1. Neoclassical Finance versus Behavioral Approach (I)
2016/02

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 and reflects all the available information.
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 behavior 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 policy and its impact on firm value and shareholders’ wealth.

8. Decision-Maker Rationality
According to the neoclassical theory of 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.

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.
Axiom of independence.

11. Decision-Maker Rationality
Probability assessment. According to the traditional theory of finance, 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.

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.

13. Decision-Maker Rationality
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 efficiently correct market pricing, as soon as irrational traders happen to derive them away from fundamentals.
Behavior 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.