Traditional Finance versus Behavioral Finance (by Fabian Leonhardt)

 Some behavioural models use the same assumptions about the behaviour of traders but come to different conclusion as to why the momentum effect exists. As mentioned above, no superior model exists. Momentum and further exploitation lead to a higher volatility in financial markets and away from the basic function of the financial market. Momentum can support the development of bubbles, which can be very costly for society. The regulators must be aware of this fact and should focus on dynamic regulation of competition and a market in which arbitrage is easier. Furthermore, regulators must intervene if a bubble occurs, even when it is not easy to realize a bubble and when the market itself is not realizing it. Nevertheless, the authorities will get feedback from the market and correct their mistakes. Leverage has to be controlled more strictly. It is clear that leverage plays a critical role in asset pricing.The most important function of a capital market is still the efficient allocation of capital and providing capital for the “real” economy. Furthermore, one has to start to accept behavioural finance not just as a red herring for explaining a few anomalies, but as a foundation for our utility theory, which is the base for our whole economic theory. That’s why Thaler chose the ironic title The End of Behavioural Finance for his paper, because is there any other finance than behavioural? On the other hand one may argue:

“If behavioural finance is ever to approach the stature of classical asset pricing, it will have to move beyond being a large collection of empirical facts and competing one- off models, and ultimately reach a similar sort of consensus. While this goal seems well within sight in the part of the field that explores limits to arbitrage, it is much further away in the part that seeks to understand the origins of market mispricing. Many horses are still running in this latter race, and it is still not clear whether a decisive winner will emerge in a foreseeable future.” (Hong, Stein (2006), p. 25)

George Soros argues that behavioural finance only explains one half of the financial world, namely why mispricing occurs. The other half is that

mispricing itself can change reality to some extent. Thus, investing itself can change the fundamental values. If this statement were true, reality would be shaped by the interests of financial markets as well as the other way around.That is what George Soros calls reflexivity. The momentum effect as a persistent market anomaly plays the role of an advocate diabolist and might help further researches to bet on the right horse and to develop a theory that improves the efficient allocation of capital in the interest of the whole economy. Finally, we must learn to be aware of our own fallibility. The progress of knowledge is framed not just by what we know, but also by gaining a better understanding of what we cannot know.


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Comments: 1
  • #1

    Alberto Zaffaroni (Tuesday, 17 January 2012 21:40)

    I carefully read your point of view about traditional vs behavioural finance. I think that the best proof of the importance of behavioural finance is given by everyday financial news we get during this tormented period. What's left of traditional finance? What's left of great assumptions, perfect models, rational behaviour leading to efficiency? Take italy, for example. We may still far away from a quiet living, but Monti and his government took serious actions to bring back Italy on the right way. Now we're much more steady and robust than we were only a few weeks ago, but markets still act so to keep high interest rates and risk rates on Italy. Is that rational? I don't think so. The financial world as a whole and the academic one too should give much more importance to this field of economic analysis, which might prove to be a more powerful instrument to better understand the (financial and economic) world we live in.