Behavioral quite evident from the fact that investors

Behavioral Finance is based on the notion
that a significant part of the investing community are subjected to behavioral
biases which means that their financial decisions may not be fully rational.
One of the most challenging propositions is that financial predispositions are
hugely affected by investor sentiment about the progress of a stock and the
underlying causes for it might be trivial.
This is quite evident from the fact
that investors either overreact or underreact to various information in the
market which hugely biases their decisions and may now be logical from any view
point. Conservatism means that individuals are slow to change their beliefs in
the face of new evidence and can explain why investors would fail to take full
account of the implications of an earnings surprise. The representativeness
heuristic means that individuals assess the probability of an event or
situation based on superficial characteristics and similar experiences they
have had rather than on the underlying probabilities. One of the best examples
pertaining to such a theory is the concept of good company and bad company in
the minds of the people. This theory is hugely prevalent especially for blue
chip companies which garner a lot of goodwill hence it helps them over price
their securities.

Another school of thought in the behavioral
aspect is the concept of rational and irrational managers which has its
implications in the timing of securities issues. The share of equity issues
relative to total equity and debt issues is high before periods of low equity
market returns, suggesting that companies time their equity issues to take
advantage of positive investor sentiment and market mispricing. The basic idea
of hubris theory suggests that overconfidence in managers gets a blurrier picture
in front of them regarding the gains that they make from corporate activity
which in turn leads to huge losses for no reason.

Fiduciaries or trustees are hugely
subjected to behavioral biases that can from a group of dynamic people in the
board of the company. The individual biases of such people might operate along
and influence the group biases towards wrong decision making. Perhaps the most
obvious implication of the behavioral biases that underpin behavioral finance
is that overconfidence and over optimism can lead individuals to underestimate
risk (Caballero & Krishnamurthy, 2008).

Behavior has now redefined the way any
financing decisions is taking. Starting from company managers to hedge funds,
everyone takes into account current investor sentiments, values, ethos and
ethics of a decision before investing as the long term investments would accrue
a lot of wealth for it. Put basically, customary financial aspects accept that
people settle on choices utilizing a controlled subjective process. Practically
speaking, choices are frequently influenced utilizing a programmed procedure,
to subject to predispositions caused by mental easy routes, or a full of
feeling process impacted by feelings. Behavioral back has developed in light of
watching how people decide. Advances in neuroscience now make coordinate
estimation of musings and sentiments conceivable and offer the possibility to
comprehend why people settle on these choices. This data may help clarify
inconsistencies in basic leadership (Daniel, Hirshleifer & Subrahmanyam, 1998).

Efficient Market Hypothesis

The efficient markets hypothesis (EMH),
popularly known as the Random Walk Theory, is the proposition that current
stock prices fully reflect available information about the value of the firm,
and there is no way to earn excess profits, (more than the market overall), by
using this information. Investors identify securities which are undervalued and
overvalued using a variety of techniques and their consequent actions lead to
increase or decrease in prices of the security till its reaches the correct
valuation. They always believe that they can outperform the market using
forecasting aids. The intense competition between such people lead to
correction of prices and the current prices incorporate all possible
information present and accessible to all.

The weak form of the efficient market
suggest that current price fully incorporates information contained in the past
history of prices only.  It emphasizes
that nobody can beat the market by analyzing the mispriced securities in the
past. The semi-strong-form of market efficiency hypothesis suggests that the current
price fully incorporates all publicly available information.  Public information means that all the financial
statements of all the companies and other macroeconomics factors. The strong
form of market efficiency hypothesis states that the current price fully incorporates
all existing information, both public and private (sometimes called inside information). 

 The
fundamental contrast between the semi-strong and strong productivity
speculations is that in the last case, no one ought to have the capacity to methodically
create benefits regardless of whether exchanging on data not freely known at
the time. Albeit no hypothesis is impeccable, the larger part of experimental
confirmation bolsters the effective market theory. By far most of understudies
of the market concur that the business sectors are exceedingly effective.
Eventually, the effective markets speculation keeps on being the best depiction
of value developments in securities markets (Anderson and Smith, 2006).

 

Modern Portfolio Theory:

Modern
Portfolio Theory states that any investor will probably boost return for any
level of risk .Risk can be decreased by making a diversified arrangement of
unrelated resources and return is considered to be the price appreciation of
any asset, as in stock price, and also any Capital inflows, such as dividends.
Risk is evaluated as the range by which the asset’s price will on average vary,
known as Standard Deviation. Modern Portfolio Theory, nonetheless, demonstrates
that a mixture of assorted resources will altogether lessen the general danger
of a portfolio. Risk, in this way, must be viewed as a total factor for the
portfolio overall and not as a straightforward expansion of single risk.

Assets that are uncorrelated will have
different risk patterns that means if two assets are similar then the prices
will move in similar fashion. Unrelated stocks will help in diversifying the
portfolio and this lack of correlation helps a diversified portfolio to lower
the risk so that our investment is protected against any shocks or unpredicted
market behavior. Efficient Frontier is a graphical representation of all the
possible mixtures of risky assets for an optimal level of Return given any
level of Risk, as measured by standard deviation. The Straight Line (Capital
Allocation Line) represents a portfolio of all risky assets and the risk-free
asset, which is usually a triple-A rated government bond. Tangency Portfolio is
the point where the portfolio of only risky assets meets the combination of
risky and risk-free assets. This portfolio maximizes return for the given level
of risk. Portfolio along the lower part of the hyperbole will have lower return
and eventually higher risk. Portfolios to the right will have higher returns
but also higher risk (Asness, 2000).