The process of making decisions on the financial market is influenced by various factors and involves a relatively complex behaviour. In general two factors drive the process, one the financial model, that represents the correlation of risk and return and second the internal factors determined by skill level, investment portfolio and education. This work at hand distinguishes between traditional and modern theory of financial markets. The Efficient Market Hypothesis (EMH) explains that investors act rationally and make economic decisions on a rational basis. These process of decision making is explained in the Expected Utility Theory and assumes that investors are doing everything to optimize their performances, which correlates with the term `homo oeconomicus`. The behavioural financial theory, taken as the modern theory, basically handles individual circumstances that result in decision makings on the market.
This work at hand will work out the changes that proceeded over the years and try to explain which way is more sufficient for analysing and understanding occasions on the financial market. The aim is to impart, how behavioural finance tries to explain the financial market with help of models. Furthermore possible shortcoming or critics of these models shall be shown.
Table of Contents
1. Introduction
1.1. Problem description
1.2. Structure and boundaries
2. Modern and Traditional Finance Theory
2.1. Basic Classification
2.2. Emergence of Behavioural Finance
2.3. Anomalies on financial markets
3. Factors of Behavioural Finance
3.1. Overconfidence
3.2. Prospect Theory
3.3. Heuristics
3.4. Comfort of Crowds
4. Criticism of Behavioural Finance
5. Conclusion
Objectives and Topics
This work explores the shift from traditional financial theories—based on the rational "homo oeconomicus"—to modern behavioural finance, aiming to explain how psychological factors and cognitive biases influence decision-making and market outcomes.
- The comparative analysis of Efficient Market Hypothesis (EMH) versus behavioural approaches.
- Identification of common market anomalies like the size effect and winner-loser reversals.
- Detailed examination of psychological factors including overconfidence, prospect theory, and heuristics.
- The role of social influence and herding behaviour (comfort of crowds) on market dynamics.
- Critical assessment of the limitations and challenges facing current behavioural finance models.
Excerpt from the book
3.1. Overconfidence
Overconfidence describes people that are too confident in judging and self-assurance. There are studies that support this assumption, for example 85% of Frenchmen estimate that they are above-average lovers, and without the overconfidence effect that figure would be exactly 50%. Particularly experts overestimate their skills by estimating to have valuable information that provides them advantages over the market and other investors. Investors are more convinced by self-developed information than public information to support their decision making. That means they overestimate their own forecasts, which leads to a selective point of view, which reduces external influence. Additionally it is assumed, that public information change investors´ confidence in an asymmetric way, which is called "self-attribution bias". If the public information randomly confirms the analysis of investors, then they trust their own investigations much more. The confidence of investors in their own analyses remains unchanged even when newer public information refutes the results of their own analyses.
Investors therefore trust only their own analyses. When your own information is positive, then investors the stock price too far in relation to the fundamental values push up. Public information but after a little time Delay correct the course. This development will generate the long-term reversals. In addition, the authors assume that public confidence information of investors and in terms of their private information in an asymmetric way Change way. This phenomenon is known as the "self-attribution bias". If the public information (random) confirms the analysis of investors, then trust it their own investigations much more. The confidence of investors in your own analyses remains unchanged even when newer public information the results of their own analyses refute. "Overconfidence" leaves the Investors seem immune to deviations from its original opinion.
Summary of Chapters
1. Introduction: Outlines the problem of financial decision-making and establishes the distinction between traditional rational models and modern behavioural theories.
2. Modern and Traditional Finance Theory: Reviews the evolution from the Efficient Market Hypothesis and rational asset pricing to the emergence of behavioural finance as a reaction to market anomalies.
3. Factors of Behavioural Finance: Provides an in-depth analysis of cognitive biases and psychological influences, specifically overconfidence, prospect theory, heuristics, and the herding effect.
4. Criticism of Behavioural Finance: Discusses arguments from traditional finance proponents who question the scientific robustness and lack of an integrated behavioural framework.
5. Conclusion: Summarizes that neither traditional nor behavioural finance currently offers a complete solution, suggesting that a hybrid perspective is necessary to understand complex market phenomena.
Keywords
Behavioural Finance, Efficient Market Hypothesis, Overconfidence, Prospect Theory, Heuristics, Comfort of Crowds, Market Anomalies, Homo oeconomicus, Self-attribution Bias, Financial Decision-making, Investor Psychology, Risk Aversion, Loss Aversion, Winner-loser Effect, Capital Asset Pricing Model.
Frequently Asked Questions
What is the core focus of this publication?
The work provides a critical analysis of behavioural finance, examining how psychological biases and human behaviour challenge the traditional view of rational financial markets.
Which central topics are discussed in this thesis?
The main topics include the evolution of financial theory, market anomalies, the impact of overconfidence, prospect theory, heuristics, and the tendency of investors to follow the crowd.
What is the primary research goal?
The aim is to demonstrate how behavioural finance explains market phenomena—such as price bubbles and crashes—that traditional models fail to account for, while acknowledging the limitations of current behavioural theories.
Which scientific methodology is employed?
The author uses a literature-based qualitative approach, evaluating key studies and theories from both traditional financial economics and behavioural science to conduct a comparative analysis.
What content is covered in the main section of the document?
The main section details the fundamental theories, specific behavioural factors like heuristics and prospect theory, and a critical look at the ongoing debate between defenders of neoclassical orthodoxy and proponents of behavioural science.
Which keywords best characterize this work?
Key terms include Behavioural Finance, Prospect Theory, Overconfidence, Market Anomalies, Efficient Market Hypothesis, and Investor Psychology.
How does "Prospect Theory" differ from traditional utility models?
Unlike traditional models that assume rational evaluation, Prospect Theory posits that individuals value potential losses more significantly than gains of the same magnitude, leading to risk-averse or risk-seeking behaviour depending on how choices are framed.
Why is "Comfort of Crowds" considered a factor in market performance?
It refers to the psychological tendency of investors to follow the majority or successful figures like Warren Buffet, which can lead to herding behaviour and market movements that deviate from fundamental values.
- Arbeit zitieren
- Lars Steilmann (Autor:in), 2015, Critical analysis of the behavioural finance as a theory, München, GRIN Verlag, https://www.hausarbeiten.de/document/378168
