A Survey of Behavioral Finance Nicholas Barberis and Richard Thaler

In this handbook, Barberis and Thaler define the differences between traditional finance and behavioral finance.

Traditional finance is rational.Rationality means two things; correct Bayesian Updating and choises consistent with expected utility. On the other hand behavioral finance assumes that market is not fully rational and analyzes the facts when the some of the princibles are loosen up.

This essay also discusses about two main topics; limits to arbitrage and psychology. These two topics are known as the two buildings blocks of the behaviour finance.

In the normal markets security prices equal to fundamental value.In this sitiuation. …show more content…

Benartzi and Thaler are one of the earliest papers link prospect theory to the equity Premium. Their study is about how an insvestor allocate his portfolio between T-Bills and the stock market with the prospect theory acknowledge. Prospect theory argues that when choosing between gambles, people compute the gains and losses for each one and select the one with the highest prospective utility. In a financial context, this suggests that people may choose a portfolio allocation by computing, for each allocation, the potential gains and losses in the value of their. One possible story is that investors believe that the mean dividend growth rate is more variable than it actually is. When they see a surge in dividends, they are too quick to believe that the mean dividend growth rate has increased. Their exuberance pushes prices up relative to dividends, adding to the volatility of returns. holdings, and then taking the allocation with the highest prospective utility.this is a example of representativness.

In the handbook they explains the cross-section of average returns. They document that one group of stocks earns higher average returns than another. These facts have come to be known as “anomalies” because they cannot be explained by the simplest and most intuitive model of risk and return in the financial economist’s toolkit, the Capital Asset Pricing Model, or CAPM. This is explainin by the size Premium, long term