Behavioural finance

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Theoretical framework

In this section different theories appropriate for the thesis will be presented. Studies made on the topics along with the basic assumptions of them will be explained. The theoretical framework will start with the efficient market hypothesis, followed by a definition of behavioural finance. It will continue with presenting the affect heuristic and end with home bias.

 Efficient market hypothesis

The efficient market hypothesis says that the prices in a market always fully reflect all avail-able information in the market. Everything that needs to be taken into account is already reflected in the prices, thus making it an efficient market. There are three sufficient condi-tions underlying the theory; the first is that there would be no transaction costs in the mar-ket, the second is that everyone can easily get all information and third, that everyone agree on the meaning of current information for the current prices and the distribution of future prices. If all of this would be true in a market, the prices would indeed fully reflect all in-formation available. On the other hand, it is easy to see that this is hardly the case in the re-al world. But the conditions are to some extent needed for the efficient market hypothesis and exist in different forms. For example, instead of everyone having unlimited access to the information existing, if a “sufficient number” of investors have the information then that could be enough for the efficient market. Eugene Fama points out that the efficient market hypothesis is of course an extreme hypothesis that is not expected to be perfectly true but on the research made on it he says that it stands up quite well to the data (Fama, 1970).
The basic conditions underlying the efficient market hypothesis are sometimes being stated otherwise. Since it was so long ago that Fama wrote the article and a lot of research have been made in the field, the formulation seems to change. When Shleifer (2000) presents the efficient market hypothesis in his book, he writes that it relies on three arguments; firstly, that investors are rational and also value securities rationally. The second argument is that if some investors are not rational, then their choices are uncorrelated and therefore cancel out each other. And last, if investors are irrational in similar ways they are met in the mar-ket by rational arbitrageurs who will take away their influence on the prices.
There are also three types of forms in the efficient market hypothesis and the tests per-formed in Fama’s article from 1970 are made independently on the different forms. In the weak form, the information used comes only from historically prices or returns. The next form, the semi-strong, uses all publicly available information, such as annual reports. The strong form however deals with information that is private, meaning that only a small amount of people has access to the information.
A connection exists between the efficient market hypothesis and the idea of random walks. The idea behind random walk says that in price series all of the following changes in price represent random departures from previous prices. It says that if the flow of information were not being prevented, then that information would be reflected directly in the stock prices. So the price change of tomorrow would only affect tomorrow’s stock price and not today’s. And since news cannot be predicted prematurely, the resulting price change will al-so be unpredicted before. In the end, if all of this is true, then all the information will be re-flected in the stock prices in the market. So anyone that would buy a diversified portfolio in the market would get the same rate of return, regardless if it is a uniformed investor or an expert (Malkiel, 2003).
The research made by Fama is considered as the basic foundations and the starting point of the efficient market hypothesis. The assumption of efficient markets has somehow always existed in a similar form but the article by Fama in 1970 was anyway a starting point in the form that it exists today (Shiller, 2000).
In the popular book “Irrational exuberance” by Shiller (2000), he describes the efficient market hypothesis closely and relates it to previous happening in the market on recent years. He uses the term “smart money” in order to refer to smart investors in the financial markets. When someone is looking for an opportunity in making a profit in the financial market, the smart money are the ones you compete against. But the efficient market hy-pothesis states that if there were possibilities in the market where the smart money could make a profit, then this would only be in order to drive the asset prices to their true value. So in other words, that would mean that they were only buying under prized stocks in or-der to get their prices up and opposite, meaning that they were selling overprized stocks that eventually would get their price down. All of this would be made so that the prices would in the end be in equilibrium.
The concept of efficiency can have a different meaning for everyone. The basics for it is of course the same but how to formulate it may be different. Malkiel wrote in 2003 is that in his article he defines efficiency in financial markets as markets where investors cannot earn above-average returns without accepting that there will be an above-average risk connected to it. This formulation is in its basis aligned with the efficient market hypothesis but on the other hand it points out what implications an above-average return may have. It says that you can sometimes earn money on the market but you will not do so without having to sacrifice some risk.
Moreover, it is said that everything that is going on in the market is reflected directly. Meaning that there would be no arbitrary situation by someone who got the information before (Ross, Westerfield & Jaffe, 2008). If, for example a firm’s share value will increase due to a change in the firm, then as soon as it is implemented or announced this would be reflected in the market. A person who sees this information should not be able to have time to make an arbitrary gain out of this. That is one of the underlying assumptions of the efficient market hypothesis.
Even though the field of efficient markets is established, it also has a lot of critiques. One of them is clearly the field of behavioural finance and it has got a lot of attention in recent years. Some of the critiques on the efficient market hypothesis are discussed in Malkiel’s ar-ticle from 2003. He points out that he is supporting the efficient market hypothesis but that it has some errors as well. One of the biggest reasons to why people do not trust the efficient market hypothesis is because of big crashes in the market. From big crashes, like the IT-crash in 2000, to small irregularities in the market, such as the January-effect. The reasons to why he still believes in efficiency are mainly because of three reasons. First, he believes that the market can be efficient even though the participants in the market some-times can make irrational choices. Second, because he believes that the market is very good at reflecting new information fast. And third, he says that the market pricing is not always perfect but that it does not mean that the market is not efficient because of this.

Behavioural finance

The field of Behavioural finance is often presented as a critique to the efficient market hy-pothesis and has therefore sometimes been given the name “Inefficient markets” (Shleifer, 2000). One of the basic foundations of the efficient market hypothesis says that efficient markets are places where investors in most cases are acting rational and where information is fully reflected in the prices (Fama, 1970).
In behavioural finance however, it is not a clear model that is being used as the foundation of the field. Instead, it can be divided into two blocks where the first one is cognitive psy-chology. This part deals with how people think and the different heuristics and biases that are noticed and studied. The second part deals with the limits to arbitrage and refers to studies regarding which arbitrage situations that will be effective (Ritter, 2003).
The definition of behavioural finance can sometimes be confusing, since authors seem to interpret it in their own way. The core meaning of it is of course the same but some of the definitions of important authors will be presented here

1 Introduction 
1..1 Background
1.2 Problem discussion
1.3 Research questions
1.4 Purpose
1.5 Methodology
1.6 Delimitations
1.7 Outline
2 Theoretical framework 
2.1 Efficient market hypothesis
2.2 Behavioural finance
2.3 Affect heuristic
2.4 Home bias
3 Method and data
3.1 Survey construction method
3.2 Quick reference guide to the companies
3.3 Questionnaires
3.4 Target groups
3.5 Data collection
3.6 Critique to surveys and experiments when collecting data
4 Empirical results and analysis .
4.1  Entire groups
4.2 Age groups
4.3 Former studies in finance
4.4 Work experience in finance
4.5 Home bias
4.6 Measuring right responses
4.7 Comparison with the article by Kida et al. from 1998
4.8 Critique to the method
5 Conclusion 
List of references 
Appendices
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Are students acting rational? A study in Behavioural finance