MODERN FINANCE vs.

BEHAVIOURAL FINANCE:
AN OVERVIEW OF KEY CONCEPTS AND MAJOR ARGUMENTS

PANAGIOTIS ANDRIKOPOULOSa
Leicester Business School
De Montfort University

Abstract

Modern Finance has dominated the area of financial economics for at least four decades.
Based on a set of strong but highly unrealistic assumptions its advocates have produced a
range of very influential theories and models. Nonetheless, in the last two decades a new
academic school of thought has emerged that refutes the key assumption of a “homo
economicus”; an assumption that represents the cornerstone for the development of the
theory of efficient markets. The first empirical evidence against efficient markets in the
mid-eighties signalled the beginning of a “fierce” debate between these two schools of
thought. This paper gives an overview of the key arguments of these two distinctive
academic doctrines.

a
Department of Accounting and Finance, Leicester Business School, De Montfort
University, Tel: +44(0) 116 257 7218, Fax: +44(0) 116 251 7548, E-mail:
Pandrikopoulos@dmu.ac.uk
 MODERN FINANCE vs. BEHAVIOURAL FINANCE:
AN OVERVIEW OF KEY CONCEPTS AND MAJOR ARGUMENTS

I. Introduction

The decades of the 1950s and 1960s were the most productive periods in finance
thought. This was the period in which finance changed from a descriptive discipline to a
modern science full of new ideas that needed to be refined. The focus of the academic
community on exploiting the full potential of mathematical probabilistic and
optimisation models and techniques led to the construction of theories and models such
as portfolio optimization theory, the capital asset pricing model and the efficient markets
hypothesis. Their principles would constitute a key influence in the years to come.
But within two decades of the introduction of these ideas contradictory evidence began
to emerge. The appearance of many anomalies led some academics to reconsider their
initial beliefs about the applicability of the leading theories of modern finance. This was
the spring of a new era, that of behavioural finance. As the new ideas of behavioural
finance were introduced, a rigorous academic debate commenced on the validity of these
new theories.
This paper focuses on this current theoretical debate. Section two describes the principle
basis of the modern finance school of thought and its historical roots in classical
economic theory. In this section, the assumption of homo economicus and the theory of
EMH will be considered. Section three will introduce the reader to the principles of the
Behavioural Finance theory. In this very section, certain ideas of psychology and
decision-making and how they can be linked with the finance discipline are discussed.
Section four discusses modern finance’s key arguments against this new theoretical
school. Finally, this paper will conclude in section five.

II. Modern Finance: The End-Product of a Long History of Economic Thought

A. The ‘Homo Economicus’ as a Key Assumption of Positive Economic Theory

Not many scholars would disagree that economic activity is a social activity. Since the
first works of classical economists such as Adam Smith, David Ricardo and J.S. Mill in
the 18th and 19th centuries, the role of humans involved in economic activity was
rigorously investigated. It is these early writings in political economy and in positive

1
economic thinking that indirectly introduced the assumption of homo economicus into the
social sciences. However, J.S. Mill was the first to explicitly define this assumption
(Pribram, 1983, p.173).
The whole idea of a ‘rational’ economic man currently represents a stronghold in modern
investment theory but for other reasons than its early form, when it was briefly discussed
back in the 18th century in the Wealth of Nations by Adam Smith. The roots of this later
version of homo economicus lie in the positivistic doctrine of economic methodology that
was introduced by Von Neumann and Morgenstern (1944) and persistently followed by
the vast majority of the financial economists of the second half of the 20th century.
Under this positivistic doctrine of financial economics, homo economicus refers to a greatly
simplified model of human behaviour where an individual is characterised by perfect self-
interest, perfect rationality and free access to perfect information regarding a specific
condition. The key rationale for the development of this assumption lies in the complex
nature and unpredictability of human behaviour and its inability to be used effectively as
a means for accurately predicting and explaining human behaviour itself. On the grounds
of simplicity, mathematical applicability and empirical reasoning, human behaviour was
oversimplified and quantified following methodologies developed and used in the field of
the ‘hard’ sciences.
Since its first appearance in financial economics literature, the over-simplification of
human behaviour represented only one part of a more generic empirical deductive
procedure aiming to define price behaviour and create a theory for it. This was the
beginning of modern finance.

B. Random Walks, EMH and the Role of Homo Economicus in a Deductive Process of a Positivistic
Theory

At the dawn of the last century a PhD thesis was about to change the course of history
for financial economics. Louis Jean-Baptiste Alphonse Bachelier produced this thesis in
1900 and his work still represents a creation of exceptional merit in the area of financial
mathematics. The introduction of new ideas in the theory of stochastic processes such as
that of brownian motion1 and martingales soon became a starting point for the
amalgamation of all economics, mathematics, accounting and finance disciplines that

1
These advances took place even before Einstein’s mathematical work in Brownian
motion for the development of the molecular-kinetic theory of thermodynamics in 1905.

