Market rationality Behavioral Finance vs. Classical Finance

1. Market rationalityBehavioral Finance vs. Classical Finance Alexander Nagornov

2. Main questions • Is classical financial theory old and incapable of explaining most of the market riddles? Or just several modifications will be enough to make it work? • What new can you find in behavioral finance? Can you use the results of research in this field to get excess returns?

3. Presentation Outline • A question of rationality • Known major deviationsfrom rational behavior • Royal Dutch / Shell Classical example • Classical theory strategic defense • Even more market anomalies

4. Are people rational? • Rationality Definition • Sometimes it’s really hard to be rational • Have you calculated NPV deciding to study at ABS? • Example of a Singing Professor • Subjective probability Overestimation of small probabilities when dealing with big potential profits and losses 1. Rationality

5. Rationality in finance • The Prime Directive • Asset prices have to be explained by rational models! • Behavioral Finance • Investors are just people with a great number of deviations from rational behaviour • That’s why there is a variety of effects, which explain market anomalies 1. Rationality

6. 1. Excessive Confidence • Excessive confidence about the precision of private information • Biased self estimation • Willingness to keep “losers” and sell “winners” • Illusion of control – unjustified belief in an opportunity to influence events 2. Deviations from rational behavior

7. 2. Statistical Errors • Gambler’s fallacy: a wish to see patterns where they can not be • Giving too small or too big probabilities to rare events • Giving excessive weight to personal experience • Excessive reaction – giving excessive weight to recent events 2. Deviations from rational behavior

8. 3. Mistakes in statements • Axioms violation (e.g. transitivity) • Influence of sunk costs on financial decisions • Dynamic inconsistency: negative discount rates, etc. • Willingness to take excessive risks • Herding • Overestimation of the model results and theory implications 2. Deviations from rational behavior

9. Limits to arbitrage Royal Dutch / Shell Deviation John Maynard Keynes: The market can remain irrational longer than you can remain solvent • LTCM tried to make money on arbitrage • They failed  • Closing positions made markets even less efficient 3. Limitations to arbitrage

10. Line of defense #1Market efficiency and rationality • Absolute rationality • all investors are rational • Rationality • “as if rational” • Weak rationality • not rational, but no profit opportunities 4. Classical Theory Defense

11. Line of defense #2Models are not perfect yet, but… • Rationality really takes into account several behavioral moments: • Greed • Risk aversion • Impatiens: discounting future values • Habit formation: need go away from additive-separable function of utility 4. Classical Theory Defense

12. Major market anomalies • Bubbles on financial markets • Excessive volatility • Risk premium riddle • Significance of Market-to-Book and Firm size vs. CAPM • Calendar effects 5. More anomalies

13. Conclusion • Markets are far from being rational and efficient • A variety of anomalies exist where they should not • Behavioral finance comes to the rescue • Takes into account decision making process • Do not ignore costs of thinking • Classical theory defense line: • Point to a weak form of rationality • Search the data errors

14. Thank you for attention!