Behavioural Finance

Anomalies found in the Efficient Market Hypothesis tests are consistent with the irrationalities of
the individuals making investment decisions and limits to arbitrage.

Information processing
Biases arise due to errors in information processing, resulting in misestimation of true
probabilities of possible events or associated rates of return.
Forecasting errors: too much weight to recent experience compared to prior beliefs, resulting
in extreme forecasts [Short memory]
Overconfidence: too much trading; dominance of active management, despite its
underperformance
Conservatism: Investors are too slow in updating their beliefs in response to new evidence.
Prices change gradually, leading to a momentum in stock price returns.
Representativeness: People ignored the size of their sample, while drawing conclusions and
doing extrapolation.

Behavioural biases
Framing: Perception of risk depends on how the situation is framed. The risk attached to
positive gains is perceived higher than the risk attached to losses (risk seeking for losses).
Mental accounting: People classify their investments based on their objectives, or the source
of funds, and are willing to take different amounts of risk on each class (for example, funds
for children's education treated differently from the funds for retired life; initial investment
treated differently from the returns earned on it).
Regret avoidance: Individuals, who make unconventional decisions regret these more, if they
turn out to be bad. This is consistent with size, and book-to-market effect. People don't have
courage to invest in small and high book-to-market firms, as these are not considered good.
Prospect theory: People are willing to take higher risks on their losses and lower risks on
their gains [Gamblers instinct in betting more on losing]. The utility curve is convex on the
positive return side and concave on the negative return side (risk seeking behaviour).

Limits to arbitrage
Rational arbitrageurs cannot fully exploit the mistakes of behavioural investors due to the
following factors:
Fundamental risk: The prices may take too long to converge to their intrinsic value.
Implementation costs: Overpricing is difficult to exploit due to restrictions on short selling.
Model risk: There is a risk that one may be using a faulty model.
o The behavioural explanations of efficient market anomalies do not give guidance as to how
to exploit irrationality.
o Many of the behavioural effects may work opposite to each other like forecasting errors and
conservatism.
o The behavioural approach is too unstructured and does not give a consistent method for
earning higher returns.
o Statistical significance of many of the phenomena is suspect.