2
created the basis of the modern finance doctrine. Eventually, the end product of this
early work was the creation of the Efficient Market Hypothesis (Fama, 1970), a theory
that still even today represents the cornerstone of modern academic finance.
According to this theory, markets are considered to be efficient relative to a given
information set, if there are no abnormal profit opportunities for investors trading on the
basis of this information (Fama, 1970). Hence, it is practically impossible for investors to
consistently earn abnormal returns on the basis of universally available information. This
proposition has dominated investment theory for the last forty years and mathematically
is illustrated using Fama’s notation as Ε ( x j ,t +1 | Φ t ) = 0 , where x j ,t +1 represents the

difference between the actual price of security j at time t+1 and its expected price based
on the given set of information Φ t . If the expectation given by the above equation is
equal to zero there are no available opportunities for investors to beat the market, as no
overpriced or underpriced stocks exist at time t. The stochastic process xj is then
considered to be a fair game (Le Roy, 1989).
The actual abnormal profit achieved is given by the difference of the actual price of stock
j at time t+1 to the expected price of that stock given the available set of information or
x j ,t +1 = p j ,t +1 − Ε ( p j ,t +1 | Φ t ) where p j ,t +1 is the price of the security j at time t +1 , and

E is the expectation operator.

Fama’s efficiency framework states that current information flows are the sole
determinant of current asset price movements and that market prices are the best
reflectors of the fundamental values of their underlying assets. This theory implies the
existence of a stochastic process with independent, identically distributed binomial
random variables, or what is commonly known as a random walk (Roberts, 1959;
Osborne, 1959; Granger and Morgenstern, 1970). Similar to the Brownian motion, the
origin of a random walk can also be traced at least as far back as the work of Louis
Bachelier (1900). According to the random walk hypothesis there is no dependency
between sequential returns, or as it is mathematically expressed Pt = Pt −1 + ε t . In this

equation, Pt is the stock price at time t, Pt −1 the stock price at time t-1, and, εt is the

residual series or error value, where E(εt)=0 and Cov(Pt,Pt-n)=0, n ≠ 0. Furthermore, an

even stronger version of the random walk hypothesis states that the probability
distribution function of returns remains constant over time, i.e. that the residual series

3
has a constant distribution. Nevertheless, this stronger version of the random walk
hypothesis is not a direct logical consequence of the EMH.
As regards the fundamental values of securities, according to the EMH these are
determined by expected future cash flows, in the case of equities the future stream of expected
dividends, discounted back to the present, or mathematically expressed as
Pt = (1 + ρ ) −1 E ( Pt +1 + d t +1 Φ t ) . Thus, fundamental prices at time t should be equal to the

expected future prices and expected dividend payments at time t+1, on the basis of the
current publicly available information set Φ t discounted at the appropriate discount
rate ρ . On the basis of the above model, any changes in share prices will be the outcome
of a speedy value re-adjustment performed by investors in response to changes in the
information set.
In line with all positivistic economic theories, EMH itself follows from certain more
basic assumptions, including that of homo economicus. Sufficient conditions for the EMH
can be summarized into four categories relating to:

i) The public availability of information,

ii) The speed with which this information can be absorbed and lead to a new price
equilibrium,
iii) Investor self-interest and
iv) Investor rationality and the extent to which investors exhibit effective and efficient
cognitive behaviour.

Of the above four assumptions the last two are considered to be the most important as
they represent the link between EMH and its positivistic philosophical roots where
reality should be oversimplified to facilitate accurate mathematical predictions. In this
specific case, possible investor irrationality could affect both the way that information is
perceived and the process by which stock market prices adjust in order to reflect any new
information sets.
Any claim that, obviously, not all investors are rational was immediately undermined by
the early scholars in this new academic field using two main theoretical arguments.
According to the first response, irrational investors as a group cannot affect security
prices, as their investment strategies are individually uncorrelated. In effect, irrational
investors are trading randomly and their trades cancel each other out, leaving efficiency
to prevail in the end.

