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Research Paper | Financial Engineering | Kenya | Volume 3 Issue 7, July 2014 | Popularity: 6.2 / 10

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The Dynamics of Behavioral Finance: A Plus for Professional Investment Practitioners'

Moses Odongo Otieno, Samuel Mwangi Miano

Abstract: Standard finance, also known as modern portfolio theory, has four foundation blocks: (1) investors are rational; (2) markets are efficient; (3) investors should design their portfolios according to the rules of mean-variance portfolio theory and, in reality, do so; and (4) expected returns are a function of risk and risk alone. Modern portfolio theory is no longer very modern, dating back to the late 1950s and early 1960s. Merton Miller and Franco Modigliani described investors as rational in 1961. Eugene Fama described markets as efficient in 1965. Harry Markowitz prescribed mean-variance portfolio theory in its early form in 1952 and in its full form in 1959. William Sharpe adopted mean-variance portfolio theory as a description of investor behavior and in 1964 introduced the capital asset pricing theory (CAPM). According to this theory, differences in expected returns are determined only by differences in risk, and beta is the measure of risk. Behavioral finance offers an alternative block for each of the foundation blocks of standard finance. According to behavioral finance, investors are normal, not rational. Markets are not efficient, even if they are difficult to beat. Investors design portfolios according to the rules of behavioral portfolio theory, not mean-variance portfolio theory. And expected returns follow behavioral asset pricing theory, in which risk is not measured by beta and expected returns are determined by more than risk.

Keywords: Portfolio theory, Mean-Variance theory, Behavioral finance, Cognitive bias, Asset Pricing theory, Arbitrage, Market efficiency

Edition: Volume 3 Issue 7, July 2014

Pages: 909 - 914

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