10 Behavioral Finance - Behavioral Finance Markets can...

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Behavioral Finance “Markets can remain irrational longer than most investors can remain solvent.” John Maynard Keynes
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Keynes is saying that even if you are ultimately right about mispricing in the market, be prepared to be “wrong” for awhile…..and have deep enough pockets to be “wronger” before you are finally proved right JMK predates modern financial theory and behavioural finance, but his statement is crucial in debate between two because one of the former’s standard response to the latter is that: There are more rational investors than irrational ones and Arbitrageurs (the alpha rationals) will exploit mispricing caused by irrational investors until
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Modern financial theory supporters also argue that to go “against the market” is irrational since the market reflects all information processed by investors behaving rationally However, new/contradictory information cannot be incorporated in the market equilibrium price without some investors going “against the market” This circular argument is one of weaker aspects of EMH When is “bucking the market” irrationality and when is it simply new rational information being processed and entering the market as EMH would expect?
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Behavioural Finance: What IS It Exactly? Behavioral Finance is not really a market model or theory of pricing It is essentially a critique of most of modern financial theory since it challenges (indeed outright rejects) one of MFT’s fundamental assumptions But behavioral finance does not really offer an alternative framework for making investment decisions In summary, BF highlights the potential implications of psychological factors affecting investor behavior: humans possess weaknesses in processing information that distort their investment decisions Humans have behavioural biases that distort our decision making processes even IF we process information rationally
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Behavioural Finance: What IS It Exactly? Recall that virtually all modern financial theory assumes rational “profit maximising/risk minimising” behaviour by investors If this is not actually true, the theory falls apart Most financial markets, investment management textbooks and financial economists believe:
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