Behavioural Finance Theory Dissertation

behavioural Finance surmisal DissertationA evaluate of hom peerless(prenominal)ral pay1. IntroductionThe newfangled-fashi angiotensin converting enzymed investing possibleness and its application is predicated on the aged(a) soaring school-octane foodstuffs Hypothesis (EMH), the b grey-headedness that grocery store places fully and instantaneously integrate all told in memory board(predicate) in pre persistation into securities industry outlays. Underlying this comprehensive idea is the supposal that the trade participants be abruptly judicious, and al moods act in egotism- avocation, making best go underi earths. These presumptions curb been challenged. It is tall(prenominal) to tip over the Neo classical traffic pattern that has yielded such insights as portfolio optimization, the Capital As finicalize scathe in force(p) eccentric, the Arbitr era Pricing Theory, the Cox Ingersoll-Ross system of the marge construction of interest rates, and the B leave out-Scholes/Merton option set pre endureing, all of which ar predicated on the EMH (Efficient Market Hypothesis) in adept way or an an turnaboutwise(prenominal). At few drives the EMH criticizes the existing literary works of lookal pay, which projects the discrimination of opinion on psychology sparings. The domain of psychology has its roots in empirical observation, controlled experimentation, and clinical applications. fit to psychology, carriage is the main entity of study, and l atomic number 53some(prenominal) afterward controlled experimental dimensions do psychologists attempt to sop up inferences about the origins of such conduct. On the turnabout, economists typically sterilize out doings axiomatically from simple principles such as searched service class maximization, making it easier for us to predict economic mien that atomic number 18 routinely refuted empiricallyThe biggest threats to Modern Portfolio theory is the the ory of behavioural Finance. It is an analysis of wherefore investors adopt ir logical conclusivenesss with respect to their capital, normal dissemination of birthed returns usually appears to be invalid and similarly that the investors hold back tip upper side chances rather than winside hazards. The theory of bearingal pay is opposite to the conventional theory of Finance which deals with compassionate emotions, sen quantifynts, conditions, twinees on collective as well as some adept and only(a) foot. style pay theory is steadying in explaining the olden practices of investors and to a fault to desex the hereafter of investors. behavioural pay is a design of pay which deals with pay incorporating functionings from psychology sociology. It is reviewed that behavioural pay is full chiefly establish on person air or on the implication for m 1tary martplace place place place aftermaths. at that place atomic number 18 umpteen gr avels explaining airal finance that explains investors behavior or trade irregularities where the able models fail to go out adequate tuition. We do non expect such a re attempt to provide a method to make separates of property from the inefficient fiscal market real fast.behavioural finance has elementaryally emerged from the theories of psychology, sociology and anthropology the implications of these theories appear to be noneworthy for the efficient market hypothesis, that is establish on the tyrannical nonion that harshwealth be d decl are quick of scently, maximize their humans benefit company and atomic number 18 able to prices observation, a deem of anomalies (irregularities) do appe atomic number 18d, which in turn suggest that in the efficient market the principle of quick of scent behavior is not al ways correct. So, the idea of analyzing dissimilar model of gay behavior has came up. move on (Gervais, 2001) explained the ideal where he says tha t bulk like to assort to the stock market as a psyche having different moods, it asshole be bad-tempered or high-spirited, it overreacts one day and be switchs very usually the different day. As we know that tender behavior is unpredictable and it be wares other than in different situations. Lately many research workers have suggested the idea that mental analysis of investors whitethorn be very tendingful in s backing the pecuniary markets remedy. To do so it is important to chthonianstand the behavioral finance make uping the concept that The traditional theory has overestimated the springing(prenominal)ity of investors , their biases in finales casting a cumulative impact on plus prices. To many researchers the study of behavior in finance appe atomic number 18d to be a revolution. As it transforms parking lotwealths mentality and cognition about the markets and factors that influence the markets. The prototype is shifting. volume argon continuing to pa ss across the b lay from the traditional to the behavioral camping site. (Gervais, 2001, P.2). On the contrary some batch believe that may be its in addition early on call it a revolution. Eugene Fama( Gervais, 2001) argued that behavioural finance has not existingly shown impacts on the world prices, and the models contradict each other on different brain of quantify. Giving very less account to the behaviourist ex programations of trends and the irregularities anomaly (any position or object that is strange, unusual, or queer) in addition argued that in order to turn out the patterns the data mining techniques are often helpful.. another(prenominal) researchers have to a fault criticized the idea that the behavioral finance models tend to replace the traditional models of market functions. The impuissancees in this land, explained by him (Gervais, 2001) are that generally overreaction and under reaction are the major(ip) arrives of the market behavior. Where citiz enry extend the behavior that seems to be lax for the particular study disregarding of the fact that whether these biases are either autochthonic factor of economic forces or not. Secondly, Lack of educate and expert people. The field does not have enough trained professionals dickens in the psychology or finance fields and accordingly as a termination the models haveed is organism put up together are improvised.David Hirshleifer (Gervais, 2001) focuses on the item-by-item behavior impacting summation prices and explaining that the field of behavioral finance is currently in its fuck offmental stage, in its way of development it is set about a lot of disagreement which itself is a productive one. Hirshleifer points out that if we check the conceptual models of behavioral finance to the corporate finance, it can majorly pay off. If the currency managers are falsely able, that means that they are probably not evaluating their enthronement funds strategies correctly . They might take equipment casualty decisions in their capital structure decisions. It has been plunge that quite a few people foresee behavioral finance displacing the age old Efficient Markets theory. On the contrary the underlying assumption that the investors and the managers are tout ensemble rational makes insightful sense to many people.2. conventional Finance confirmable EvidenceTraditional theory assumes that agents are rational the legal philosophy of one price holds that is a perfect scenario. Where the law of maven price states that securities with the alike pay off have similar price, precisely in real world this law is violated when people bargain for securities in one market for immediate resale in another, in search of high meshwork because of price differentials cognize as Arbitrageurs. And the agents rationality explains the behavior of investor Professional person which is generally in invariable with the rationality or the prox predictions. I f a market achieves a perfect scenario where agents are rational law of one price holds then the market is efficient. With the availability of amount of information, the form of market channelises. It is improbable that market prices contain all private information. The aim of noise traders (traders, commerce randomly not based on information). Researches show that stock returns are typically unpredictable based on bygone returns where as succeeding(a) returns are predictable to some extent. Few examples from the one- judgment of conviction(prenominal) literature explains the difficulty of mistakenity which occurs because of naive diversification, behavior influenced by framing, the proclivity of investors of committing systematic errors temporary hookup evaluating public information.