1.1 Abnormal Markets, Irrational Investors
This book represents one of the first two volumes in the series, âQuantitative Perspectives on Behavioral Economics and Finance.â Its companion volume, Postmodern Portfolio Theory: Navigating Abnormal Markets and Investor Behavior, addresses leading departures from the putative efficiency of financial markets. 1 Intense pressure on the conventional capital asset pricing model gave rise to theoretical innovations such as Eugene Fama and Kenneth Frenchâs three-factor model. Postmodern Portfolio Theory traces this story through the four statistical moments of the distribution of financial returns: mean, variance, skewness, and kurtosis.
This book conducts a fuller exploration of behavioral phenomena in finance, such as the low-volatility anomaly, the equity premium puzzle, and momentum in stock returns. Mental accounting, persistent gaps between hypothetical investment return and actual investor return, and alternatives to modern portfolio theory and the conventional capital asset model contribute to the development of behavioral approaches to portfolio design and risk management. Gaps in perception and behavioral departures from rational decision-making appear to spur momentum, even irrational exuberance and speculative bubbles. Ultimately, this book hopes to explain emotion-laden deviations from the strict rationality traditionally associated with mathematical finance. Together with Postmodern Portfolio Theory, this book synthesizes observations on abnormal markets and irrational investors into a coherent behavioral account of financial risk management.
Chapter 1 traces the rise of the behavioral revolution in portfolio theory and, more generally, in mathematical finance. Like any other story in the history and philosophy of science, the transformation of portfolio theory begins with the identification of anomalies. Only after identifying anomalies and challenging an established paradigm can dissenters lay a credible claim to a competing intellectual movement.
Behavioral accounting, arising from the irresistible human urge to keep emotional score, undermines modern portfolio theoryâs rational premises. The separation theorem and the two mutual fund theorem counsel investors to consolidate all assets into a single portfolio along the efficient frontier. But individual and even institutional investors consistently reject that sort of normative guidance. Assets and portfolios are imbued with âaffect,â and positive and negative emotions warp investment decisions. Chapter 2 explores two seemingly divergent but ultimately similar manifestations of emotion in economics: Maslowian portfolio theory and behavioral environmental economics.
Chapter 3 introduces some of the most important mathematical tools in behavioral finance. After summarizing the conventional capital asset pricing model, Chapter 3 presents a higher-moment approach to capital asset pricing as an outgrowth of the Taylor series expansion of logarithmic returns.
Finance proceeds from the assumption that risk and return are positively correlated. If investors are generally risk averse, they will presumably demand a higher return in exchange for buying assets whose prices exhibit higher variance. Departures from this relationship between risk and return undermine this theoretical foundation of finance. In reality, some of the highest returns are available on the stocks exhibiting the lowest levels of volatility. Along with its analogue in accounting, Bowmanâs paradox, the low-volatility anomaly poses a serious challenge to the conventional financial narrative. Chapter 4 tracks the low-volatility anomaly in behavioral space by examining beta on either side of mean returns and analyzing the separate volatility and correlation components of beta. Chapter 5 introduces the intertemporal capital asset pricing model and the prospect of explaining the low-volatility anomaly according to time as well as space.
Chapter 6 outlines a quantitative approach to risk aversion. It specifies the ArrowâPratt measures of absolute and relative aversion, as well as the famously tractable model of hyperbolic absolute risk aversion, as a prelude to examining a more behaviorally sensitive account of human responses to risk. Two paradoxes, Allaisâs paradox and the St. Petersburg paradox, suggest that conventional accounts of risk aversion do not provide a comprehensive explanation of economic behavior in the face of risk or uncertainty.
Risk aversion provides at least a partial explanation for the historic premium that equities have commanded over lower-risk investments such as bonds. Though accounts vary, the equity risk premium rests in the neighborhood of 3â6% per year. The magnitude of this premium, however, poses a formidable (and arguably, still unresolved) theoretical challenge to conventional asset pricing models. Building on Chapter 6âs measures of risk aversion, Chapter 7 explores both the equity risk premium and the econometric puzzle to which that premium has given rise. The equity premium puzzle is to behavioral finance as the low-volatility anomaly is to modern portfolio theory and the conventional capital asset pricing model: Without resolving contradictions of this magnitude, many of the theoretical suppositions of mathematical and behavioral finance will be squarely contradicted by the behavior of real markets and real investors.
The final chapters of this book present two leading accounts of behavioral finance, prospect theory and SP/A (security-potential/aspiration) theory. Those chapters also offer thoughts on speculative bubbles in finance. Chapter 8 introduces prospect theory, arguably the most prominent manifestation of behavioral economics in finance. The theoryâs fourfold pattern provides the most widely accepted account of risk-averse as well as risk-seeking behavior. Prospect theory explains the financial impact of fear and greed. Humans depart from purely rational utility in three ways. First, humans heed reference points. Second, humans hate losing more than they like win...