Behavioral Finance and Capital Markets

This chapter confronts the main foundations of the neoclassical theory of finance with allegations of the behavioral approach. Theoretical models of classical financial economics do not take into account the possibility of decision maker irrationality. It is often assumed that irrational investors are not coordinated and therefore their behavior cancels out. And even if irrationality becomes strong and common among a large group of investors, it will be voided by rational actions of arbitrageurs. However, behavioral finance points out limits to arbitrage. It is argued that irrationality of investors may indeed influence asset pricing. This position challenges the main theoretical foundations of the neoclassical paradigm, including the Markowitz’s portfolio theory, traditional asset pricing models, and the Efficient Market Hypothesis. The behavioral approach is of high importance also for the second side of capital market, that is issuers. A discussion on key elements of corporate finance policy in the light of behavioral implications concludes the first chapter.

In its quest to explain the phenomena taking place in the capital market, behavioral finance has drawn a lot on psychological findings applying selected insights of this branch of science to the study of investor behavior. The great majority of these insights do not provide theoretical background as such. Rather, they concern certain phenomena previously described by psychology which were later transposed onto economics and finance. Only then were they used to construct models of investor behavior and develop a new school of thought in the theory of finance.

This chapter discusses the different attitudes investors adopt when making decisions about buying securities and managing investments in the capital market. It shows how psychological factors described in the previous chapter may impact investors’ beliefs about future price changes, influence the perception of company value, investment selection, and portfolio management. The discussion that follows usually focuses on individual players, but may sometimes also be relevant for professional investors.

This chapter systematizes and thoroughly discusses a number of phenomena observed on the capital market that the classical theory of finance considers abnormal.

This chapter focuses on the consequences of behavioral biases to the capital market as a whole. Two major anomalies in the aggregate market-wide data, that is, the equity premium puzzle and the excessive volatility puzzle, are discussed in the first instance. Later, we move on to attempts of market modeling within the behavioral framework. Early models based on beliefs and preferences of investors do well with explaining some aspects, but lack power to describe other peculiarities of market behavior. Hence, the Generalized Behavioral Model is developed that aims to explain the whole range of market anomalies described in this book.

In a few recent years, we experienced market turbulences on the scale and scope not seen since the Great Depression in the 1930s. First, the problems started in the United States with the burst of the real estate bubble and the credit crunch. Soon the crisis spread globally. Its spin-off effects revealed major weaknesses of the Eurozone, particularly unbearable levels of public and private indebtness in a few member states.

In this chapter, it is assumed that corporate managers behave in a fully rational manner and attempt to take advantage of investors’ irrationality and temporary market anomalies. We investigate how investor biases and market inefficiency may impact financial and investment policy of corporations. In the area of financial decisions, we study equity offerings, stock repurchases, debt issues and asset exchange offers, and dividend policy. In regard to investment choices, we investigate real investment, mergers and acquisitions, decisions to enter a new market, and the choice between focus or diversity in business operations. We also look at earnings management, adjusting nominal share price, changing firm names, and other managerial practices targeted at market timing, catering to investor tastes, and exploiting market inefficiencies.

In the previous chapter it was taken for granted that corporate managers act fully rationally and adopt their decisions to temporary market inefficiencies and investor biases. In this chapter we take a different approach and assume that managers, similar to investors, may behave in less than fully rational ways.

In previous chapters, we discussed the theoretical background and empirical evidence behind the actual behavior of market participants, that is, investors and corporate managers. With respect to corporate managers, first, we showed how rational managers may attempt to exploit investor irrationality and market inefficiency (chapter 7). Later, we argued that not only investors, but also corporate managers might be subject to psychological biases and act irrationally (chapter 8).

In chapter 2, we presented psychological aspects of decision making as well as various heuristics and biases. Certain phenomena previously described in the psychology literature were later transposed onto economics and finance in an attempt to explain the real behavior of market participants. Typically, most of the focus on the irrational behavior of investors.