Behavioral Finance

(1.5 Credits)

Examines the causes and effects of inefficient stock and bond markets Topics covered include a review of theory and evidence of efficient securities markets empirical facts that do not fit the efficient market paradigm bubbles valuation ratio spreads momentum and market timing issues closed end fund discounts limits on arbitrage that allow mispricings to persist and aspects of investor psychology that may be behind observed phenomena. [Long] The field of Finance has traditionally made assumptions of human rationality in decision making in order to facilitate modeling. It has been a great success that has developed powerful Nobel prize-winning theories that are quite consistent with observation – contributions such as portfolio theory, option-pricing, valuation, agency and signaling among others. These contributions have gone on to revolutionize the practice of both investment and corporate finance. However, there remain many anomalies that these traditional models struggle to explain; such as, various anomalies in the price of assets (e.g., why low P/E firms outperform the high ones), the wide swings in stock prices – say relative to the more stable dividends shareholders receive, and why managers attempt to keep earnings stable through Earnings Per Share (EPS) manipulation. The field of Behavioral Finance has put forth explanations for these anomalies and others by relaxing the assumption of the completely rational, disciplined and selfish human. In this course, we define the traditional finance's decision-maker as having three traits: (1) he is only interested in maximizing his own welfare; (2) his models for determining his utility as a function of his actions follow perfect mathematical logic; and (3) the cool, calm and collected decision-maker takes actions without emotional bias. We will find that there are substantial violations of each of these. What behavioral economists call bounded self-interest, bounded rationality and bounded will-power. Thus, humans being aware of them can help themselves in their everyday life as well as in finance, and that they might shed light on some of the anomalies that Traditional Finance have had a hard time explaining.