Question

3. What is the behavioral critique?

regarding behavioral finance and technical analysis

Answer 1

BEHAVIOURAL CRITIQUE:

Behavioural finance, a sub-field of behavioural economics, proposes psychology-based theories to explain financial anomalies, such as severe rises or falls in stock price. The purpose is to identify and understand why people make certain financial choices. Within behavioural finance, it is assumed the information structure and the characteristics of market participants systematically influence individuals' investment decisions as well as market outcomes.

As investors, they are concerned with the existence of profit opportunities. The behavioural explanations of efficient market anomalies do not give guidance as to how to exploit any irrationality. For investors, the question is still whether there is money to be made from mispricing, and the behavioural literature is largely silent on this point. If prices are distorted, then capital markets will give misleading signals (and incentives) as to where the economy may best allocate resources. In this crucial dimension, the behavioural critique of the EMH is certainly important irrespective of any implications for investment strategies.

Behavioural finance encompasses many concepts, but four are key:

• Mental accounting
• Herd behaviour
• Anchoring
• High self-rating and overconfidence.

Mental accounting refers to the propensity for people to allocate money for specific purposes based on miscellaneous subjective criteria, including the source of the money and the intended use for each account. The theory of mental accounting suggests that individuals are likely to assign different functions to each asset group or account, the result of which can be an illogical, even detrimental, set of behaviours. For instance, some people keep a special “money jar” set aside for a vacation or a new home while at the same time carrying substantial credit card debt.

Herd behaviour states that people tend to mimic the financial behaviours of the majority, or herd, whether those actions are rational or irrational. In many cases, herd behaviour is a set of decisions and actions that an individual would not necessarily make on his or her own, but which seem to have legitimacy because "everyone's doing it." Herd behaviour often is considered a major cause of financial panics and stock market crashes.

Anchoring refers to attaching spending to a certain reference point or level, even though it may have no logical relevance to the decision at hand. One common example of “anchoring” is the conventional wisdom that a diamond engagement ring should cost about two months’ worth of salary. Another might be buying a stock that briefly rose from trading around $65 to hit $80 and then fell back to $65, out of a sense that it's now a bargain (anchoring your strategy at that $80 price). While that could be true, it's more likely that the $80 figure was an anomaly, and $65 is the true value of the shares.

High self-rating refers to a person's tendency to rank him/herself better than others or higher than an average person. For example, an investor may think that he is an investment guru when his investments perform optimally (and blocks out the investments that are performing poorly). High self-rating goes hand-in-hand with overconfidence, which reflects the tendency to overestimate or exaggerate one’s ability to successfully perform a given task. Overconfidence can be harmful to an investor’s ability to pick stocks, for example. A 1998 study entitled “Volume, Volatility, Price, and Profit When All Traders Are Above Average,” by researcher Terrence Odean found that overconfident investors typically conducted more trades as compared with their less-confident counterparts—and these trades actually produced yields significantly lower than the market.