"The Portfolio Theory" by Harry Markowitz, the "Capital Asset Pricing Model" by William Sharpe and the concept of the "Homo Oeconomicus" of Adam Smith – all of these models that are taught to business students and referred to by financial specialists all over the world are based on the assumption of the fundamental efficiency of markets.
Market analysts build their substantial economic and financial predictions on the supposition that investors and corporations always behave and decide rationally. Consequently there would not be a chance that manias, panics or crashes ever occur. Nevertheless there were various speculation bubbles in the past such as the 1929 Stock-market-crash, the Dot-com bubble starting 1997 and the US-Subprime crisis as of 2007.
So stock prices show fluctuations that cannot be only elucidated by economic factors. Moreover there are studies that come to the conclusion that there is only a low correlation between share prices and fundamental data. Concomitant new research approaches deployed that either developed the existing models further or even created a complete paradigmatic change. Nowadays when it comes to explaining the occurrences on the stock markets the field of psychology and the behavioral science gain in relevance.
However the following question arises: Can the theory of Behavioral Finance depict the reality on stock markets and its participants and does it make a contribution for the progression in the Capital Market Theory?
Yet there are some approaches that attempted to answer this question but there is no scientific consensus about it. Hence this term paper should accomplish a concise but fundamental contribution for the contemplation of this topic.
Table of Contents
1 Introduction
1.1 Problem Description and Objectives
1.2 Scope of Work
2 Theoretical Background
2.1 Basic Assumptions of Neoclassical Capital Market Theory
2.2 Dissociation of Behavioral Finance as a Theory
2.2.1 AvailabilityHeuristic
2.2.2 Herding
3 Dot-com Bubble
3.1 Historical Background Information
3.2 Critical Analysis based on Neoclassical Capital Market Theory and Behavioral Finance
4 Conclusion
4.1 Target Achievements
4.2 Prospects
Objective and Research Focus
This paper investigates the explanatory power of Behavioral Finance in contrast to traditional Neoclassical Capital Market Theory, specifically focusing on its ability to depict market realities during speculative events like the Dot-com bubble.
- The divergence between rational market assumptions and actual investor behavior.
- The role of psychological factors such as the Availability Heuristic and herding behavior in economic crises.
- A critical evaluation of the Dot-com bubble as a case study for market irrationality.
- The limitations of classical models in predicting or explaining speculative price bubbles.
Excerpt from the Book
2.2.1 Availability Heuristic
The term Availability Heuristic was introduced by the psychologists Tversky and Kahneman in 1973 in their paper “Availability: A heuristic for judging frequency and probability”. Referring to these two theorists Baker and Nofsinger define availability as something that “causes probabilities to be assigned, based on how easily similar examples can be brought to mind”. This implies that a person first compares the structure of an experience or an event to already existing moments it still has in mind. The better an event or situation can be remembered, the more likely or the more possible a person will judge it to happen again.
Similarities, connotative distances or associative distance might be weighed during that process so that the feasibility that the same event structure will occur again, can be estimated. Furthermore there are factors that strengthen one’s memories which impacts that these experiences will be more available than others. This effect can for example be achieved by repetitiveness, due to happenings that are very likely or when an occurrence is very emotional or salient. The theory implies that the use of the Availability Heuristic, affected by these factors, will certainly lead to biases, which describes a preference of a particular way of thinking or acting in a certain situation. This heuristic and biases have a cognitive source and therefore they can be improved by better resources.
Summary of Chapters
1 Introduction: Introduces the research context by contrasting traditional economic models with the reality of market manias and bubbles.
2 Theoretical Background: Outlines the axioms of Neoclassical Theory while introducing Behavioral Finance as a framework for understanding irrational decision-making through heuristics and herding.
3 Dot-com Bubble: Analyzes the Dot-com bubble using the concepts of behavioral science to highlight how investor psychology and market dynamics deviate from efficient market theories.
4 Conclusion: Assesses the findings, affirming that Behavioral Finance provides essential insights into market anomalies while identifying the need for a more comprehensive future model.
Keywords
Behavioral Finance, Neoclassical Capital Market Theory, Dot-com Bubble, Availability Heuristic, Herding, Market Efficiency, Homo Oeconomicus, Investment Behavior, Speculation, Financial Crises, Cognitive Psychology, Market Anomalies, Investor Sentiment, Rationality, New Economy.
Frequently Asked Questions
What is the central focus of this paper?
The paper examines whether the theory of Behavioral Finance effectively describes stock market realities and contributes to the progression of Capital Market Theory compared to traditional neoclassical models.
What are the primary themes discussed?
The central themes include the assumptions of the Homo Oeconomicus, the psychological impact of the Availability Heuristic, the phenomenon of herding, and the historical analysis of the Dot-com bubble.
What is the core research question?
The paper asks whether Behavioral Finance can depict the reality of stock markets and their participants and if it offers a meaningful contribution to the advancement of Capital Market Theory.
Which scientific methods were employed?
The authors utilize a theoretical comparison, contrasting neoclassical axioms with empirical findings from cognitive psychology and behavioral economics, followed by an application of these theories to the Dot-com crisis.
What is covered in the main body?
The main body breaks down the theoretical foundations of both neoclassical and behavioral theories, provides a historical overview of the Dot-com bubble, and conducts a critical analysis of market events using these two opposing frameworks.
Which keywords characterize this study?
Key terms include Behavioral Finance, Neoclassical Theory, Dot-com Bubble, Availability Heuristic, Herding, and Market Efficiency.
How does the Availability Heuristic influence investors during bubbles?
It causes investors to judge the likelihood of future events based on how easily they can recall past similar experiences or salient media reports, often leading to irrational decision-making in unique or volatile market conditions.
What role did the "Neuer Markt" play in the Dot-com bubble?
The "Neuer Markt" served as a segment where speculative, often unprofitable companies flourished, fueled by high expectations and herd behavior, eventually contributing to the severe market correction observed in 2000-2002.
Does the paper conclude that neoclassical theory is still relevant?
While the paper labels the pure Neoclassical Market Theory as "obsolete" in explaining market bubbles, it acknowledges that many neoclassical foundational concepts remain influential in contemporary financial research.
- Quote paper
- Stephan Hoppe (Author), Carina Anna Schebitz (Author), 2015, Can the theory of Behavioral Finance depict the reality on stock markets and does it contribute to the progression in the Capital Market Theory?, Munich, GRIN Verlag, https://www.grin.com/document/384956