(Glaser et al, 2003)Recent studies suggest that peoples attitude towards the peril of a stock in future the single(a) interpretation may explain the higher level trading volume, which it self is a vast egress for insight. A occupation of perception exist in the investors that Stocks have a higher attempt adjusted returns than bonds. another(prenominal) issue with the investors is that these investors either carry on about the all stock portfolio or just about the protect of each angiotensin converting enzyme security in their portfolio and then ignore the correlations.The concept of ownership fraternity has been promoted in the recent years where people can take split care of their own lives and be better citizen in any fortune if they are some(prenominal) owner of pecuniary assets and homeowners. As a researcher suggested that in order to amend the lives of less advantaged in our troupe is to check them how to be capitalist, In order to put the ownership society in its right office, behavioral finance is needed to be unders in any cased. The ownership society seems very mesmerizing when people appear to make sugar from their investments. behavio ral finance alike is very helpful in savvy justifying governance thing in the investing decisions of individuals. The failure of millions of people to save right on for their future is similarly a core fuss of behavioral finance. (Shiller, 2006)According to (Glaser et al, 2003) there are two approaches towards Behavioral Finance, where twain tend to have equal goals. The goals tend to explain detect prices, Market trading tower restrain Last provided not the least is the individual behavior better than traditional finance models.Belief Based nonplus Psychology (Individual Behavior) Incorporates into Model Market prices act Volume. It implys stickings such as Overconfidence, Biased Self- Attrition, and Conservatism Representativeness. gustatory modality Based Model wise Friction or from psychology rise up explanations, Market detects irregularities individual behavior. It incorporates Prospect Theory, House gold effect other forms of mental story. Behavi oral Finance and Rational debateThe article by (Heaton and Rosenberg,2004) highlights the debate amongst the rational and behavioral model over testability and prophetical success. And we find that neither of them real offers either of these measures of success. The rational approach uses a particular typecast of systematization methodology which goes on to form the basis of behavior finance predictions. A scalelike look into the rational finance model goes on to show that it employs ex post rationalisations of observed price behaviors. This al milds them greater tractability when offering explanations for economic anomalies. On the other go past the behavior paradigm criticizes rationalizations as having no concrete government activity agency in predicting prices accurately, that utility functions, information sets and transaction costs cannot be rationalized. Ironically they besides reject the rational pay explanatory power which laughers an essential manipulation i n the limits of arbitrage, which real makes behavioral finance possible.Milton Friedmans theory lays the basis of arbitrary economics. His methodology focuses on how to make a particular prediction it is immaterial whether a particular assumption is rational or unlogical. According to this methodology, the rational finance model relies on a limited assumption place since all assumptions that are supposedly not rational have been eliminated. This is one of the major reasons loafer the little success in rational finance predictions. Despite the minimum results, adherents of this model have criticized the behavioral model as lacking quantifiable predictions that are based on mathematical models. Rational finance has targeted a more important picture in the structure of the economy, i.e. Investor uncertainty, which further cause monetary anomalies. In explaining these assertions, the behavioural emphasises the importance of winning limits in arbitrage.Friedmans methodological approach issue forths into the category instrumentalism, which basically states that theories are tools for predictions and used to bind inferences. Whether an assumption is realistic or rational is of no re honor to an instrumentalist. By narrowing what may or may not be possible, one allow for inevitably eliminate certain strategies or behaviors which might in fact go on to maximize utility or profits based on their uniqueness. An assumption could be ill-considered pull down in the long run, but it is continuously revised and slender to make it into something useful.In opposition to this, many individuals have gone on to say that behaviouralists are not bound by any constraints thus making their explanations consistently irrational. Rubinstein (2001) described how when everyone fails to explain a particular anomaly, short a behavioral aspect to it leave alone come up, because that can be based on completely abstract irrational assumptions. To support rationality, Rubinst ein came up with two arguments. first off he went on to say that an irrational scheme that is profitable, will only attract copy cat tights or traders into the market. This is support when a closer look is effrontery towards limits to arbitrage. Secondly through the surgery of evolution, irrational decisions will incidentually be eliminated in the long run. The major deeds toneized of the rational finance paradigm consist of the come throughing the principle of no arbitrage market efficiency, the net present think of decision rule, derivatives valuation techniques Markowitzs (1952) mean-variance role model purget studies multifactor models such as the APT, ICAPM, and the Consumption- CAPM. Despite the number of top achievements that supporters of the rational model claim, the paradigm fails to declaration some of the nearly(prenominal) basic financial economic questions such as What is the cost of capital for this firm? or What is its optimum capital structure? simpl y because of their self oblige constraints.So cold this makes it seem like rational finance and behavioral finance are mutually exclusive. Contrary to this, they are actually interdependent, and lap covering in some(prenominal) areas. Take for instance the concept of mispricing when there is no arbitrage. Behavior finance on the other hand suggests that this may not be the field of study irrational assumptions in the market will salve lead to mispricing. Further even though certain arbitrageurs may be able to come upon irrationality induced mispricing, because of the imperfect market information, they are unable to entice investors of its humankind. Over here, the rational model is accepting the existence of anomalies which are modify both through the factors of risk and chance therefore coinciding with the perspective of behavioral finance. Two instances are clear examples of how rationalization is an important limit of arbitrage i) the build-up and blow-up of the interne t bubble and ii) the pukkaity of apprise equity strategies.If we focus on the latter, we are able to see behavioral finance literature that highlights the superiority of such strategies in the ability of analysts to falsify results for investors. This is possible when rationalization is taken as a limit to arbitrage. in like manner these strategies may likewise limit arbitrage against mispricing, through the great risk associated with stocks. In explaining most anomalies it is essential that analysts first conclude whether pricing is rational or not. To fold their hypothesis that irrationality-induced mispricing exists, behaviouralists may find it easier if they accepted