4
The second response states that the process of arbitrage (Friedman, 1953; Fama, 1965)
and competition amongst arbitrageurs will ensure that irrational traders will tend to
accumulate cumulative losses and eventually their wealth will diminish, leaving the field
open to rational investors. If either response is correct, prices will be set back to
equilibrium and market efficiency will hold.
The above arguments for market rationality and the existence of ‘perfect human beings’
have profound importance for modern finance. If correct, they justify working with the
simplifying assumption that all investors are rational. This simple rational expectations
world is used as a basis for the development of more advanced theoretical models, such
as linear asset pricing ones. Under these simplifying assumptions, which aim to deduct
certain empirical complexities, expected returns on securities are purely a function of
their individual risk characteristics. This risk is determined by the non-diversifiable
component of volatility of the future income stream.
Empirical testing of the theory has proved problematic. As EMH provides the
theoretical framework within which linear asset-pricing models are embedded, critical
testing of a model by itself is impossible. This problem is often referred to as the joint-
hypothesis problem (Fama, 1970; 1991). However, empirical evidence against market
efficiency and the theoretical linear risk/expected-return relationship may undermine the
above sufficient conditions and in particular the assumptions and arguments for market
rationality. Recent empirical tests especially and the literature of fundamental anomalies
proved to be the most challenging to the modern finance position as they provided an
opportunity for a new theoretical school to emerge, that of behavioural finance.

III. Behavioural Finance: A New Perspective in Financial Empiricism

A. The Rule of Bayes, Rational Decision Making and Basic Principles of Behavioural Finance
Thought

Behavioural finance offers alternative explanations on the key question of why prices
deviate from their fundamental values. Its key argument is based on the claim that
human behaviour and perceptions represent two crucial elements of financial decision
making (Hirshleifer, 2001). This has led to the search for new models and ideas that may
be able to explain and predict market behaviour from various psychological biases.
Scholars in the area of behavioural finance have focused their attention on importing

5
various psychological theories into the study of finance. To fully appreciate the
behaviourists’ theoretical propositions, we need to first understand the nature of a
decision making process under the homo economicus assumption whose foundations are
based on the principle of conditional probabilities as was mathematically established in
1763 by the mathematician Thomas Bayes.
Bayes’ rule represents a fundamental principle of rational decision making. Bayesian
theory argues that the probability of an event can be viewed as the degree of belief of an
“ideal” person. These ideal persons’ beliefs are considered the most efficient ones even if
they are completely subjective, as long as they are consistent and follow the basic axioms
of probability theory. According to the Bayesians’ argument, rational decision making
and probabilistic reasoning should be based on the key axiom of indifference, where if
concrete evidence does not exist regarding the relative likelihood of two events, these
events should be considered equiprobable with one another. In addition, Bayesians
consider these conditional probabilities to be more basic than joint probabilities.
Hence, instead of referring to the joint probability of two events as P(A,B), where P is
the probability of occurrence and where A and B the two events, Bayesian probabilities
emphasise the conditional probability P(A|B), where P(A|B)*P(B) = P(A,B). By symmetry
we also have P(B|A)*P(A) = P(A,B). A version of Bayes’ Rule states that the probability
of event A occurring given that the event B occurs is equal to the probability of both
events occurring divided by the probability of B, or mathematically expressed as
P ( B | A) * P ( A) . According to this Bayesian probabilistic reasoning, the update of
P( A B) =
P( B)

beliefs P ( A B ) concerning an outcome A in the light of the evidence B, is a function

of the prior belief A, the likelihood P( B | A) , and the probability of B. Using the law of
total probabilities for mutually exclusive and exhaustive events Ak , i = k ,..., n , we have
n n
P( B) = ∑ P ( B, Ak ) =∑ P ( B Ak ) * P ( Ak ) . By substituting this equation from the one
k =1 k =1

above we can finally obtain the generalisation of Bayes’ theorem, given by

P ( B | Ai ) * P ( Ai )
P ( Ai B ) = n
.
∑ P( B A ) * P( A )
k =1
k k

Bayes’ theorem provides the probabilistic framework within which rational investment
decisions should be made on the basis of all relevant, available information. It gives a
highly structured procedure for rational decision making, which was also adopted in the

