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Chapter 2 Literature Review

Abstract

This chapter provides the background for the book. The chapter begins with a brief overview of behavioural finance, covering the aspects of portfolio construction, investor segmentation and securities markets. A section on prospect theory and its relevance to financial theory ends the section on behavioural finance. Further, the key concepts of regulatory focus theory were explored. The chapter concludes with a summary and critical evaluation of studies coupling both regu- latory focus theory and financial concepts.

2.1 Behavioural Finance

At present, financial theory is in flux, as previously established models are being challenged and re-evaluated. Even the Markowitz Model (Markowitz 1959), the foundation of classical finance, has been called into question. Simply put, the belief that investors are rational and make cogent decisions is no longer a given, and this has called several well-established theories into question. With the vestigial effects of the subprime crisis and the ongoing European sovereign debt crisis, it is more apparent now than ever that irrational decision-making is the prime mover behind critical economic events.

Whenever the finance industry is portrayed in the media, the image that is construed is of people engaged in activity, busy in the trading room, or in their high-powered offices on Wall Street. This is a stark contrast from standard finance textbooks and early finance journals which seem to be devoid of human activity and interaction. There is much time spent on calculating rates of return, present values as such, and far too few studies on the people who are actually involved in financial markets. We all know that people are the raison d'être of financial markets, but why have they been largely ignored? Perhaps almost a century of stock price data on COMPUSTAT is hard to resist, compared to relatively few studies on the behavior of individuals. Bluntly, if stock prices can fall 20 % in one day,[1] without any news, can one say with certainty that why people are irrelevant (Thaler 1993)?

Standard finance, also known as Modern Portfolio Theory (MPT) (Markowitz 1952), but not very modern at this point, has four foundational blocks, and posits that investors are rational, markets are efficient, investors should design their portfolios according to the rules of mean–variance portfolio theory and that expected returns are solely a function of risk (Kahneman and Tversky 1979; Statman 2008). Behavioural finance, however, restructures and questions this framework, postulating that markets are inefficient, and that investors are 'normal'. Rational investors always prefer more wealth to less, but normal ones are affected by cognitive biases and emotions (Statman 2008). Behavioural finance[2] utilises insights from the field of psychology and applies them to explain stock market anomalies and other financial issues. This may lead some to believe that behav- ioural finance aims to bring psychology into finance, but psychology has always been a part of finance, albeit unnoticed. Although psychological methods have been utilised to explain financial anomalies, the motivations behind these phenomena have yet to be explored. Regulatory focus theory, a goal-pursuit theory has been put forth to explain the motivations that underlie financial decisions, and will be detailed in Sect. 2.2.

The following sections will explore the various facets of behavioural finance, from portfolio construction to investor optimism, and from IPO market behaviour to dividend policy. These sections summarise the key findings in behavioural finance, to give insight into various market phenomena that exist.

  • [1] On 19 October 1987, the Dow Jones Industrial Average dropped by 508 points to 1738.74, a 22.61 % change
  • [2] Behavioural finance is the use of psychological methods to explain the behaviour of investors and subsequent market effects (Sewell 2010)
 
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