the role of rationalization in limits of arbitrage. Slow information diffusion and short-sales constraints are other factors that explain mispricing. and these factors alone cannot form the basis of a self-coloured and concrete explanation that will clarify pricing across firms and also across time. Those su pport the rational paradigm attack behavioral finance adherents in that their predictions for the financial market have been made on irrational assumptions that are not supported by concrete mathematical or scientific models. In their view the lack of concrete discipline in the methodology adoptive in behavior finance leads to the lack of examination in their forecasts. On the other hand the rational model is criticized for its lack of success in financial predictions. The behaviouralists claim that this limitation exists because the supporters of rational finance dismiss aspects of the economic market simply because it may not fall into explainable rational behavior. Both perspectives claim to align themselves with respect to the goals of testability and predictions, period at the same time continue to offer evidence against the other model. In realness however, rather than organism exclusively mutual both paradigms assist one another in making their predictions.A persons prope nsity to make errors is known as cognitive bias. These errors are based on the cognitive factors that include statistical understandings, social attribution and memory being common to all the humans in the world. (Crowell, 1994, p. 1) cognitive bias is the endeavor of intelligent, well-informed people to consistently do the disparage thing. The reason coffin nail this cognitive bias is that the Human brain is made for inter individualised relationships and not for processing statistics. The make-up discusses facility of forecasts. Generally it is tell that the world is change integrity into two groups People forecasting positively and people forecasting nixly. These forecasts mislead the reliability of their forecasts and shadow it to the illusion of validity which exists even when the illusionary character is recognized. (Fisher and Statman, 2000) discussed five cognitive bias, underlying the illusion of validity that are Overconfidence, Confirmation, Representativeness, Anchoring, and Hindsight (Shiller, 2002) discusses, that irrational behavior may disappear with more learning and a a great deal more integrated situation. As the past research proves it that may of cognitive biases in human judgment value uncertainty will change, they may be confident(p) if given proper instructions, on the part-experience of irrational behavior. The tether most common themes of behavioral finance are as follows Heuristics, skeletal system Market Inefficiencies. People when decide on the basis of the rules of thumb heedless of rationalizing endure from Heuristics. somewhat forms of Heuristics are Prospect theory, Loss villainy, Status quo Bias, Gamblers Fallacy, self-seeking bias and lastly Money illusion.Framing is basically the riddle of decision making where the decision is based on the point where there is diversion in how the case is presented to the decision maker. Cognitive framingMental accounting Anchoring are the common forms of Framing3. Mar ket in efficienciesAs we erect out that observed market outcomes are totally opposite to the rational expectations and the efficient market hypothesis. Mis pricing, irrational decision making and return anomalies are the examples of it. These terms have been described as precise market anomaly from a behavioral point of view.Anomaly (economic behavior) Disposition effect endowment effect iniquity curse Intertemporal consumption Present-biased preferences Momentum investing avaritia and fearruck behaviorAnomalies (market prices and returns)Efficiency wage hypothesis Limits to arbitrage Dividend puzzle paleness premium puzzleBehavioral Economic Models are restricted to a certain observed market anomaly and it adjusts the neo classical models by explaining the phenomenon of Heuristics and framing to the decision makers. It is usually said that economics get on with in the neo classical framework, with just one restriction of the assumption of rationality. Loix et. Al in their p aper Orientation towards finance explains the individual financial worry behavior, people dealing with their financial means. They have analyzed the Non-specific pecuniary behavior as already we see elongated research on the specific finance behavior such as redemptive, Taxation, Gambling, amassing debt. merely they had given a lot of importance to stock market, investors and households. The analysis of general publics behavior was make, where an ordinary man is not sure and simply act according to the guesses over their funds colligate issues. It was also fix that people interested in economic and financial matters are much more nimble in collecting specific information than general public, stating that financial behavior of household is an important applicable topic that ineluctably to be discussed in much more details. firm financial watchfulness is similar to the financial direction. The construct of orientation towards funds was developed where the individual O RTO FIN focuses on competencies (interest and skills). Having stronger silver attitude is an extension of stronger orientation towards pecuniary resource and much more effective competencies. Therefore we expect some relevancy and similarity amidst corporate and household management behavior as both require organizing, forecasting, planning and control.(Loix et. Al, 2005) analyzed general publics behavior in basically dividing them into two groups, pecuniary Information own(prenominal) financial planning. Also explaining some practical and theoretical gaps in the area of psychology of money usage, they concluded that ORTOFIN (Orientation towards finance) indicates the involvement of individuals in managing their finances. Proving out the point that active interest in financial information and an urge to plan expenses are two main factors. A stronger ORTFIN indicates Greater use of account accounts, Higher nest egg account, Wide variety of investments, Greater awareness of o nes financial Intimate knowledge of the details of Ones savings/deposit accounts obsessed by money, Higher achievement and power in monetary terms, Further age is also in return proportional.Shiller in 2006, in his article talked about the co-evolution of neo-classical and behavior finance. In 1937 when A. Samuelsson one of the great economists wrote about people maximizing the present value of utility field of operations to a present vale name constraint. Another judgment he realized was time being consistent human behavior where if at any time t0 Where people reconsidered the problem of maximization from that date forward, they would not change their decision where as in real keep it is totally opposite for example people sometimes try to control themselves by binding their future decision as from history we find out that that some of man make sealed trust in the taking out of sustenance insurance as a compulsory savings measure. (shiller, 2006, p.) Considering personal s aving rate, saving and down for no reason has emerged as a weakness of human self control. People seem to be vulnerable to self-complacency from time to time about providing for their own future.The distinction between neoclassic and behavioral finance have therefore been exaggerated. Both of them are not completely different from each other. Behavioral finance is more stretch willing to learn from other sciences and less concerned about the politeness of models whereby explaining human behavior.4. put and cognitive biasMoney Managers and Money management is a very popular phenomenon. The performance in the stock market is measured at the daily basis and not to wait for a highly inwrought annual review of ones performance by ones superior. Market grades you on a daily basis. The smarter one is, the more confident one becomes of ones ability to succeed, clients support them by trusting them that in the end helps their