the opinion of prospect theory, it considers that the investor might prefer the certain one to the uncertain one. Evidently, this example gives us an experimental conclusion that people preferred a certain outcome to an uncertain outcome. Even if the uncertain outcomes offer a higher payoff, people still prefer the certain one. This is obviously in contradiction with the expected utility hypothesis, because it suggests that rational investors might prefer highest payoff.
Secondly, another critique mentioned by Kahneman and Tversky is labeled as the reflection effect. There is an alternative example present in the paper that if there two options, A might loss 4000 with the probability of 0.8, and B loss 3000 with certainty. Now, the investor might choose the first one, loss 4000 with uncertainty. This example tells us that if investors facing a gamble with positive outcomes, they might be risk averse, however, if they facing a gamble with negative outcomes, they become risk loving. As mention above, the expected utility hypothesis suggests that, the decision maker are always be risk averse, so it is in contrast with the prospect theory.
Thirdly, the last critique mentioned in paper called the isolation effect. It implies that when investors facing a complex problem like two options with the same probabilities and outcomes, the contingent certainty of the fixed return make the option more attractive than the risky venture (Kahneman and Tversky, 1979).
Nevertheless, Brabazon(2000) has a point of view that there are several states that might influence the investors' decision making process, including loss aversion, regret aversion, mental accounting and self control. Generally, loss aversion means that the mental penalty from a given loss is greater than the mental reward from a gain of the same size, the sadness from loss money is greater than the happiness from gain money. In the stock market, several studies have found that the traders in stock markets tend to hold the losing portfolio longer than the gaining portfolio. There is also evidence that people prefer to play safe when protecting gains but are willing to take risk in an attempt to reduce their loss. Loss aversion also can be considered as the reason of the sunk const effect which present the phenomenon that decision maker always like to include past costs when evaluating current decisions Brabazon(2000). Regret is the emotional pain that arises when decision maker realize that a previous decision turned out to be a bad one. Regret aversion suggests that people are desire to avoid the bad feeling of regret resulting from a poor investment decision. This aversion will make the decision maker to continue to hold the poorly performing shares (Nofsinger, 2002). The regret aversion may decrease the willing of investors to make new investment decisions in the markets that have performed poorly in the past. Mental accounting means that people tend to organize their information into separate 'mental accounts', like they treat each element of their investment portfolio separately which can lead to incorrect decision making Brabazon(2000). Our brain uses a mental accounting system similar to a file cabinet, the separation of mental accounting might influences the decisions in unexpected ways (Nofsinger, 2002). With the suggestion of mental accounting, we can explain that investors may be less willing to sell a losing investment because his 'mental account' telling him a loss. And investors may be risk adverse in their downside protection accounts and risk seeking in their more speculative accounts Brabazon(2000). The mental accounting can be explained by the imperfect investor self control. The self control problem can be considered as the interaction between two personal selves: the planner and the doer (Nofsinger, 2002). The planners prefer to complete the unpleasant tasks first, but the doer willing to consume now instead of unpleasant tasks.
Similar to prospect theory, in 1985, Shefrin and Statman extended the prospect theory to predict that investors will tend to hold their losing investments too long and sell their winners too soon because of their desire to avoid regret, and they labeled this phenomenon the disposition effect (Barber and Odean, 1998). In the stock market, suppose an investor purchases a stock that he believe it will appreciate a lot and can justify its risk. If the stock appreciates and he continues to use the purchase price as a reference point, than the stock price will be in a more concave, risk avers part of the investors' value function. If the stock declines, its price is in the convex, risk seeking part of the value function. Generally, the disposition effect also suggests that the investors will be a risk averse if they are gaining, and they will be a risk loving if they are losing. Selling winners too soon suggests that those stocks will continue to perform well after they are sold. Holding losers too long suggests that those stocks which decrease in price will continue to perform poorly (Nofsinger, 2002). Indeed, similar to the loss aversion which I mention above, the fear of regret and the seeking of pride decline the investors' wealth because investors are paying more in taxes because of the disposition to sell winners instead of losers and earn a lower return on their portfolio because they sell the winners too early and hold the portfolio which has poorly performing and seems to be continue.
â…£. Conclusion
