CRITICISMS OF BEHAVIOURAL FINANCE

Despite its pioneering work in pushing the boundaries of traditional economics theories, critics such as Eugene Fama (whose work established the Efficient Market Theory explained earlier in the course) claims that behavioural finance and economics is less a true branch of economics and more a collection of anomalies – all of which can be explained by traditional market microstructure theory, or will eventually be priced out of the market. However, while these may explain certain individual market discrepancies, they do less well in explaining those anomalies which may occur across the overall markets, which also have the potential to create feedback loops leading to markets operating further and further away from a “fair price” equilibrium.

One particular topic of debate between behavioural finance and economics researchers and their critics is the Equity Premium Puzzle (EPP). This describes the anomalously higher historical rate of return of stocks over government bonds, with various studies calculating this premium to be approximately 6% on average. On one hand, many argue that EPP occurs simply as a result of both practical and psychological barriers to entry, which have traditionally prevented individuals from investing in the stock market – an aberration which will slowly disappear as more and more markets begin to open up to electronic trading which will eventually cancel the premium stocks command over bonds.

However, behavioural finance practitioners contend that this simply is another case of loss aversion. With typical stock market investors being relatively small retail traders, these market participants would have been more reluctant to sell out their shares in the event of prices falling than typical bond market investors (who are typically large banks and financial institutions), since the former would be more averse to converting a paper loss into a real one.