Behavioral Finance

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Behavioral Finance

Behavioral Finance studies how the psychology of investors or managers affects financial decisions and markets. Behavioral finance has grown over the last few decades to become central to finance.

Behavioral finance includes such topics as:

Empirical studies that demonstrate significant deviations from classical theories.

Models of how psychology affects trading and prices

Forecasting based on these methods.

Studies of experimental asset markets and use of models to forecast experiments.

A strand of behavioral finance has been dubbed Quantitative Behavioral Finance, which uses mathematical and statistical methodology to understand behavioral biases in conjunction with valuation. Some of this endeavor has been lead by Gunduz Caginalp (Professor of Mathematics and Editor of Journal of Behavioral Finance during 2001-2004) and collaborators including Vernon Smith (2002 Nobel Laureate in Economics), David Porter, Don Balenovich, Vladimira Ilieva, Ahmet Duran). Studies by Jeff Madura, Ray Sturm and others have demonstrated significant behavioral effects in stocks and exchange traded funds. Among other topics, quantitative behavioral finance studies behavioral effects together with the non-classical assumption of the finiteness of assets.

The article Finance Theory and Financial Strategy by S. Myers provided and interesting perspective on the relationship between finance theory and financial strategy. In essence he attempts to answer the question as to why managers do not use theory in strategic planning.

The article addresses a gap between theory and strategy. Myers states three reasons why this gap exists. First, it's due to differences in language and "culture". Second, it's the misuse of finance and hence not accepted in the strategic formula. And third, it is a result of a failed discounted cash flow analysis. (Myers) This gap is most apparent when a firms strategic goals and financial goals are in conflict. This appears as managements concern for EPS while implementing strategic maneuvers. This ultimately is a short-term vs. long-term approach conflict among and within managers.

The ...
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