What does Behavioral Finance mean?

Evolved in1950s, still dominating paradigm, portfolio theory, option price model.

Assumptions about people: logical, autonomous economic agents characterized by

·       expected utility maximization over time, risk aversion... and Assumptions about markets:

·       perfect, no transaction cost or taxes, no constraining regulations,perfect competition

·       information is costless and received simultaneously by all individuals is also complete and liquid . As a result, market values are the relevant signals for consumption and investment decisions.

As a result, asset pricing (AP) and corporate finance (CF) theorems emerged: 

·       AP: all agents reach their maximum

·       AP: portfolios are mean-variance efficient (Markowitz)

·       AP: only systematic non-diversifiable risk is priced (CAPM founded by Sharpe)

·       AP: no opportunities left for arbitrage

·       AP: price equals value

·       CF: irrelevance of capital structure (Modgliani & Miller)

·       CF: irrelevance of dividend structure (Miller & Modgliani)

Conclusion: Divergence between theory and reality is unsatisfactorily large

·       theory predicts direct relation between surplus and deficit economic units

·       theory leaves no space for financial intermediaries, regulations etc. (this is part of institutional economic-based finance)

·       behaviour of individuals and resulting aggregate (= market) outcomes: irrational behaviour of individuals can be observed, anomalies of financial market prices (this is part of behavioural finance)