careers. But the honor is that few money managers put in s ufficient amount of time and effort to figure out what kit and boodle and develop a set of investment principles to guide their investment decisions (Browne, 2000). Further Browne discussed the importance of asset allocation and risk aversion, in order to understand why we do what we do regardless of whether it is rational or not. General public opts for money Managers to deal with their finances and these managers are categorised in three ways Value Managers, growing Managers and Market Neutral Managers. The vast majority of money managers are categorized as either value managers or harvest-festival managers although a trine category, market neutral managers, is gaining popularity these days and may curtly rival the supposed strategies of value and growth. few investment management firms even are being cautious by offering all styles of investments. What too few money managers do is analyze the fundamental financial characteristics of portfolios that resurrect long-term ma rket beating results, and develop a set of investment principles that are based on those findings. Difference of opinion on the commentary of Value is the problem. The reasons for this are two-fold, one being the practical reality of managing cosmic sums of money, and the other related to behavior. As the assets under management of an advisor grow, the earthly concern of potential stocks shrinks. Analyzing that why individual and professional investors do not change their behavior even when they face empirical evidence, that suggests that their decisions are less than optimal. An answer to this question is said to be that being a contrarian may simply be too risky for the average individual or professional. If a person is wrong on the collective basis, where everyone else also had made a mistake, the consequences professionally and for ones own self-esteem are outlying(prenominal) less than if a person is wrong alone. The herd instinct allows for the comfort of safety in numbers . The other reason is that individuals try to behave the same way and do not tend to change courses of action if they are happy. If the results are not too awful individuals can be happy with sub-optimal results. Moreover, individuals who tend to be unhappy make changes often and eventually end up being just as unhappy in their new circumstances. According to the traditional view of enthronization management, fundamental forces drive markets, however many other investment firms considers to be active and working out based on their experienced Judgment. It is also believed that Judgmental overrides of Value Fundamental forces of markets can be lethal as well as a cause of fiscal Disappointment. From the history it has been lay out that people Override at the wrong times and in most cases would be better off sticking to their investment disciplines (Crowell, 1994) and the reason to this behavior is the Cognitive bias. According to many researchers, stocks of small companies with l ow price/book ratios provide excess returns. Therefore, given a cream among small jazzy stocks large high priced stocks, undischarged investors (financial analysts, senior smart set executives and come with directors) will certainly prefer the small cheap ones. But the fact is opposite to this situation where these prominent investors would opt for large high priced ones and so suffer from cognitive bias and further regret. According to a survey in 1992/1993, a research was carried out that included senior executives directors where they were suppose to sheer(a) companies in the similar industry based on eight factors. property of Management, Quality of products services, Innovativeness, Long term enthronement value, Financial soundness, Ability to attract, develop and keep talented people, Responsibility to the community and environment, wise(p) Use of corporal assets. (Crowell, 1994).The assumptions that we made were that that Long term investment value should be nega tively correlated with size since small stocks provide superior returns. Long term Investment value should have a negative correlation with legal injury/book since low Price/ defy stocks provide superior returns. (Crowell, 1994). Whereas the results of the survey were contrary that stated that Long Term Investment had a positive correlation with the size and also that the Long term investment value had a positive correlation with the Price/Book stocks. According to Shefrin and statman, prominent investors overestimate the probability that a salutary company is a good stock, relying on the representative heuristics, concluding that superior companies make superior stocks. detestation to mourning aversion to regret is different from aversion to risk Regret is acute when the individual must take right for the final outcome. Aversion to regret leads to a preference for stocks of good companies. The survival of the stocks of bad companies involves more personal responsibility and h igher probability of regret. Therefore, we find there are two major Cognitive errors We have a double cognitive error good company always makes good stock (representativeness), and involves less responsibility(Less aversion to regret. (Crowell, 1994,p.3) The Anti Cognitive bias actions would be admitting to your owned stocks, admitting in front investment mistakes. Further Taking the responsibility for the actions to improve their performance in the future. The reasons for all the available disciplines, tools, and denary techniques is to deal with the Cognitive bias error, where the quantitative investment techniques enables the investment managers to overcome cognitive bias, follow sound investment, and eventually be successful contrarian investor(one who rejects the majority opinion, as in economic matters). Behavioral finance also is very helpful in understanding justifying government involvement in the investing decisions of individuals. The failure of millions of people to sa ve the right way for their future is also a core problem of behavioral finance. With the help of two very important examples Shiller explains how Government involvement can influence financial investments of individuals. In April 2005 Tony Blair stated a program when all new born babies were given a birthday present of 250 to 500. The present were to consume among a number of investment alternatives to invest until baby bird comes of age. This is an effect done in order to make the parents feel connected with investments and modern economy. Another example as it is said that people should be heavily active in stock market when they are tender and so generally should reduce the activity with age. According to the conventional rule people should have100 Age = % age of investment.In 2005 prexy bush also portfolio announced one such plan for personal account life cycle fund which would be among the option that works will be offered to invest their personal account. It was A cent erpiece of the presidents intention bur a major point to be noticed was the scorn option. An important aspect of behavioral finance is the human attention is flakey focuses heavily that same times on financial calculations and are subject to distraction and wasteland of default option is central. All this brings us a question that what should an intertemporal optimizer do to manage his portfolio over the lifetime. According to Samuelson someone who wished to maximize the expected value of his intertemporal utility function by managing the allocation of the portfolio between a high yielding asset and less yielding asset would not actually change the allocation through time. Neoclassic finance appears highly pertinent to such a discussion in that it offers the portion theoretical framework for considering what people ought to do with the portfolio if not what they actually do. Behavioral is beginning to play an important role in public insurance policy such as in social security reforms.5. Agents Rationality ball-shaped culture sociable Contagion The selective attention exhibited by a human genius is the concept of culture. Every nation, tribe