6
case of homo economicus and the pursuit of its rational self-interest objectives. And this is
exactly the point from which the behaviourists’ main arguments are derived. Behavioural
Finance argues that people often fail to respond rationally to new information as they
completely fail to follow the above idealistic mathematical framework. This is caused by
humans’ inability to differentiate information that requires probabilistic judgement from
that which requires value judgement. As Garnham and Oakhill (1995) argue ‘…although
people make informal judgements of likelihood and about what might and might not happen, it is far
from clear that their judgements conform to these principles. For example, they might judge two events to
be independent, yet their estimate of the likelihood of both happening might be quite different from the
result of multiplying their estimates of the individual events happening. If they make inferences based on
such judgements, those inferences cannot be modeled using probability theory’.
Despite the fact that the above statement derives from psychology, it can be considered
central to the principles of behavioural finance. People often fail to compute the
probabilities of outcomes in accordance with Bayes’ theorem, as past experience and
cognitive biases increase the likelihood of decisions being taken on the basis of
value/personal judgement.
Similar conditions are applicable to investment decision making, as this process requires
both intuition and knowledge gained from past experience. Positive evidences of the
existence of biased judgement in investors’ heuristic framework would imply that
investment behaviour suffers from a number of illusions and market signals
pragmatagnosia2. Hence, due to the illusion of control, knowledge, experience etc. and
investors’ inability to understand and apply successfully their own knowledge to past and
current information signals3, investment behaviour can lack sound judgement leading to
incorrect decision making, so as to give rise to the appearance of the evidenced
mispricing phenomena. According to behaviourists, these biases need to be fully
comprehended and models developed on the basis of them. This is also supported by
Bowman and Buchanan (1995) who argue that, ‘…the knowledge on human behaviour should be
used in order to help us understand how investors may misperceive the results of their actions and, by

2
The term pragmatagnosia refers to the incapability of humans to recognise these signals
and act accordingly.
3
This can be due to the inability of the human mind to weight any kind of information
equally resulting in recent information being weighted more heavily than older and bad
decisions more heavily than good ones.

7
extension, the functioning of the share markets’. Using these existing investment judgement
biases as a basis, hitherto stock market anomalies can now be analysed and evaluated.

B. Behavioural Finance and the Concept of ‘Noise’ Traders

‘Noise’ traders are defined as those whose investment decisions rely more on
psychological factors than on sound investment management principles (Friedman,
1953). According to the arguments for market rationality, irrational trading cannot be
sustained in the long run as efficient rational arbitrageurs effectively eliminate noise
trading. Additionally, due to the random and uncorrelated nature of their trades, noise
traders cancel each other out leaving asset prices unaffected. These arguments on the
relationship between noise traders and asset prices are not unfamiliar, as the first studies
on the matter date back to the late 1950s and 1960s (Friedman, 1953; Fama, 1965). These
arguments support the claim that the market may be rational, even though individual
investors may not.
Behavioural finance has responded to these arguments and demonstrated that they are
valid only if certain other assumptions are made, assumptions that appear to be false by
principle for real markets. The evidence of persistent fundamental anomalies dictates that
noise investors can seriously affect equilibrium prices even in the long term. This is
because rational arbitrage in reality is not only limited but can also create by itself price
inefficiency under certain circumstances (De Long et al., 1990; Jacobsen, 1999). The
rationale behind the ability of ‘noise’ traders to affect stock prices lies in two limitations
of rational arbitrageurs, namely short investment horizons and risk aversion. Also, the
relative size of the two groups is relevant.
Rational arbitrageurs cannot entirely wipe out the effect of noise traders on the market if
the size and the ability of the former group to trade are very limited (Camerer, 1992).
Additionally, the risk aversion of arbitrageurs by itself limits their ability to cancel noise
trades even if arbitrageurs have infinite buy-and-hold horizons (Shiller, 1984; Campbell
and Kyle, 1987). If noise traders undervalue or overvalue stocks, industries or markets
over a long period of time, the short horizon under which arbitrageurs’ performance is
evaluated limits their ability to force asset prices back to their fundamental values (Black,
1986). Noise trading can therefore force asset prices to diverge from fundamental values
for extended periods of time and create the basis for a long-term mean reversion effect.

8
This mean reversion is based on the claim that even noise traders will eventually
recognise extreme mispricing, causing prices to revert to fair value over the long term.
Rational arbitrageurs must also bear in mind the risk that noise investors’ beliefs may
become more extreme and unpredictable, a factor referred to as noise investor risk. Noise
investor risk is non-diversifiable, systematic and rational arbitrageurs can price it.
Consequently, unsophisticated trading should be considered as a new source of
systematic risk, creating additional volatility on the stock markets that rational
arbitrageurs would not bear unless compensated with higher expected returns (Figlewski,
1979; De Long et al., 1990). This again limits the ability of arbitrageurs to enforce
rational asset pricing.
Apart from altering the risk structure of the market, according to behaviourists the
presence of noise investors also affects the expected returns structure. The willingness of
noise investors to bear the risk of holding over-priced assets gives them the opportunity
to earn higher returns than their rational counterparts. This is due to the fact that noise
trading itself can drive prices up leading to abnormal profits performance (De Long et
al., 1990). Given that noise traders can change the systematic risk-expected returns
structure of the market, it may become rational for arbitrageurs to trade in the same
direction as noise investors, driving prices even further from equilibrium, creating further
changes in assets’ systematic risk and expected returns. Hence, noise trading can be
considered as one of the most important explanations for the existence of regularities
within stock markets.

