1. Neoclassical Finance versus Behavioral Approach
2017/03

2. Neoclassical Finance
The neoclassical financial theory made various strong assumptions including decision makers’ rationality, common risk aversion, perfect market, and easy access to information for all market participants.
The neoclassical financial economics assumed that all decision makers, or at least a large majority of them, behave rationally.
Rational decision makers try to maximizes the total expected utility, while displaying general risk aversion in making risky decisions.

3. Neoclassical Finance
Rational decision makers know how to interpret incoming information and correctly estimate the probability of future events on that basis.
Markowitz (1952) developed the portfolio theory according to which rational investors should create well-diversified portfolio.
The CAPM reflected that specific factors have no impact on investment returns. The expected returns on securities should depend only on the level of systemic (market) risk.

4. Neoclassical Finance
The neoclassical theory also assumed that if there are instances of irrationality on the part of some investors resulting in asset mispricing, this is quickly corrected by actions taken by rational market players.
Consequently, capital markets is always efficient in that it prices assets correctly reflects all the available information (Fama 1965,1970).
Although many of the assumptions of neoclassical financial theory were unrealistic, financial economists accepted it because its predictions seemed to fit reality. Early empirical evidence was supportive of EFM and the CAPM.

5. Behavioral Finance
Behavioral Finance emerged in response to recent empirical results that contradicted the traditional finance. Yet, issues related to investors’ behavior and the way it affects valuations of assets are complex. Thus it is difficult to develop a comprehensive theory.
So far behavioral models focus on selected aspects of the market. Some studies identify a specific market peculiarity and then attempt to explain it. Some papers focus on a given irrational behavior and its impact on asset pricing. Some authors concentrate more on the psychology of decision making and risk taking, but to a lesser extent to its impact on the market.

6. Behavioral Finance
A comprehensive behavioral approach should study the whole story starting with psychology, to irrational behavior of market participants and anomalous results of such behavior in asset pricing, to the implications for real-life practice.
As behavioral finance changes the way we look at investor behavior and asset pricing in capital markets, it must naturally also have implications for the second group of capital market participants, that is, for corporations. Behavioral corporate finance takes two distinctive approaches.

7. Behavioral Finance
The first one emphasizes the effect of market inefficiency on corporate policy, assuming that executives act as rational professionals. It focuses on how a smart manager adapts corporate policy in order to exploit investor irrationality and market inefficiency.
The second approach emphasizes how managerial biases affect corporate policy and its impact on firm value and shareholders’ wealth.

8. Decision-Maker Rationality
According to the neoclassical finance, a rational decision maker follows two general rules. First, he displays so-called risk aversion in that he is willing to take risk only when he stands a chance of being rewarded with a risk premium. Second, decision makers always make choices in such a way as to maximize total expected utility. Behavioral approach challenges both these assumptions.
Von Neumann and Morgenstern (1944) formalized the classical theorem on the existence of the utility function. Four axioms cause the most controversy among representatives of behavioral finance.

9. Decision-Maker Rationality
Axiom of completeness. This axiom assumes that a rational decision maker knows how to compare different options and has well-defined preferences.
Axiom of transitivity. If a decision maker prefers variant A to B and rates variant B higher than C, then he will also prefer A to C.
Axiom of continuity. This axiom says that the choice between two variants should depend upon differences between them and conditions under which the two variants lead to different results. If both options are changed in the same way, decision maker’s preferences should remain as they were.

10. Decision-Maker Rationality
A (6000, 0.45) C (6000, 0.001)
Choice Choice 2
B (3000, 0.9) D (3000, 0.002)
Another aspect putting the axiom into question is the issue of sensitivity to the way in which a decision problem is presented. In other words, dependence on information framing (see the example in p.12).
Axiom of independence.

