Market rationality Behavioral Finance vs. Classical Finance

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Market rationalityBehavioral Finance vs.
Classical Finance

• Alexander Nagornov

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Main questions

• Is classical financial theory old and incapable
  of explaining most of the market riddles? Or just
  several modifications will be enough to make it
  work?
• What new can you find in behavioral finance? Can
  you use the results of research in this field to
  get excess returns?

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Presentation Outline

1. A question of rationality
2. Known major deviations from rational behavior
3. Royal Dutch / Shell Classical example
4. Classical theory strategic defense
5. Even more market anomalies

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Are people rational?

• Rationality Definition
• Sometimes its really hard to be rational
• Have you calculated NPV deciding to study at ABS?
• Example of a Singing Professor
• Subjective probability
• Overestimation of small probabilities when
  dealing with big potential profits and losses

1. Rationality
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Rationality in finance

• The Prime Directive
• Asset prices have to be explained by rational
  models!
• Behavioral Finance
• Investors are just people with a great number of
  deviations from rational behaviour
• Thats why there is a variety of effects, which
  explain market anomalies

1. Rationality
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1. Excessive Confidence

• Excessive confidence about the precision of
  private information
• Biased self estimation
• Willingness to keep losers and sell winners
• Illusion of control unjustified belief in an
  opportunity to influence events

2. Deviations from rational behavior
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2. Statistical Errors

• Gamblers fallacy a wish to see patterns where
  they can not be
• Giving too small or too big probabilities to rare
  events
• Giving excessive weight to personal experience
• Excessive reaction giving excessive weight to
  recent events

2. Deviations from rational behavior
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3. Mistakes in statements

• Axioms violation (e.g. transitivity)
• Influence of sunk costs on financial decisions
• Dynamic inconsistency negative discount rates,
  etc.
• Willingness to take excessive risks
• Herding
• Overestimation of the model results and theory
  implications

2. Deviations from rational behavior
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Limits to arbitrage
Royal Dutch / Shell Deviation
John Maynard Keynes The market can remain
irrational longer than you can remain solvent

• LTCM tried to make money on arbitrage
• They failed ?
• Closing positions made markets even less
  efficient

3. Limitations to arbitrage
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Line of defense 1Market efficiency and
rationality

• Absolute rationality
• all investors are rational
• Rationality
• as if rational
• Weak rationality
• not rational, but no profit opportunities

4. Classical Theory Defense
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Line of defense 2Models are not perfect yet,
but

• Rationality really takes into account several
  behavioral moments
• Greed
• Risk aversion
• Impatiens discounting future values
• Habit formation need go away from
  additive-separable function of utility

4. Classical Theory Defense
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Major market anomalies

• Bubbles on financial markets
• Excessive volatility
• Risk premium riddle
• Significance of Market-to-Book and Firm size vs.
  CAPM
• Calendar effects

5. More anomalies
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Conclusion

• Markets are far from being rational and efficient
• A variety of anomalies exist where they should
  not
• Behavioral finance comes to the rescue
• Takes into account decision making process
• Do not ignore costs of thinking
• Classical theory defense line
• Point to a weak form of rationality
• Search the data errors

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Thank you for attention!