C. The Overreaction and Under-Reaction Hypotheses of Behavioural Finance

Two of the most important hypotheses that can partially explain the evident price
equilibrium anomalies are those of overreaction and under-reaction. The overreaction
and under-reaction hypotheses are especially important in behavioural explanations of
the value effect.
The tendency of human beings to overreact and under-react in certain circumstances,
deviating from Bayesian optimum rational decision-making, arises from psychological
biases such as conservatism and the representativeness heuristic (Kahneman and Tversky, 1973;
Kahneman, Slovic and Tversky, 1982; Daniel, Hirshleifer and Subrahmanyam, 1998;
Kaestner, 2005). The former psychological bias, the state of conservatism, refers to the
condition where investors subconsciously are reluctant to alter their beliefs in the face of

9
new evidence (Edwards, 1968). The main impact of this bias in investment decision
making is that even if investors’ beliefs are changed in the light of new information, the
magnitude of that change is relatively low in terms of what it should be under strictly
rational conditions. On the other hand, the representativeness heuristic is the illusion of seeing
patterns in a random walk or more generally ‘order among chaos’ (Barberis, Shleifer and
Vishny, 1998).
The effects of these biases were studied in an experiment some years ago (Bloomfield
and Hales, 2001). Subjects were exposed to a series of outcomes; continuous regimes,
reversal regimes and various shifting regimes (combinations of continuous and reversal
regimes). They evidenced overreacting behaviour when encountering continuous regimes
followed by reversals, and under-reactive behaviour reversal regimes were followed by
further reversals. The importance of these two psychological biases in the under- and
overreaction hypotheses is that investors under conservatism will only partially evaluate
new publicly available information, or even disregard it altogether if it is not in favour of
their beliefs.
Under the representativeness heuristic, investors will consider a series of positive company
performances as representative of a continuous growth potential, and ignore the
possibility that this performance is of a random nature. This leads to excessive optimism
and overvaluation of the company’s prospects. In addition, memory constraints such as
memory loss in humans also provide an explanation why investors tend to weight recent
information more favourably than earlier information. Research in this area shows that
memory loss does play a significant role in forming decisions, and that decisions are
highly influenced by the environment within which the decisions are formed. Thus,
stable environments will trigger inertia while in highly volatile environments individuals
show signs of excessive impulsiveness (Hirshleifer and Welch, 2000).
Apart from the psychological state of conservatism, another cause of investors’ under-
reaction to new information is the heterogeneity of the investing public. Not everyone
has equal access to sources of information. Rather, information diffuses gradually across
the public domain, while the ability of investors to successfully extract information from
current prices has been questioned (Hong and Stein, 1998). In the stock market
environment, reactions to new information are asymmetric and industry related. There is
a large reaction to bad news about past winning stocks, while the reaction to bad news
from past losing stocks is comparatively small.

10
This asymmetry is considered to be important in behavioural explanations of the value
anomaly (De Bondt and Thaler, 1985; Lakonishok, Shleifer and Vishny, 1994; Griffin
and Lemmon, 2001, Antoniou, Galariotis and Spyrou, 2003). As past winning stocks are
subject to a larger response to negative surprises they tend to be more volatile than past
losing stocks/value stocks, contradicting the rational relationship between risk and
expected return (Jegadeesh and Titman, 1993; Skinner and Sloan, 2000; Andrikopoulos
and Daynes, 2004). Hence, as investors generally fail to judge correctly when dealing with
uncertain outcomes, trading patterns can be identified such as overreaction following bad
earnings announcements of past winners and under-reaction to good earnings
announcements from past losers (Barberis, Shleifer and Vishny, 1998). The failure of
investors to alter their beliefs about certain stocks and to foresee that a good earnings
signal from a past losing firm is a sign of more to come creates opportunities for certain
investment strategies such as the momentum and contrarian to achieve above average
results.
Apart from individual stocks, according to behavioural finance the phenomenon of
judgement bias is also evident when examining industry performance. Under-reaction to
information related to new and changing industries can explain the higher profitability of
momentum strategies when applied to stocks of a single industry compared to individual
stocks across different industries and markets (Moskowitz and Grinblatt, 1999)
Behaviourists also argue that different trading attitudes and information flow in the
market can also trigger irrational behaviour. Further evidence on this hypothesis was
given by Hong and Stein (1998). According to their study both overreaction and under-
reaction of stock prices could be explained by the trading attitudes of news-watchers and
momentum traders4 as well as the different information flow between these two investment
groups. If information spreads across agents gradually, then prices will adjust slowly to
new information, creating under-reaction. This under-reaction will be followed by
overreaction as the spread of information causes late news-watchers and momentum
traders to enter the market (Hvidkjaer, 2004). This gradual spread and speed of
information flow throughout different investor groups is highly important as slow
information flow can lead to short-run return correlation and subsequently to long-term
strong reversals, a condition that obviously violates market efficiency.

