Behavioral finance Assignment Example | Topics and Well Written Essays - 2500 words

Behavioral finance - Assignment Example Modern financial economics are pegged on the assumption that financial practitioners act both meticulously and with rationale. However as evidenced and earlier stated, this is not always the case. These deviations from the norm are not rampant and inherent but follow a systematic chain of events. With this information in mind it is possible to incorporate these systematic human deviations into the standard model of financial markets (Rutledge 264). In so doing, two commonly overlooked mistakes come to the foreground: Financial practitioners tend to indulge in excessive trading with belief that the next trade will rake in more lucrative returns. This is irrational trading and is propelled by emotion rather than rational thinking. The human trait of being too overconfident or corky in this case is the key driving motivation behind this bias. Some financial practitioners are also in the habit of holding on to losing stocks while at the same selling their winning stocks. This again is in stigated by lack of confidence and the need to avoid both failure and regrets coupled with poor judgments. Behavioral finance contributes to asset pricing in two major dimensions. These dimensions are reached upon by use of agents which may in them are not completely rational. These are: I. Limits to arbitrage This argues that the damage caused by irrational traders in their irrational deviations may be difficult, if not impossible to be undone by the more rational trades. The traditional asset-pricing model does not factor in market frictions and greatly undermined trading frictions like transaction cost, bid spread, ask spread etc. These forces have a great impact on asset returns and therefore should not be ignored. The limits to arbitrage create a model where mispricing exist for the simple reason that risk adverse arbitragers are not concerned mainly with the riskless values of an asset, but about the price of assets in periods following these irrational traders. This model con siders the cost of arbitrage more so the volatility returns and states that the habit of mispricing will inevitably dominate markets especially in the cases of highly volatile stocks whereby arbitragers may avoid the risky volatile position. Finding mispricing is a tasking affair and may involve institutional laws that should regulate the type of trade to be done. For instance short selling which is essential to effective arbitrage including cost of borrowing, legal fees and liquidity risk is not allowed in mutual and pension funds. Therefore there should exist a cap on the limits to arbitrage. II. Psychology: This helps in creating a continuum of deviations spurning from full rationality to completely irrational. The known concept of asset pricing therefore is in a very vibrant flux whereby there is a slow paradigm shift from the completely irrational approach to a more accommodating broader outlook based on the psychology of investors. Risk and misevaluations are therefore the two main determinants of the security expected returns. This is roughly based on a concept by Savage (183) which is a decision making method with imminent or existing risks in consideration. This concept is known as the Subjective Expected Utility whereby it is widely