Behavioral Finance

Nate Manuel

Fin 4500

January 19, 2015

Paper Review 1: Option 1

The article begins by exploring the idea that maybe not all individuals are fully rational in their financial and economic decisions, and that if they are not fully rational, decisions of rationality will eventually come into play in decision making preventing long term changes which deviate because of irrationality and psychology. In other words, this can be described as arbitrage. Friedman argues that rational traders would swiftly capitalize on the opportunity that irrational traders make by mispricing, which creates an investment opportunity. The noise traders would argue that any strategy designed to correct a misprice would be relatively risky, which would dilute the interest of “arbitrageurs.” Now, most arbitrageurs would be professional portfolio managers, which calls into question the agency feature. These managers will be judged harshly in the short run, even though a manager might be trying to exploit a misprice for the long run, the investors may decide he is incapable because of the short run aesthetics and lack of strategic insight. On the implementation side, traditionalists once thought that if noise traders had any influence on a stock price, it would become predictable. Shiller and Summers argue the exact opposite, stating that even if they had the majority demand causing large mispricing, it would cause such little predictability that it may be undetectable. Most arguments against Behavioral Finance come at the principle of rationality and denial of psychological aspects in decision-making. While there are constraints to the behavioral approach, it remains a big stepping-stone in understanding financial and economic trend tracking in today’s society. The limitation of arbitrage, for example, arbitragers buying into the mispricing caused by noise traders driving the prices up. The evidence of arbitrage constraints exists because mispricing does not disappear. It is seen as a...