4
Newswatchers analyse fundamentals while momentum traders mainly rely on
information that can be extracted from price movements.

11
Another argument of Behavioural Finance with respect to the overreaction phenomenon
is the impact of analysts’ coverage on certain stocks. Small stocks with no coverage at all
will not exhibit a strong overreaction effect as they are usually excluded from analysts’
recommendations. On the other hand, for small size stocks with low analysts’ coverage,
the very gradual information flow will result in these stocks exhibiting the strongest
reversal effect of all (Hong and Stein, 1998). Thus, although judgement biases and the
flow of information of investors may be key elements in explaining under-reaction and
overreaction effects, the behaviour of financial agents, such as investment analysts and
brokers, is an additional important feature. The ability of brokers to form and structure
investors’ beliefs and expectations will contribute to inefficient pricing if their
recommendations are biased in the first place. This idea in conjunction with the
inefficient expectation hypothesis is discussed immediately below.

D. The Overconfidence Hypothesis and Bias of Investment Agents

Overreaction and under-reaction to new information may be viewed as a combination of

three distinct inefficiencies; firstly, the inability of investment players to correctly
distinguish between the length of the short-run and the long-run, leading to a persistent
and gross over-estimation of the mean reversion horizon; secondly, the excessive
optimism of all investment agents due to biased self-attribution, and thirdly, the influence
that one investment group has on another. Where structural inefficiencies and biased
decision making is found in the hypothetically strongest group, this will be passed to the
weaker party.
With regards to the first inefficiency, it is arguable that investors in general fail to
correctly define the length of the short and long run (Jegadeesh and Titman, 1993;
Haugen, 1995). Indeed, although the dynamic nature of modern business dictates that
severe competition in the market place restrains successful firms from retaining
abnormal profits for a long period of time, most investors fail to foresee this reality. This
overestimation leads to the overpricing of currently successful firms. This mistake is then
followed by the second inefficiency, biased self-attribution, whose roots are again found in
the area of psychology. Individuals tend strongly to attribute events that confirm the
validity of their actions to high ability, while at the same time attributing events that
disconfirm their actions to external reasons. A combination of these two factors can
result in the creation of excessive optimism about certain stocks, while simultaneously
reducing the chance/probability of correcting their beliefs. Both elements reinforce

12
behavioural finance’s overconfidence hypothesis, whereby investors’ engramic
brachychronic5 behaviour indirectly eliminates consideration of correct alternative
outcomes. This leads them to initially under-react to future unconsidered information
flows, while if this information flow persists it eventually leads to the phenomenon of
overreaction. Similar conditions apply to the theoretically well-informed investing agents,
where their excessive optimism about certain companies can significantly influence their
recommendations and increase public overconfidence. Investors’ biased self-attribution
represents a key explanation for short-term momentum, positive short-term autocorrelation of
stock returns for individual stocks and the market as a whole (Daniel, Hirshleifer and
Subrahmanyam, 1998).
With regards to the behaviourists’ argument on analysts’ and brokers’ overoptimistic
recommendations, empirical research supports the view that analysts do tend to overstate
their forecasts for various political and career reasons. Positive prospects regarding
glamour companies can motivate investors to increase transactions. On the other hand, if
things go wrong, and things could go wrong at any time, their recommendations can be easily
justified. Empirical research is strongly supportive to the case of positive bias in the
forecasts and recommendations of investment analysts. This can lead investors, whose
beliefs are based on those analysts’ forecasts, to under-value firms that have past low
performance and over-value those firms with past excellent performance (Dechow and
Sloan, 1997; Beaver and Ryan, 1998; Billings and Morton, 1999; Krische and Lee, 2000).
Analysts’ overoptimistic forecasts are also evident during common stock offerings and
initial public offerings, with a plausible explanation being that of career incentives.
Analysts employed by the leading offering managers produce the most optimistic
forecasts concerning the potential growth of the offering firms (Dechow, Hutton and
Sloan, 2000; Chahine, 2001). This is consistent with empirical research on the positive
relationship between the level of fees paid to analysts’ firms and the level of analysts’
growth forecasts and with the fact that companies with the most positive forecasts are
found to significantly under-perform the market averages after the public offering.
Additional explanations can follow from the structure of the financial analysis industry.
Analysts’ remuneration is based on their ability to generate trading volumes for their
employers, rather than on the accuracy of their predictions. Accuracy of their predictions
suffers, as it is a secondary objective (Mikhail, Walther and Willis, 1999). This positive

5
The author refers to the failure of investors in generating alternative short-term courses
of action due to the unconscious existence of erroneous memory.