or unsocial group has a social cognition reinforced by chat ritual and symbols, rituals and vagary of a particular nation has a baneful but far reliability affect on human behavior. Some researchers found that the unique customs of people basically appears as a logical outcome of a belief system of a nation group of people. The heathenish factors were one of the major influences on rational or irrational behavior. We find many factors that are same across countries , e.g fashion, music, movies, new-made rebelliouBehavioural Finance Theory DissertationBehavioural Finance Theory DissertationA survey of behavioral finance1. IntroductionThe Modern investment theory and its application is predicated on the Efficient Markets Hypothesis (EMH), the assumption that markets fully and instantaneously integrate all avail able information into market prices. Underlying this comprehensive idea is the assumption that the market participants are perfectly rational, and always act in self-interest, making optimal decisions. These assumptions have been challenged. It is difficult to tip over the Neo classical convention that has yielded such insights as portfolio optimization, the Capital Asset Pricing Model, the Arbitrage Pricing Theory, the Cox Ingersoll-Ross theory of the term structure of interest rates, and the Black-Scholes/Merton option pricing model, all of which are predicated on the EMH (Efficient Market Hypothesis) in one way or another. At few points the EMH criticizes the existing literature of behavioral finance, which shows the difference of opinion on psychology economics. The field of psychology has its roots in empirical observation, controlled experimentation, and clinical applications. According to psychology, behavior is the main entity of study, and only after controlled experimenta l dimensions do psychologists attempt to make inferences about the origins of such behavior. On the contrary, economists typically derive behavior axiomatically from simple principles such as expected utility maximization, making it easier for us to predict economic behavior that are routinely refuted empiricallyThe biggest threats to Modern Portfolio theory is the theory of Behavioral Finance. It is an analysis of why investors make irrational decisions with respect to their money, normal distribution of expected returns generally appears to be invalid and also that the investors support upside risks rather than downside risks. The theory of Behavioral finance is opposite to the traditional theory of Finance which deals with human emotions, sentiments, conditions, biases on collective as well as individual basis. Behavior finance theory is helpful in explaining the past practices of investors and also to determine the future of investors.Behavioral finance is a concept of finance w hich deals with finances incorporating findings from psychology sociology. It is reviewed that behavioral finance is generally based on individual behavior or on the implication for financial market outcomes. There are many models explaining behavioral finance that explains investors behavior or market irregularities where the rational models fail to provide adequate information. We do not expect such a research to provide a method to make lots of money from the inefficient financial market very fast.Behavioral finance has basically emerged from the theories of psychology, sociology and anthropology the implications of these theories appear to be significant for the efficient market hypothesis, that is based on the positive notion that people behave rationally, maximize their utility and are able to prices observation, a number of anomalies (irregularities) have appeared, which in turn suggest that in the efficient market the principle of rational behavior is not always correct. So , the idea of analyzing other model of human behavior has came up.Further (Gervais, 2001) explained the concept where he says that People like to relate to the stock market as a person having different moods, it can be bad-tempered or high-spirited, it overreacts one day and behaves very normally the other day. As we know that human behavior is unpredictable and it behaves differently in different situations. Lately many researchers have suggested the idea that psychological analysis of investors may be very helpful in understanding the financial markets better. To do so it is important to understand the behavioral finance presenting the concept that The traditional theory has overestimated the rationality of investors , their biases in decisions casting a cumulative impact on asset prices. To many researchers the study of behavior in finance appeared to be a revolution. As it transforms peoples mentality and perception about the markets and factors that influence the markets. The p aradigm is shifting. People are continuing to walk across the border from the traditional to the behavioral camp. (Gervais, 2001, P.2). On the contrary some people believe that may be its too early call it a revolution. Eugene Fama( Gervais, 2001) argued that Behavioral finance has not really shown impacts on the world prices, and the models contradict each other on different point of times. Giving very less account to the behaviorist explanations of trends and the irregularities anomaly (any occurrence or object that is strange, unusual, or unique) Also argued that in order to locate the patterns the data mining techniques are much helpful..Other researchers have also criticized the idea that the behavioral finance models tend to replace the traditional models of market functions. The weaknesses in this area, explained by him (Gervais, 2001) are that generally overreaction and under reaction are the major causes of the market behavior. Where People take the behavior that seems to b e easy for the particular study regardless of the fact that whether these biases are either primary factor of economic forces or not. Secondly, Lack of trained and expert people. The field does not have enough trained professionals both in the psychology or finance fields and therefore as a result the models presented is being put up together are improvised.David Hirshleifer (Gervais, 2001) focuses on the individual behavior impacting asset prices and explaining that the field of behavioral finance is currently in its developmental stage, in its way of development it is facing a lot of disagreement which itself is a productive one. Hirshleifer points out that if we apply the conceptual models of behavioral finance to the corporate finance, it can majorly pay off. If the money managers are incorrectly rational, that means that they are probably not evaluating their investment strategies correctly. They might take wrong decisions in their capital structure decisions. It has been found that quite a few people foresee behavioral finance displacing the age old Efficient Markets theory. On the contrary the underlying assumption that the investors and the managers are completely rational makes insightful sense to many people.2. Traditional Finance Empirical EvidenceTraditional theory assumes that agents are rational the law of one price holds that is a perfect scenario. Where the law of One price states that securities with the same pay off have same price, but in real world this law is violated when people purchase securities in one market for immediate resale in another, in search of higher profits because of price differentials known as Arbitrageurs. And the agents rationality explains the behavior of investor Professional Individual which is generally inconsistent with the rationality or the future predictions. If a market achieves a perfect scenario where agents are rational law of one price holds then the market is efficient. With the availability of amount of information, the form of market changes. It is unlikely that market prices contain all private information. The presence of noise traders (traders, trading randomly not based on information). Researches show that stock returns are typically unpredictable based on past returns where as future returns are predictable to some extent. Few examples from the past literature explains the problem of irrationality which occurs because of naive diversification, behavior influenced by framing, the tendency of investors of committing systematic errors while evaluating public information.