Thursday, September 15, 2005

Modern Finance vs. Behavioural Finance: An Overview of Key Concepts and Major Arguments by Panagiotis Andrikopoulos

It is about the time of the semester when many finance classes turn their attention to market efficiency. Thus, it is perfect timing for Andrikopoulous' refresher comparing and contrasting Modern Fiance and Behavioural Finance.

SSRN-Modern Finance vs. Behavioural Finance: An Overview of Key Concepts and Major Arguments by Panagiotis Andrikopoulos:

A quick look in:
  • "Modern Finance has dominated the area of financial economics for at least four decades. Based on a set of strong but highly unrealistic assumptions its advocates have produced a range of very influential theories and models."
  • "The importance of these two psychological biases in the under- and overreaction hypotheses is that investors under conservatism will only partially evaluate new publicly available information, or even disregard it altogether if it is not in favour of their beliefs"
  • "Under the representativeness heuristic, investors will consider a series of positive company performances as representative of a continuous growth potential, and ignore the possibility that this performance is of a random nature."
  • "Overreaction and under-reaction to new information may be viewed as a combination of three distinct inefficiencies; firstly, the inability of investment players to correctly distinguish between the length of the short-run and the long-run...; secondly, the excessive optimism of all investment agents due to biased self-attribution, and thirdly, the influence that one investment group has on another."
Of course, not everyone believes this new Behavioural School of thought. Again from the paper:

"Soon after the first empirical papers on behavioural finance were published, their claims came in for considerable criticism from supporters of the modern finance paradigm."

"important counter-argument disputes the existence of certain regularities and argues for the existence of research biases and other methodological shortcomings in behavioural finance studies. More commonly, the evidence on the existence of pricing anomalies is accepted but in that case, the most important response concerns the existence of additional risk factors, e.g. value premium can be explained as compensation for bearing additional systematic risk."
In this light of continually counter-punching against evidence suggesting rationality does not dominate
"It is also claimed that the positive contributions of modern finance are at an end and that its energies are now devoted to protecting itself in various ad hoc ways from the threat posed by the vast and growing anomalies literature. The simplifying models of modern finance, under this view, should be regarded as merely rough first approximations to how markets really behave, and that they stand in need of substantial revision and extension."
Andrikopoulos concludes:
"Nevertheless, the rational expectations model and the efficient markets model can never become obsolete, since they represent an ideal market. Should the behavioural finance revolution succeed, its applications in practice will simply move real markets closer to the ideal of semi-strong market efficiency."
Very nice. I like the perspective it gives even though at times I thought he made the division stronger than it generally appears to be.

My view? Probably be that modern finance is a very good first approximation and more often than not, the correct view. That said, I will concede (and indeed stress) that markets are far from perfect and behavioural finance is rightly here to stay for it does add to our understanding and (as Andrikopoulos points out) most assuredly moves markets closer to the ideal held by modern finance.

Andrikopoulos, Panagiotis, "Modern Finance vs. Behavioural Finance: An Overview of Key Concepts and Major Arguments" (June 2005).

1 comment:

Anonymous said...

What about time varying risk premia ? It´s under the modern finance paradigm and can account for a lot of the anomalies behavioralists call inneficiencies, like the "excessive volatility" of prices.