Neoclassical Finance versus Behavioral Approach (II) 2016/03

Portfolio Theory Classical portfolio theory is based on the concept according to which every investment in security is accompanied with two kinds of risk: systemic (market) and nonsystemic (unique, specific). Rational investors should diversify their investments in such a way as to eliminate nonsystemic risk and create efficient portfolio displaying minimum variance (risk) for specific expected returns or guaranteeing maximum expected return for a given risk level. The set of efficient portfolios is known as the efficient frontier.

Portfolio Theory Proponents of behavioral finance challenge the classical portfolio theory. They undermine the standard utility hypothesis and show that probability is incorrectly estimated. This suggests that fundamental assumptions behind Markowitz theory are not fulfilled. Another assumption that do not work in practice is the one related to normal distribution and the ability to precisely describe the process whereby returns are generated.

Portfolio Theory Many empirical results show that investors often do not follow the rule of minimizing nonsystemic risk, running portfolios that are not diversified enough. In addition, they do not attach enough importance to the issue of correlation between different kinds of assets. Low level of diversification and underestimating the importance of mutual correlation between assets blatantly undermine Markowitz’s classical portfolio theory. If some investors create inefficient portfolios, the entire market portfolio might turn out to be inefficient.

Capital Asset Pricing Model Markowitz’s portfolio theory paved the way for the Capital Asset Pricing Model (CAPM) formulated by Sharpe (1964), Lintner (1965), and Mossin (1966). The CAPM model was put forward based on a series of assumptions. Investors are risk averse and try to maximize utility, shaping their preferences in accordance with Von Neumann and Morgenstern’s theory. They create efficient portfolios on the basis of Markowitz’s portfolio theory. All market players are homogeneous. Capital market is perfect.

Capital Asset Pricing Model Pioneer empirical tests of the CAPM were carried out by Black, Jensen, and Scholes (1972), and Fama and MacBeth (1973). The former group performed a time-series regression for returns of portfolios listed at the New York Stock Exchange (NYSE) in the years 1931–1965; the latter studied the period of 1926–1968. Results of their analysis generally confirmed that the CAPM works well as a tool describing the process shaping returns on the American market.

Capital Asset Pricing Model Later studies led to many controversial results. It was more and more often said that returns could be predicted not only on the basis of the beta coefficient, which was supposed to be the only determinant of the expected risk premium. Fama and French (1992, 1993, 1996) argue that the wide range of identified relationships may be in fact reduced to two important phenomena—the size effect and the book-to-market equity effect. They suggest a Three Factor pricing model (determined empirically instead of theoretically).

Capital Asset Pricing Model In the Three Factor pricing model the traditional market risk premium is supplemented by two additional elements related to the size of the company and the book-to-market equity ratio. Proponents of behavioral finance do not negate the empirical observations made by Fama and French (1992, 1993, 1996), but they reject their interpretation. They account for the company size effect by the presence of individual noise traders and explain higher returns for companies with high book-to-market equity ratios as related to market overreaction.

Capital Asset Pricing Model They challenge the classical school of thought, which says that if there were higher average returns for a given category of companies, they must have represented a rational premium for extra risk.

Efficient Market Hypothesis According to the classical definition suggested by Fama (1970), an efficient market is a market in which prices always fully reflect available information. Roberts (1967) first distinguished, and then Fama (1970) adopted and wildly publicized, three basic forms of informational efficiency of capital market depending on the scope of information to be reflected in asset prices. The EMH rests on three main assumptions. Investors are assumed to be rational and hence to value assets rationally.

Efficient Market Hypothesis Irrational investors in the market trade randomly. In such a case, markets remain efficient even if not all investors are rational. Even if irrationality becomes common for a relatively large group of investors who act in a correlated manner, and therefore are able to move prices away from fundamental levels, it is assumed that rational arbitrageurs quickly notice the mispricing and act appropriately. As a result, market forces will bring asset prices back to fundamentals.

Efficient Market Hypothesis Until the mid-1980s, the EMH turned into an enormous theoretical and empirical success. However, from the beginning of the 1980s, and more and more in the 1990s, new empirical studies of security prices have reversed some of the earlier evidence favoring the EMH. The traditional finance school named these observations anomalies, because they could not be explained in the neoclassical framework.

Corporate Finance Traditional corporate finance theory shares many assumptions with the neoclassical financial economics. It typically assumes that managerial performance is targeted at maximization of shareholder wealth. The CAPM has been typically used to determine the cost of equity. Under the EMH, the cost of firm financing should be always adequate and depend solely on how risky the company is. Capital budgeting and investment policy A decision to invest in a new project should be made according to whether the project increases the firm’s value. Dean (1951) formally introduced the NPV rule.

Corporate Finance Behavioral corporate finance proposes that because the estimation of a project’s future cash flows and the discount rate is complex and difficult, the evaluation process may be affected by managerial personal traits and psychological biases. Excessive optimism is likely to lift upward the forecasted cash flows, and overconfidence might lead to the underestimation of the project’s risk, hence application of too low a discount rate. Behavioral distortions in corporate investment policies may also result from market inefficiency.

Corporate Finance Financial policy and capital structure Modigliani and Miller (MM, 1958) formulated their famous theorem of capital structure irrelevance to corporate value. MM (1963) extended their initial model by introducing personal and corporate taxation. The pecking order theory predicts that firms tend to use their accumulated internal funds first, then debt financing, and decide to raise money from new equity issuances only as a last resort.

Corporate Finance Behavioral finance argues that the same capital structure preference as predicted by the pecking order theory may result from managerial overconfidence and excessive optimism. Another approach within the context of behavioral reasoning relates to market timing. In this framework, managers are assumed to act rationally in the interest of long-term shareholders and to exploit temporary market mispricing and investor irrationality. Finally, behavioral finance argues that in some cases, rational managers may cater to investor tastes.