13
bias mentioned above is evidenced to increase investors’ confidence generally and to
generate larger trading volumes. Apart from the trend towards buying larger and more
glamorous stocks for political or career reasons, overestimation of firms’ future
prospects can also create a more general overconfidence in investors that results in
increased trading volume, with subsequent financial benefits for their companies and the
investment industry in general (Statman and Thorley, 1999).
Overall, behaviourists’ argument that investment professionals’ preference for ‘easy to sell’
glamour stocks, and the fact that the time horizon in which their performance is
evaluated is significantly shorter than the time required for certain investment strategies
to pay off, provides further explanation of the inefficient pricing of past losing stocks
(Lakonishok, Shleifer and Vishny, 1994; Brower, Van Der Put and Veld, 1996). Over
fifty percent of the out-performance of value/contrarian investment strategies has been
attributed to investors’ naïve reliance on analysts’ biased long-term earnings growth
forecasts (Dechow and Sloan, 1997; Easterwood and Nutt, 1998).
Overoptimistic forecasts can also have substantial impacts on the forecasted companies’
management. Managers of companies with poor performance forecasts will tend to
follow and meet those forecasts, contributing to medium term inertia. On the other
hand, poor performance forecasts can result in a management response that can drive
their performance measures away from those forecasts, resulting in possible positive
surprises to the market (Abarbanell and Lehavy, 1999). This can contribute to the
reversals observed in companies with past poor performance.
According to behavioural finance, the psychological, institutional and agency factors
discussed so far not only drive prices away from fair value but create excess volatility in
the markets. This excess volatility is systematic and non-diversifiable and thus itself
becomes a factor of concern in the investment decisions of both rational and irrational
investors. In addition, the ex ante nature of measurement and quantification of these
inefficiencies makes it almost impossible for the excess volatility they create to be
quantified and modelled on a prior basis.

IV. Behavioural Inefficiencies under the Modern Finance View

A. Frequency and Nature of the Behavioural Effects

Soon after the first empirical papers on behavioural finance were published, their claims
came in for considerable criticism from supporters of the modern finance paradigm. One

14
important counter-argument disputes the existence of certain regularities and argues for
the existence of research biases and other methodological shortcomings in behavioural
finance studies. More commonly, the evidence on the existence of pricing anomalies is
accepted but in that case, the most important response concerns the existence of
additional risk factors, e.g. value premium can be explained as compensation for bearing additional
systematic risk.
Analytically, according to Modern Finance advocates, the observed long-term and short-
term under-reaction and overreaction phenomena should not be considered as
inconsistent with market efficiency. Over the long term both phenomena eventually
appear with the same frequency. The market under-reacts as frequently as it over-reacts.
This is consistent with market efficiency, which only requires that investors’ expectations
are unbiased, and correct on average, or over the long term, (Fama, 1998). Despite the fact that
behaviourists have identified apparent anomalies and proposed various explanatory
theories and models, according to the former finance doctrine, none of these theories is
sufficiently developed to realistically challenge the existing efficient markets model.
With regard to bad–model errors (Barber and Lyon, 1996; Fama, 1998; Barber, Lyon and
Tsai, 1999), long-term financial anomalies are found to be extremely sensitive to different
methods of calculating returns. Important issues concern new listing bias, rebalancing
bias and cross-sectional dependence. If long-term returns are calculated using the buy
and hold abnormal return metric over long intervals, abnormal returns will be
overestimated. As most of the recent behavioural studies have used these return metrics,
their results should be considered as weak. Buy and hold abnormal return calculations
can be error free in cases where the population mean abnormal stock return of the
portfolio is equal to zero. However, this approach is still subject to a large amount of
cross-sectional dependence (Barber, Lyon and Tsai, 1999). If, instead, average or total
abnormal monthly returns are used and shorter intervals are examined, statistical
inferences will be less problematic. However, where the latter metrics are used, the
anomalies become marginal and tend to disappear. Hence, the phenomena observed in
behavioural studies may be attributed to biased models and erroneous methodologies.
The previous two counter-arguments have not been found totally convincing, even by a
majority within the modern finance school. An example is the existence of a non-
equilibrium relationship between risk and return in contrarian strategies, a phenomenon
also supported by many modern finance authors (Fama and French, 1992; Fama, 1998;
Fama and French, 1998; Davis, Fama and French, 2000). The most common response is

15
to argue that this violation of the market efficiency rule is due to an additional systematic
distress factor that is priced in the market. In that case, additional factor loadings to
already existing models, or extensions or variations of existing models, such as ICAPM,
international APT, or the Fama and French three-factor model, may produce far more
reliable results and capture this particular risk element (Fama and French, 1998; Metrick,
1999; Liew and Vassalou, 1999; Doukas, Kim and Pantzalis, 2001). According to these
studies, a pure factor-based portfolio is capable of explaining value out-performance,
contradicting proponents of market irrationality explanations (Daniel and Titman, 1997).
The development and testing of such multi-factor risk models continues to be an
extremely active area of research.