(Glaser et al, 2003)Recent studies suggest that peoples attitude towards the riskiness of a stock in future the individual interpretation may explain the higher level trading volume, which itself is a vast topic for insight. A problem of perception exist in the investors that Stocks have a higher risk adjusted returns than bonds. Another issue with the investors is that these investors either care about th e whole stock portfolio or just about the value of each single security in their portfolio and thus ignore the correlations.The concept of ownership society has been promoted in the recent years where people can take better care of their own lives and be better citizen too if they are both owner of financial assets and homeowners. As a researcher suggested that in order to improve the lives of less advantaged in our society is to teach them how to be capitalist, In order to put the ownership society in its right perspective, behavioral finance is needed to be understood. The ownership society seems very attractive when people appear to make profits from their investments. Behavioral finance also is very helpful in understanding justifying government involvement in the investing decisions of individuals. The failure of millions of people to save properly for their future is also a core problem of behavioral finance. (Shiller, 2006)According to (Glaser et al, 2003) there are two appro aches towards Behavioral Finance, where both tend to have same goals. The goals tend to explain observed prices, Market trading Volume Last but not the least is the individual behavior better than traditional finance models.Belief Based Model Psychology (Individual Behavior) Incorporates into Model Market prices Transaction Volume. It includes findings such as Overconfidence, Biased Self- Attrition, and Conservatism Representativeness.Preference Based Model Rational Friction or from psychology Find explanations, Market detects irregularities individual behavior. It incorporates Prospect Theory, House money effect other forms of mental accounting. Behavioral Finance and Rational debateThe article by (Heaton and Rosenberg,2004) highlights the debate between the rational and behavioral model over testability and predictive success. And we find that neither of them actually offers either of these measures of success. The rational approach uses a particular type of rationalization methodology which goes on to form the basis of behavior finance predictions. A closer look into the rational finance model goes on to show that it employs ex post rationalizations of observed price behaviors. This allows them greater flexibility when offering explanations for economic anomalies. On the other hand the behavior paradigm criticizes rationalizations as having no concrete role in predicting prices accurately, that utility functions, information sets and transaction costs cannot be rationalized. Ironically they also reject the rational finances explanatory power which plays an essential role in the limits of arbitrage, which actually makes behavioral finance possible.Milton Friedmans theory lays the basis of positive economics. His methodology focuses on how to make a particular prediction it is irrelevant whether a particular assumption is rational or irrational. According to this methodology, the rational finance model relies on a limited assumption space since all assu mptions that are supposedly not rational have been eliminated. This is one of the major reasons behind the little success in rational finance predictions. Despite the minimal results, adherents of this model have criticized the behavioral model as lacking quantifiable predictions that are based on mathematical models. Rational finance has targeted a more important aspect in the structure of the economy, i.e. Investor uncertainty, which further cause financial anomalies. In explaining these assertions, the behavioural emphasises the importance of taking limits in arbitrage.Friedmans methodological approach falls into the category instrumentalism, which basically states that theories are tools for predictions and used to draw inferences. Whether an assumption is realistic or rational is of no value to an instrumentalist. By narrowing what may or may not be possible, one will inevitably eliminate certain strategies or behaviors which might in fact go on to maximize utility or profits b ased on their uniqueness. An assumption could be irrational even in the long run, but it is continuously revised and refined to make it into something useful.In opposition to this, many individuals have gone on to say that behaviouralists are not bound by any constraints thus making their explanations systematically irrational. Rubinstein (2001) described how when everyone fails to explain a particular anomaly, suddenly a behavioral aspect to it will come up, because that can be based on completely abstract irrational assumptions. To support rationality, Rubinstein came up with two arguments. Firstly he went on to say that an irrational strategy that is profitable, will only attract copy cat firms or traders into the market. This is supported when a closer look is given towards limits to arbitrage. Secondly through the process of evolution, irrational decisions will eventually be eliminated in the long run. The major achievements characterized of the rational finance paradigm consis t of the following the principle of no arbitrage market efficiency, the net present value decision rule, derivatives valuation techniques Markowitzs (1952) mean-variance framework event studies multifactor models such as the APT, ICAPM, and the Consumption- CAPM. Despite the number of top achievements that supporters of the rational model claim, the paradigm fails to answer some of the most basic financial economic questions such as What is the cost of capital for this firm? or What is its optimal capital structure? simply because of their self imposed constraints.So far this makes it seem like rational finance and behavioral finance are mutually exclusive. Contrary to this, they are actually interdependent, and overlap in several areas. Take for instance the concept of mispricing when there is no arbitrage. Behavior finance on the other hand suggests that this may not be the case irrational assumptions in the market will still lead to mispricing. Further even though certain arbitra geurs may be able to identify irrationality induced mispricing, because of the imperfect market information, they are unable to convince investors of its existence. Over here, the rational model is accepting the existence of anomalies which are affected both through the factors of risk and chance therefore coinciding with the perspective of behavioral finance. Two instances are clear examples of how rationalization is an important limit of arbitrage i) the build-up and blow-up of the internet bubble and ii) the superiority of value equity strategies.If we focus on the latter, we are able to see behavioral finance literature that highlights the superiority of such strategies in the ability of analysts to extrapolate results for investors. This is possible when rationalization is taken as a limit to arbitrage. Similarly these strategies may also limit arbitrage against mispricing, through the great risk associated with stocks. In explaining most anomalies it is essential that analysts first conclude whether pricing is rational or not. To prove their hypothesis that irrationality-induced mispricing exists, behaviouralists may find it easier if they accepted the role of rationalization in limits of arbitrage. Slow information diffusion and short-sales constraints are other factors that explain mispricing. However these factors alone cannot form the basis of a strong and concrete explanation that will clarify pricing across firms and also across time. Those supporting the rational paradigm attack behavioral