Behavioral Finance is based on the notionthat a significant part of the investing community are subjected to behavioralbiases which means that their financial decisions may not be fully rational.
One of the most challenging propositions is that financial predispositions arehugely affected by investor sentiment about the progress of a stock and theunderlying causes for it might be trivial.This is quite evident from the factthat investors either overreact or underreact to various information in themarket which hugely biases their decisions and may now be logical from any viewpoint. Conservatism means that individuals are slow to change their beliefs inthe face of new evidence and can explain why investors would fail to take fullaccount of the implications of an earnings surprise. The representativenessheuristic means that individuals assess the probability of an event orsituation based on superficial characteristics and similar experiences theyhave had rather than on the underlying probabilities. One of the best examplespertaining to such a theory is the concept of good company and bad company inthe minds of the people. This theory is hugely prevalent especially for bluechip companies which garner a lot of goodwill hence it helps them over pricetheir securities.Another school of thought in the behavioralaspect is the concept of rational and irrational managers which has itsimplications in the timing of securities issues.
The share of equity issuesrelative to total equity and debt issues is high before periods of low equitymarket returns, suggesting that companies time their equity issues to takeadvantage of positive investor sentiment and market mispricing. The basic ideaof hubris theory suggests that overconfidence in managers gets a blurrier picturein front of them regarding the gains that they make from corporate activitywhich in turn leads to huge losses for no reason.Fiduciaries or trustees are hugelysubjected to behavioral biases that can from a group of dynamic people in theboard of the company. The individual biases of such people might operate alongand influence the group biases towards wrong decision making. Perhaps the mostobvious implication of the behavioral biases that underpin behavioral financeis that overconfidence and over optimism can lead individuals to underestimaterisk (Caballero & Krishnamurthy, 2008).Behavior has now redefined the way anyfinancing decisions is taking.
Starting from company managers to hedge funds,everyone takes into account current investor sentiments, values, ethos andethics of a decision before investing as the long term investments would accruea lot of wealth for it. Put basically, customary financial aspects accept thatpeople settle on choices utilizing a controlled subjective process. Practicallyspeaking, choices are frequently influenced utilizing a programmed procedure,to subject to predispositions caused by mental easy routes, or a full offeeling process impacted by feelings.
Behavioral back has developed in light ofwatching how people decide. Advances in neuroscience now make coordinateestimation of musings and sentiments conceivable and offer the possibility tocomprehend why people settle on these choices. This data may help clarifyinconsistencies in basic leadership (Daniel, Hirshleifer & Subrahmanyam, 1998).Efficient Market HypothesisThe efficient markets hypothesis (EMH),popularly known as the Random Walk Theory, is the proposition that currentstock 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), byusing this information. Investors identify securities which are undervalued andovervalued using a variety of techniques and their consequent actions lead toincrease or decrease in prices of the security till its reaches the correctvaluation. They always believe that they can outperform the market usingforecasting aids.
The intense competition between such people lead tocorrection of prices and the current prices incorporate all possibleinformation present and accessible to all.The weak form of the efficient marketsuggest that current price fully incorporates information contained in the pasthistory of prices only. It emphasizesthat nobody can beat the market by analyzing the mispriced securities in thepast. The semi-strong-form of market efficiency hypothesis suggests that the currentprice fully incorporates all publicly available information. Public information means that all the financialstatements of all the companies and other macroeconomics factors.
The strongform of market efficiency hypothesis states that the current price fully incorporatesall existing information, both public and private (sometimes called inside information). Thefundamental contrast between the semi-strong and strong productivityspeculations is that in the last case, no one ought to have the capacity to methodicallycreate benefits regardless of whether exchanging on data not freely known atthe time. Albeit no hypothesis is impeccable, the larger part of experimentalconfirmation bolsters the effective market theory. By far most of understudiesof the market concur that the business sectors are exceedingly effective.Eventually, the effective markets speculation keeps on being the best depictionof value developments in securities markets (Anderson and Smith, 2006).
Modern Portfolio Theory:ModernPortfolio Theory states that any investor will probably boost return for anylevel of risk .Risk can be decreased by making a diversified arrangement ofunrelated resources and return is considered to be the price appreciation ofany 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, demonstratesthat a mixture of assorted resources will altogether lessen the general dangerof a portfolio. Risk, in this way, must be viewed as a total factor for theportfolio overall and not as a straightforward expansion of single risk.
Assets that are uncorrelated will havedifferent risk patterns that means if two assets are similar then the priceswill move in similar fashion. Unrelated stocks will help in diversifying theportfolio and this lack of correlation helps a diversified portfolio to lowerthe risk so that our investment is protected against any shocks or unpredictedmarket behavior. Efficient Frontier is a graphical representation of all thepossible mixtures of risky assets for an optimal level of Return given anylevel of Risk, as measured by standard deviation. The Straight Line (CapitalAllocation Line) represents a portfolio of all risky assets and the risk-freeasset, which is usually a triple-A rated government bond. Tangency Portfolio isthe point where the portfolio of only risky assets meets the combination ofrisky and risk-free assets. This portfolio maximizes return for the given levelof risk.
Portfolio along the lower part of the hyperbole will have lower returnand eventually higher risk. Portfolios to the right will have higher returnsbut also higher risk (Asness, 2000).