11. Decision-Maker Rationality
Probability assessment. According to the traditional theory, rational decision makers can correctly estimate the probability of different scenarios and modify their belief in the light of new information. Such verification of probability should be done according to Bayes’s rule.
Proponents of behavioral finance provide many arguments proving that investors struggle to correctly estimate probability, finding it especially difficult to apply Bayes’s rule properly(see the example in p.15).

12. Decision-Maker Rationality
People overreact to powerful information of a descriptive nature downplaying the importance of underlying statistical data.
Another demonstration of problems with base probability and application of Bayes’s rule is a judgment based on a stereotype. Having noticed a clear personal trait corresponding to a common stereotype, respondents are overconfident about the probability that the person will follow the stereotype and underestimate base probability (see the Linda example in p.15~16).

13. Decision-Maker Rationality
On the other hand, if the information received cannot be assigned to any specific pattern already familiar to the decision maker, the opposite phenomenon, the so-called conservatism bias, may take place.
Decision makers do not pay enough attention to the size of the sample on the basis of which they estimate probability. They overemphasize information derived from small samples to the detriment of signals generated by samples containing a lot of observations.

14. Decision-Maker Rationality
Another obstacle to estimating probability correctly is overconfidence observed in the form of calibration error. Respondents are overconfident as to the precision of their knowledge.
Kaheman and Tversky (1979) claim that, in general, people attach too much importance to highly unlikely events, underestimating those where the probability is relatively high.

15. Limits to arbitrage
The existence of irrational investors was not ruled out in the traditional financial economics. However, it was assumed either that irrational investors are not coordinated and therefore their behavior cancels out or that the actions of rational arbitrageurs can efficiently correct market mispricing.
Behavioral finance does not negate the principle of arbitrage itself. However, in practice, arbitragers face a series of limitations that partly or totally constrain their actions.

16. Limits to arbitrage
Fundamental risk. This kind of risk is due to the fact that financial markets do not always offer an ideal substitute whose price will react to news in exactly the same way as the price of the security to be initially mispriced.
Noise trader risk. This kind of risk stems basically from the danger of more intense activities on the part of noise traders who may cause the price of the security to deviate even further from its fundamental value.

17. Limits to arbitrage Implementation costs and regulatory barriers.
Risk of synchronization. Abreu and Brunnermeier (2002) propose a model demonstrating that arbitrageurs are exposed to the so-called risk of synchronization stemming from uncertainty on the part of individual arbitrageurs as to when other rational traders will notice the incorrect pricing of the security and take steps to eliminate it.
Implementation costs and regulatory barriers.

18. Portfolio Theory
Classical portfolio theory was developed primarily by Markowitz (1952). It is based on the concept that every investment in securities 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.

19. 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. The choice between alternative investment portfolios may not be made solely on the comparison between expected returns and variance.

20. 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.

21. 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 expected utility. They create efficient portfolios on the basis of Markowitz’s portfolio theory. All market players are homogeneous. Capital market is perfect.

22. Capital Asset Pricing Model
Pioneer empirical tests of the CAPM were carried out by Black, Jensen, and Scholes (1972), and Fama and MacBeth (1973). Results of their analysis generally confirmed that the CAPM works well as a tool describing the process shaping returns on the American market.
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.

23. Capital Asset Pricing Model
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).
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.

24. Capital Asset Pricing Model
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.
In other words, they challenge the classical school of thought: If there were higher average returns for a given category of companies, they must have represented a rational premium for extra risk.

25. 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.
(1)Investors are assumed to be rational and hence to value assets rationally.

26. Efficient Market Hypothesis
(2)Irrational investors in the market trade randomly. In such a case, markets remain efficient even if not all investors are rational.
(3)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.

27. 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.

28. Corporate Finance
Traditional corporate finance theory shares many assumptions with the neoclassical financial economics. It typically assumes that manager is targeted at maximization of shareholder wealth. The CAPM has been typically used to determine the cost of equity.
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.

29. 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 a discount rate that is too low. Behavioral distortions in corporate investment policies may also result from market inefficiency.

30. 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.

31. 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.