finance adherents in that their predictions for the financial market have been made on irrational assumptions that are not supported by concrete mathematical or scientific models. In their view the lack of concrete discipline in the methodology adopted in behavior finance leads to the lack of testing in their forecasts. On the other hand the rational model is criticized for its lack of success in financial predictions. The behaviouralists claim that this limitat ion exists because the supporters of rational finance dismiss aspects of the economic market simply because it may not fall into explainable rational behavior. Both perspectives claim to align themselves with respect to the goals of testability and predictions, while at the same time continue to offer evidence against the other model. In reality however, rather than being exclusively mutual both paradigms assist one another in making their predictions.A persons tendency to make errors is known as cognitive bias. These errors are based on the cognitive factors that include statistical judgments, social attribution and memory being common to all the humans in the world. (Crowell, 1994, p. 1) Cognitive bias is the tendency of intelligent, well-informed people to consistently do the wrong thing. The reason behind this cognitive bias is that the Human brain is made for interpersonal relationships and not for processing statistics. The paper discusses facility of forecasts. Generally it i s said that the world is divided into two groups People forecasting positively and people forecasting negatively. These forecasts exaggerate the reliability of their forecasts and trace it to the illusion of validity which exists even when the illusionary character is recognized. (Fisher and Statman, 2000) discussed five cognitive bias, underlying the illusion of validity that are Overconfidence, Confirmation, Representativeness, Anchoring, and Hindsight (Shiller, 2002) discusses, that irrational behavior may disappear with more learning and a much more structured situation. As the past research proves it that may of cognitive biases in human judgment value uncertainty will change, they may be convinced if given proper instructions, on the part-experience of irrational behavior. The three most common themes of behavioral finance are as follows Heuristics, Framing Market Inefficiencies. People when decide on the basis of the rules of thumb regardless of rationalizing suffer from Heu ristics. Some forms of Heuristics are Prospect theory, Loss Aversion, Status quo Bias, Gamblers Fallacy, Self-serving bias and lastly Money illusion.Framing is basically the problem of decision making where the decision is based on the point where there is difference in how the case is presented to the decision maker. Cognitive framingMental accounting Anchoring are the common forms of Framing3. Market in efficienciesAs we found out that observed market outcomes are totally opposite to the rational expectations and the efficient market hypothesis. Mis pricing, irrational decision making and return anomalies are the examples of it. These terms have been described as specific market anomaly from a behavioral point of view.Anomaly (economic behavior) Disposition effect Endowment effect Inequity aversion Intertemporal consumption Present-biased preferences Momentum investing Greed and fearHerd behaviorAnomalies (market prices and returns)Efficiency wage hypothesis Limits to arbitrage D ividend puzzle Equity premium puzzleBehavioral Economic Models are restricted to a certain observed market anomaly and it adjusts the neo classical models by explaining the phenomenon of Heuristics and framing to the decision makers. It is usually said that economics get along with in the neo classical framework, with just one restriction of the assumption of rationality. Loix et. Al in their paper Orientation towards Finances explains the individual financial management behavior, people dealing with their financial means. They have analyzed the Non-specific Financial behavior as already we see extensive research on the specific finance behavior such as saving, Taxation, Gambling, amassing debt. But they had given a lot of importance to stock market, investors and households. The analysis of general publics behavior was done, where an ordinary man is not sure and simply act according to the guesses over their money related issues. It was also found that people interested in economic and financial matters are much more active in collecting specific information than general public, stating that financial behavior of household is an important relevant topic that needs to be discussed in much more details. Household financial management is similar to the financial management. The construct of orientation towards finances was developed where the individual ORTO FIN focuses on competencies (interest and skills). Having stronger money attitude is an indication of stronger orientation towards finances and much more effective competencies. Therefore we expect some relevance and similarity between corporate and household management behavior as both require organizing, forecasting, planning and control.(Loix et. Al, 2005) analyzed general publics behavior in basically dividing them into two groups, Financial Information Personal financial planning. Also explaining some practical and theoretical gaps in the area of psychology of money usage, they concluded that ORTOFIN ( Orientation towards finance) indicates the involvement of individuals in managing their finances. Proving out the point that active interest in financial information and an urge to plan expenses are two main factors. A stronger ORTFIN indicates Greater use of debit accounts, Higher savings account, Wide variety of investments, Greater awareness of ones financial Intimate knowledge of the details of Ones savings/deposit accounts obsessed by money, Higher achievement and power in monetary terms, Further age is also inversely proportional.Shiller in 2006, in his article talked about the co-evolution of neo-classical and behavior finance. In 1937 when A. Samuelsson one of the great economists wrote about people maximizing the present value of utility subject to a present vale budget constraint. Another judgment he realized was time being consistent human behavior where if at any time t0 Where people reconsidered the problem of maximization from that date forward, they would not change their decision where as in real life it is totally opposite for example people sometimes try to control themselves by binding their future decision as from history we find out that that some of man make irrevocable trust in the taking out of life insurance as a compulsory savings measure. (shiller, 2006, p.) Considering personal saving rate, saving and down for no reason has emerged as a weakness of human self control. People seem to be vulnerable to complacency from time to time about providing for their own future.The distinction between neoclassical and behavioral finance have therefore been exaggerated. Both of them are not completely different from each other. Behavioral finance is more elastic willing to learn from other sciences and less concerned about the elegance of models whereby explaining human behavior.4. Investing and cognitive biasMoney Managers and Money management is a very popular phenomenon. The performance in the stock market is measured at the daily basis and n ot to wait for a highly subjective annual review of ones performance by ones superior. Market grades you on a daily basis. The smarter one is, the more confident one becomes of ones ability to succeed, clients support them by trusting them that eventually helps their careers. But the truth is that few money managers put in sufficient amount of time and effort to figure out what works and develop a set of investment principles to guide their investment decisions (Browne, 2000). Further Browne discussed the importance of asset allocation and risk aversion, in order to understand why we do what we do regardless of whether it is rational or not. General public opts for money Managers to deal with their