Tuesday, May 15, 2012

Behavioral Finance Theory

Behavioral Finance abandoned the quest of the efficient markets theory to find a rational, mathematical model to explain fluctuations in asset prices. Instead, behavioral finance looked to psychology to explain asset valuation and why prices rise and fall. The primary representation of market behavior postulated by behavioral finance is the price-to-price feedback model: prices go up because prices have been going up, and prices go down because prices have been going down.

If investors are making money because asset prices increase, other investors take note of the profits being made, and they want to capture those profits as well. They buy the asset, and prices continue to rise. The higher prices rise and the longer it goes on, the more attention is brought to the positive price changes and the more investors want to get involved. These investors are not buying because they think the asset is fairly valued, they are buying because the value is going up. They assume other rational investors must be bidding prices higher, and in their minds they "borrow" the collective expertise of the market. In reality, they are just following the herd.

This herd-following has long been a valid investment technique employed by traders known as "momentum" investing. It is not investing by any conventional definition because it relies completely on capturing speculative price changes. Success or failure often hinges on knowing when to sell. It is not a "buy and hold" strategy.

The efficient markets theory does explain the behavior of asset prices in a typical market, but when price change begins to feedback on itself, behavioral finance is the only theory that explains this phenomenon. There is often a precipitating factor causing the break with the normal pattern and releasing the tether from fundamental valuations.

During the Great Housing Bubble, the primary precipitating factor was the lowering of interest rates. The precipitating factor simply acts as a catalyst to get prices moving. Once a directional bias is in place, then price-to-price feedback can take over. The perception of fundamental valuation is based solely on the expectation of future price increases, and the asset is always perceived to be undervalued. There are often brave and foolhardy attempts to justify these valuations and provide a rationalization for irrational behavior. Many witnessing the event assume the "smart money" must know something, and there is a widespread belief prices could not rise so much without a good reason. Herd mentality takes over.

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