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2017 | Book

The Rise and Fall of Neoclassical Finance Read chapter Read first chapter

The Financial Consequences of Behavioural Biases

An Analysis of Bias in Corporate Finance and Financial Planning

Authors: Prof. Imad A. Moosa, Vikash Ramiah

Publisher: Springer International Publishing

Part of: Springer Professional "Wirtschaft+Technik" , Springer Professional "Wirtschaft"

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About this book

This book provides a concise analysis of behavioural biases and their implications for financial decision making. The book is written in the normative tradition, arguing strongly for the superiority of behavioural finance with respect to explaining observed phenomena in financial markets. It offers some unique features, including a discussion of the issue of conspiracy theory and how behavioural biases lead to belief in conspiracy theories. Lingering belief in the principles of neoclassical finance is attributed in part to the doctrine of publish or perish, which dominates contemporary academia. The offshoots of behavioural finance are discussed in detail, including ecological finance, environmental finance, social finance, experimental finance, neurofinance, and emotional finance. A comprehensive discussion of narcissism is presented where it is demonstrated that narcissistic behaviour is prevalent in the finance industry and that it led to the eruption of the global financial crisis.

Table of Contents

Frontmatter
Chapter 1. The Rise and Fall of Neoclassical Finance
Abstract
The principles of neoclassical finance can be rationalized in terms of classical game theory, which reduces human behaviour to pure mathematics. The neoclassical finance era started in the early 1950s with the work of Harry Markowitz on portfolio optimization theory, followed by the work of Modigliani and Miller on capital structure and the work of Sharpe and Lintner on asset pricing models, including the CAPM, and the development of the efficient market hypothesis by Eugene Fama. While the principles of neoclassical finance, as the mainstream school of thought, were at one time unquestionable, some market events pose a challenge to the soundness of these principles, particularly the propositions that market prices reflect the intrinsic values of the underlying assets.
Imad A. Moosa, Vikash Ramiah
Chapter 2. The Rise and Rise of Behavioural Finance
Abstract
Behavioural finance discards the assumptions of rationality and fair pricing, seeking to explain observed behaviour in financial markets by using the principles of psychology. Irrationality can be attributed to behavioural biases, which are either cognitive or emotional, both of which can lead to poor and irrational financial decisions. Kahneman and Tversky provided the early psychological theories that constitute the foundation of behavioural finance, and they also developed prospect theory that explains loss aversion. Irrationality is readily observable when, for example, people gamble against the odds or accept higher risk for lower return. Behavioural finance seeks to explain irrationality and the presence of market anomalies such as the calendar effects and profitable trading.
Imad A. Moosa, Vikash Ramiah
Chapter 3. Overconfidence and Self-Serving Bias
Abstract
Overconfidence is manifested by the overestimation or exaggeration of one’s ability to perform a particular task successfully. It may take one of three forms: (i) overestimation of one’s actual performance, (ii) overplacement of one’s performance relative to others and (iii) excessive confidence in own beliefs. People are prone to self-serving bias (also referred to as self-serving attribution bias) when they attribute positive events to their own character (internal attribution) and negative events to external factors (external attribution). Self-serving bias is common and observable in our day-to-day environment, it can be detected easily, and it feeds on financial crises as it provides a fertile ground for factors to which people can attribute their failure. Overconfidence is linked to self-serving bias.
Imad A. Moosa, Vikash Ramiah
Chapter 4. Loss Aversion Bias, the Disposition Effect and Representativeness Bias
Abstract
Loss aversion bias, the disposition effect and representativeness bias have implications for trading decisions, financial planning and working capital management. We provide a discussion of the regret associated with losses and then illustrate the relevance of this bias to the equity premium puzzle, optimal portfolio choice and other issues. We also explain how prospect theory is linked to the disposition effect. We discuss momentum and contrarian trading behaviour as it is a major focus for academics and practitioners and explore the implications of the disposition effect for various areas of finance. As far as representativeness is concerned, we examine its implications for investors’ sentiment, using the evidence provided by the overreaction and under-reaction literature.
Imad A. Moosa, Vikash Ramiah
Chapter 5. Other Biases in the Behavioural Finance Literature
Abstract
This chapter deals with a variety of biases, including the gambler’s fallacy, hindsight bias, panic, herd behaviour, status quo bias, survivorship bias, money illusion, attachment bias, familiarity and home bias, illusion of control, conservatism bias and narcissism. We show that narcissists are drawn to finance, law and politics and suggest that narcissistic behaviour is to blame for the global financial crisis as the narcissistic personality disorder of corporate leaders led them to substitute robust risk management for greed and personal gains by promoting self-serving and grandiose aims. We argue that money illusion is more problematical than it appears to be because governments always under-report inflation, and that the status quo bias can lead to better or less bad outcomes than otherwise.
Imad A. Moosa, Vikash Ramiah
Chapter 6. Recent Developments
Abstract
New forms or branches of finance have emerged since the development of behavioural finance, including quantitative behavioural finance, emotional finance, experimental finance and neurofinance. Sometimes distinction is made between behavioural finance, which focuses on the phenomena of how people behave when they are faced with choice, and cognitive finance, which looks at what is actually going on within the individual’s mind when they make that choice. We also consider ecological finance and environmental finance. We suggest that indulgence in quantitative behavioural finance is a step backward and an attempt to preserve the methodology of neoclassical finance.
Imad A. Moosa, Vikash Ramiah
Chapter 7. Epilogue
Abstract
While neoclassical finance cannot explain irrationality and market anomalies, behavioural finance utilizes the principles of psychology to present plausible explanations for observed phenomena. It is argued that neoclassical finance models have failed miserably and that research in neoclassical finance has persisted because of the culture of publish or perish, which dominates contemporary academia. Belief in conspiracy theory is attributed to several behavioural biases, including confirmation bias, proportionality bias, projection, intentionality bias, pattern-seeking, availability bias, overconfidence, anchoring, the bandwagon effect, the base rate fallacy, conservatism and the focusing effect. It is concluded that the unrealistic propositions of neoclassical finance should go the way of the dinosaurs.
Imad A. Moosa, Vikash Ramiah
Backmatter
Metadata
Title
The Financial Consequences of Behavioural Biases
Authors
Prof. Imad A. Moosa
Vikash Ramiah
Copyright Year
2017
Electronic ISBN
978-3-319-69389-7
Print ISBN
978-3-319-69388-0
DOI
https://doi.org/10.1007/978-3-319-69389-7