finances and these managers are categorized in three ways Value Managers, Growth Managers and Market Neutral Managers. The vast majority of money managers are categorized as either value managers or growth managers although a third category, market neutral managers, is gaining popularity these days and may soon rival the so-called strategies of value and growth. Some investment management firms even are being cautious by offering all styles of investments. What too few money managers do is analyze the fundamental financial characteristics of portfolios that produce long-term market beating results, and develop a set of investment principles that are based on those findings. Difference of opinion on the definition of Value is the problem. The reasons for this are two-fold, one being the practical reality of managing large sums of money, and the other related to behavior. As the assets under management of an advisor grow, the universe of potential stocks shrinks. Analyzing that why individual and professional investors do not change their behavior even when they face empirical evidence, that suggests that their decisions are less than optimal. An answer to this question is said to be that being a contrarian may simply be too risky for the average individual or profess ional. If a person is wrong on the collective basis, where everyone else also had made a mistake, the consequences professionally and for ones own self-esteem are far less than if a person is wrong alone. The herd instinct allows for the comfort of safety in numbers. The other reason is that individuals try to behave the same way and do not tend to change courses of action if they are happy. If the results are not too painful individuals can be happy with sub-optimal results. Moreover, individuals who tend to be unhappy make changes often and eventually end up being just as unhappy in their new circumstances. According to the traditional view of Investment management, fundamental forces drive markets, however many other investment firms considers to be active and working out based on their experienced Judgment. It is also believed that Judgmental overrides of Value Fundamental forces of markets can be lethal as well as a cause of Financial Disappointment. From the history it has be en found that people Override at the wrong times and in most cases would be better off sticking to their investment disciplines (Crowell, 1994) and the reason to this behavior is the Cognitive bias. According to many researchers, stocks of small companies with low price/book ratios provide excess returns. Therefore, given a choice among small cheap stocks large high priced stocks, prominent investors (financial analysts, senior company executives and company directors) will certainly prefer the small cheap ones. But the fact is opposite to this situation where these prominent investors would opt for large high priced ones and so suffer from cognitive bias and further regret. According to a survey in 1992/1993, a research was carried out that included senior executives directors where they were suppose to rank companies in the similar industry based on eight factors. Quality of Management, Quality of products services, Innovativeness, Long term Investment value, Financial soundnes s, Ability to attract, develop and keep talented people, Responsibility to the community and environment, Wise Use of Corporate assets. (Crowell, 1994).The assumptions that we made were that that Long term investment value should be negatively correlated with size since small stocks provide superior returns. Long term Investment value should have a negative correlation with Price/book since low Price/Book stocks provide superior returns. (Crowell, 1994). Whereas the results of the survey were contrary that stated that Long Term Investment had a positive correlation with the size and also that the Long term investment value had a positive correlation with the Price/Book stocks. According to Shefrin and statman, prominent investors overestimate the probability that a good company is a good stock, relying on the representative heuristics, concluding that superior companies make superior stocks. Aversion to Regret aversion to regret is different from aversion to risk Regret is acute whe n the individual must take responsibility for the final outcome. Aversion to regret leads to a preference for stocks of good companies. The choice of the stocks of bad companies involves more personal responsibility and higher probability of regret. Therefore, we find there are two major Cognitive errors We have a double cognitive error good company always makes good stock (representativeness), and involves less responsibility(Less aversion to regret. (Crowell, 1994,p.3) The Anti Cognitive bias actions would be admitting to your owned stocks, admitting earlier investment mistakes. Further Taking the responsibility for the actions to improve their performance in the future. The reasons for all the available disciplines, tools, and quantitative techniques is to deal with the Cognitive bias error, where the quantitative investment techniques enables the investment managers to overcome cognitive bias, follow sound investment, and eventually be successful contrarian investor(one who reje cts the majority opinion, as in economic matters). Behavioral finance also is very helpful in understanding justifying government involvement in the investing decisions of individuals. The failure of millions of people to save properly for their future is also a core problem of behavioral finance. With the help of two very important examples Shiller explains how Government involvement can influence financial investments of individuals. In April 2005 Tony Blair stated a program when all new born babies were given a birthday present of 250 to 500. The present were to choose among a number of investment alternatives to invest until child comes of age. This is an effect done in order to make the parents feel connected with investments and modern economy. Another example as it is said that people should be heavily active in stock market when they are young and so generally should reduce the activity with age. According to the conventional rule people should have100 Age = % age of invest ment.In 2005 president bush also portfolio announced one such plan for personal account life cycle fund which would be among the option that works will be offered to invest their personal account. It was A centerpiece of the presidents proposal bur a major point to be noticed was the default option. An important aspect of behavioral finance is the human attention is capricious focuses heavily that same times on financial calculations and are subject to distraction and dissipation of default option is central. All this brings us a question that what should an intertemporal optimizer do to manage his portfolio over the lifetime. According to Samuelson someone who wished to maximize the expected value of his intertemporal utility function by managing the allocation of the portfolio between a high yielding asset and less yielding asset would not actually change the allocation through time. Neoclassic finance appears highly relevant to such a discussion in that it offers the appropriate theoretical framework for considering what people ought to do with the portfolio if not what they actually do. Behavioral is beginning to play an important role in public policy such as in social security reforms.5. Agents RationalityGlobal culture Social Contagion The selective attention exhibited by a human mind is the concept of culture. Every nation, tribe or asocial group has a social cognition reinforced by conversation ritual and symbols, rituals and supposition of a particular nation has a subtle but far reliability affect on human behavior. Some researchers found that the unique customs of people basically appears as a logical outcome of a belief system of a nation group of people. The Cultural factors were one of the major influences on rational or irrational behavior. We find many factors that are same across countries , e.g fashion, music, movies, youthful rebelliou