B. Behavioural Studies and Research Bias

Equally important counter-arguments against the behavioural position concern the

adequacy of the data used. Data bias has always represented a source of uneasiness to
researchers. Although certain techniques have evolved to deal with these problems, bias
may not be fully eliminated. In addition there are cases where its existence cannot easily
be identified.
Many studies of the US stock market use COMPUSTAT as a primary source of data.
However, COMPUSTAT is subject to both past selection/survivorship bias and look-
ahead bias (Banz and Breen, 1986). Past selection/survivorship bias refers to the exclusion of
dead companies from the database. Exclusion of dead companies occurs in particular
when the database is back-filled, since only viable companies are added at this time,
excluding dead companies. Look-ahead bias refers to the situation where data is recorded
in the database at a given point in time although the information was not publicly
available until a later date. According to Banz and Breen (1986), an examination of the
P/E and small firm effects indicated a significant degree of both these biases. Earnings in
the standard COMPUSTAT files seemed to be distorted when compared to earnings in
the more reliable research version of the database, while small companies with high E/P
ratios were excluded from the database after they ceased trading. Consequently, any
statistical examination of securities’ returns using a sample based on size would tend to
be dominated by larger companies.
The authors proposed certain techniques to alleviate these problems, the most important
one being the formation of stock portfolios in March, three months after the December

16
balance sheet date. This would minimise look-ahead bias. Restricting the research sample
to large, liquid stocks, or to stocks comprising an index would eliminate the small firm
bias in COMPUSTAT. However, this places a limit on the kinds of research that can be
undertaken. As a number of behavioural finance studies have been carried out using the
COMPUSTAT facility, some of the conclusions may be vulnerable to criticisms of the
quality of the data used.
Further arguments against the existence of anomalies concern data mining and model
mining (Sullivan, Timmermann and White, 1999). Nevertheless, in responding to the data
biases arguments, behaviourists have countered that the ability of past returns to affect
the cross section of future returns has not only been captured through the use of the
biased accounting indicators included in the COMPUSTAT facility, but in a wider range
of indicators and different databases used from researchers to form characteristic-based
portfolios (Grinblatt and Moskowitz, 1999; Wermers, 1997). Regarding the data mining
and model mining claims, the anomalies are pervasive and have been observed in out-of-
sample tests covering a wide range of time periods and markets. Overall, defenders of the
modern finance position tend to accept the existence of stock market anomalies,
responding to behaviourists’ claims using the risk-based counter-arguments discussed
above.

V. Final Comments

The last five decades have seen the development of the rational expectations revolution
in finance theory. This has lead to the theories of efficient markets and rational asset
pricing that now dominate the subject. Applications of modern finance have been
extensively applied in financial management in practice.
It has been claimed by proponents of the new behavioural finance paradigm that finance
is undergoing a new revolution. According to this view the modern finance research
programme is in decline. It is also claimed that the positive contributions of modern
finance are at an end and that its energies are now devoted to protecting itself in various
ad hoc ways from the threat posed by the vast and growing anomalies literature. The
simplifying models of modern finance, under this view, should be regarded as merely
rough first approximations to how markets really behave, and that they stand in need of
substantial revision and extension. The models of behavioural finance, incorporating
behavioural, psychological, agency and institutional factors as well as risk factors, are now

17
beginning to challenge modern finance models in terms of explanatory and predictive
power. As Haugen (1999) points out, those theories that deliver models with the greatest
predictive power are the ones that will remain at the end of the debate. Nevertheless, the
rational expectations model and the efficient markets model can never become obsolete,
since they represent an ideal market. Should the behavioural finance revolution succeed,
its applications in practice will simply move real markets closer to the ideal of semi-
strong market efficiency.
The ‘behavioural finance revolution’, if such a movement indeed exists, is yet at an early
stage, and any advances in the discipline will be made one step at a time. Similarly, any
defeat of the claims of behavioural finance can only be made by careful and rigorous
scientific research. As more scientific evidences come to the surface they add more “heat”
to this ongoing debate till the time where a new theory will come to finally replace the
old doctrine and the science of financial economics will at last successfully resemble real-
life investing.

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