|Behavioral Finance: Oxymoron?
What if investors do not behave rationally according to longstanding market theory? What if their pervasive psychological biases influence the market as a whole—and markets don’t really reflect a correct price?
These questions are at the foundation of behavioral finance, a controversial new area of study. Last October, the Mendoza College of Business Finance Department sponsored a conference with leading researchers in the field from Princeton University, Northwestern University, and the University of Amsterdam, among others.
Some of their findings were provocative:
• Because individuals prefer to invest in local businesses, companies will have higher stock prices if they are located in areas with fewer companies and more dollars to be invested. Research shows this bias alone should increase a small company’s stock price by 14%.
• Individual investors tend to trade too much and think they are better at picking stocks than they actually are. Men, in particular, are subject to what radio host Garrison Keillor might dub the “Lake Wobegon Syndrome.” Men trade more than women do, pay more in transaction costs, and are shown to have poorer investment returns.
While research in behavioral finance is moving into the mainstream, major questions remain about its application to the study of markets. Traditional finance theory holds that the actions of individual investors tend to be random and to balance each other out, so that the markets do reflect an accurate price. Behavioral finance scholars are wondering, what if they don’t?