The basics of Behavioral Finance

The financial market theory Behavioral Finance opposes the neoclassical view of the market participant as a homo economicus who knows everything and always acts efficiently and rationally. Rather, market participants behave rationally only to a limited extent. This results in systematic price distortions on the financial markets.

The efficiency market hypothesis, which goes back to Nobel Prize winner Eugene Fama, states that share prices correctly reflect all available information and that only rationally acting market participants – in the human image of homo economicus – react immediately to all available information. Active portfolio management could therefore not outperform.

In recent years, there has been increasing criticism of established capital market theory. The focus of criticism is the human image of homo economicus, the assumption of complete market efficiency and the capital market models derived from it. These assumptions are increasingly regarded as unrealistic and incompatible with the reality of the financial markets.

Numerous empirical studies question the validity of the established neoclassical view. The results of studies indicate that, in certain phases, stock prices do not reflect the current information situation exactly and are at odds with market efficiency. The effects are called value, quality, size, volatility or momentum effects. The Behavioral Finance research approach was developed on this basis.

The occurrence of systematic price distortions, triggered by emotions, psychological factors and cognitive limitations, is to be regarded as the center of financial market theory Behavioral Finance. In comparison to the neoclassical view, this financial market theory assumes that securities prices predictably deviate from the fundamentally justified price level due to irrational market participants acting in situ.

Behavioral Finance is of the opinion that market participants only behave rationally to a limited extent and that this results in systematic price distortions on the financial markets. The US capital market researcher Vernon Smith speaks in this context of limited rationality, so-called bounded rationality. Limited rationality can be seen as the result of the heuristics used in the decision-making process – in simple terms these are rules of thumb – and distortions. The application of heuristics and distortions has been proven by numerous psychological laboratory tests.

These can lead to a misjudgment of probabilities, information, objective realities or even one’s own ability. Cognitive psychology can be used to explain and justify the occurrence of different heuristics and distortions.

Neoclassical capital market theory tries to describe a perfect world. Behavioral finance, on the other hand, attempts to describe and explain the behavioral patterns of market participants in focus that are observed in reality and the resulting effects and price developments on the financial markets.