Key observations made the behavioral finance literature include the lack of symmetry between decisions to acquire or keep resources, called colloquially the "bird in the bush" paradox, and the strong loss aversion or regret attached to any decision where some emotionally valued resources (e.g. a home) might be totally lost. Loss aversion appears to manifest itself in investor behavior as an unwillingness to sell shares or other equity, if doing so would force the trader to realise a nominal loss (Genesove & Mayer, 2001). It may also help explain why housing market prices do not adjust downwards to market clearing levels during periods of low demand.
Applying a version of prospect theory, Benartzi and Thaler (1995) claim to have solved the equity premium puzzle, something conventional finance models have been unable to do.
Behavioral finance models
- Some financial models used in money management and asset valuation use behavioral finance parameters.
- Thaler's model of price reactions to information, with three phases, underreaction - adjustment - overreaction, creating a price trend
- The stock image coefficient
Criticisms of behavioral finance:
Critics of behavioral finance, such as Eugene Fama, typically
support the efficient market theory. They contend that behavioral
finance is more a collection of anomalies than a true branch of
finance and that these anomalies will eventually be priced out of
the market or explained by appeal to market microstructure arguments.
However, a distinction should be noted between individual biases
and social biases; the former can be averaged out by the market,
while the other can create feedback loops that drive the market
further and further from the equilibrium of the "fair price".
A specific example of this criticism is found in some attempted explanations of the equity premium puzzle. It is argued that the puzzle simply arises due to entry barriers (both practical and psychological) which have traditionally impeded entry by individuals into the stock market, and that returns between stocks and bonds should stabilize as electronic resources open up the stock market to a greater number of traders. In reply, others contend that most personal investment funds are managed through superannuation funds, so the effect of these putative barriers to entry would be minimal. In addition, professional investors and fund managers seem to hold more bonds than one would would expect given return differentials.
