Literature Review

Overview

Finance could broadly be explained as the study of how limited resources are allocated by humans, and how these resources are managed, obtained and invested over time. There are two key models within the traditional Theory of Finance:(i) Market agents are perfectly rational: Perfect rational behavior is referred as any new information available for agents is interpreted correctly and uniformly while they are updating their thoughts about the markets, and (ii) Markets are Efficient: The Efficient Market Hypothesis (EMH) considers that all the relevant information has immediate and full impact on the prices. In the last twenty years, there has been an intense research made on developing and testing different asset pricing models. Subrahmanyam (2007) categorizes central models of finance as (i) Portfolio allocation based on expected return and risk (ii) risk-based asset pricing models (e.g. Capital Asset Pricing Model) (iii) the pricing of contingent claims, and (iv) the Modigliani-miller theorem and its augmentation by the theory of agency. The presumption is that, since people’s focus is on increasing their wealth, they act rationally while taking financial decisions. Although these models reformed the study of finance, there are still unanswered gap within these theories. Traditional financial theory can be limited when we try to answer the following questions; (i) Why do individual investors trade? (ii) Why is there a difference among the returns across stocks other than risk? While these questions were raised among the financial world, scholars in psychology noticed that individuals often behave in unpredictable ways while giving decisions which involves money. One of the results of research has been that economic decisions are often made in a seemingly irrational manner. Investor may not be able to give the right investment decisions because of cognitive errors and extreme emotions. Shiller (2002) has shown that CAPM and EMH and other traditional financial theories are certainly very useful explaining certain events. Nevertheless researches also started to question anomalies and behaviors which the traditional models could not explain. Two common examples are: (i) The January Effect, a general increases in the stock prices during the moth of January without a fundamental reasons (Rozeff and Kinney, 1976), (ii) The Winner's Curse, tendency for the winning bid in an auction tends to exceed intrinsic value of the item purchased, commonly due to lack of information, and emotions causing the bidder to over value the item’s price (Thaler, 1988). Scholars where motivated to look in to cognitive psychology to account for irrational and unexpected investor behavior (Phung, 2002).
Behavioral finance is arguably new branch of finance, which seeks to support the standard financial theories by bringing a behavioral approach to the decision making process. The early supporters of behavioral finance were considered as visionaries by some people in the industry. After the 2002 Nobel Prize in economics had been given to a psychologist called Daniel Kahneman and experimental economist Vernon Smith, which made the field became more noticeable. Kahneman’s research area is human judgment and decision making under uncertainty and Smith researched on alternative market mechanism through experimental research. In the history of Nobel Prices it was the first time a psychologist won the price for economics, which played a very important role in convincing many financial economist that investors can behave irrationally.
Efficient Market Hypothesis
"An 'efficient' market is defined as a market where there are large numbers of rational, profit-maximizers actively competing, with each trying to predict future market values of individual securities, and where important current information is almost freely available to all participants. In an efficient market, competition among the many intelligent participants leads