History of Behavioural Economics - Essay Example

Behavioural economics has emerged as a critical discipline of economics. Behavioural economics is a form of departure from the mainstream economics as it highlights some issues such as methodological, philosophical and historical nature of economics that pure economics ignored. It is evident that this field has not received enough recognition from history and reflective science department (Ardalan, 2017). The term behavioural economics was first used in 1958 when it was referred to the initial attempt to provide the explanatory and predictive power to economic theories. However, behavioural economics has little to do with behavioural characteristics since its originality can be graced from cognitive psychology (Muradoglu and Harvey, 2012). Cognitive psychology is an entirely different field compared to behavioural psychology. Although, the area is critical to being redundant and irrelevant since economics is all about behavior. Behavioural economics cannot disagree that most of its concepts have come in from other fields such as anthropology, sociology, and neighboring courses. It is fair to say that the idea of behavioural economics revolves around psychology, a good example is a related subfield known as social commerce which collaborates efficiently with behavioural economics. As a result, behavioural economics is a branch of cognitive science, and it is significant in determining the origin, strengths, nature, and weakness of behavioural economics (Berndt, 2015)

The origin and gradual development of behavioural economics were to serve two purposes. First, it was because behavioural economics mainly emerged as a critical of neoclassical and economics. Secondly, because most behavioural economics critics have a neoclassical background a department in cognitive psychology. It is evident that it enables us to get a better understanding of their critic nature and their motive of getting economics as an attachment to psychology (Young and Conboy, 2013). Before the emergence of behavioural economics, in the first decade of the twentieth century, classical psychologists were comfortable talking about mental states and concentrating on the key issues of psychological thinking, problem solving and nature of positive thinking. It is eminent that neoclassical economics made regular reference to cognitive and affective states. Neoclassical believe of human life, and rational decision making is significant since there are a lot of misconceptions about human nature explicit in the classical economist of the 18th century.

History of Behavioural Finance

Behavioural finance is a subfield of economics that concentrates on the ideas of efficient markets. The term dynamic markets may mean differently to many economists, but it is a platform that business finance theory is built upon. Business finance states that at any given moment that a price of a given asset and security is traded correctly, it reflects all current information. Since luminance finance revolves around an efficient market system, it has features such as the law of commodity price, which dictates that there is only one price of a commodity at that very moment (Fairchild, 2010). Business finance is all about dictating exact prices of products in the efficient market system. However, the most significant question always asked is, Is it true that the law of price exists." It is evident that efficient markets appear in bubbles in the stock market which tend to question its legitimization. To fully understand the concept of business finance in the contemporary world, one should fully understand how it came to be. In the year 1980, the consistency of the business market was starting to decline. One of the problems of its decline was due to excess volatility in the efficient market system. It emerged that economic theories were formed to explain the swings in the stock prices (Mir and Pinnington, 2014). However, it was hard to come up with a solution, since the current situation is a tip of an iceberg of future dividends (Mir and Pinnington, 2014). Such measures show that the business finance was wrong about the nature of the stock market or economic investors were not rational in its ideas. It emerged that stock markets exchange might bring profits on a micro level stage but different on a macro level stage in the same market system. Such knowledge meant that individual stock markets made more gains than the movement of the entire market. It was during this period that business finance became a legitimate field contrary to efficient markets believes that investment would not take up the business market (Turner, 2006).

Business finance tried to explain several concepts to prove it was legitimate in the market. The first was the feedback models which explains that whenever investors trade, they listen to fellow investors rather than follow up the best information in the stock market (Leybourne, Warburton and Kanabar, 2014). It is evident that such an issue can lead to problems and bubbles that economic theories cannot explain. The second concept is the differentiation of smart money and average investors. The efficient market system works in a way that intelligent funds can do away with any factor that is brought about by sub-optimal decision making. Behavioural economic which in all its definition include business finance was as a result of both Amos Tversky and Daniel Kahneman who were both classical psychologists and had little knowledge of traditional banking. They believed that through a theory they formed known as prospect theory that economics always relied on decisions of other investors rather than looking up to utility decision marketing strategies that make up to finance approach (Oprean and Tanasescu, 2014).

Business Finance Influence on Investment Decisions Generally

Mispricing and Biases

Business finance is all about explaining mispricing in the financial market. Price inefficiency in business finance is well depicted when exploring equity carve out of the technology sector companies and their inherent mispricing following the firm creating the Initial Public Offering ( IPO). An excellent example has to be the Palm Carves out of three Comm Company. In the final curve out, three comm Company issued an initial public offering to its palm and vowed to distribute the remaining stake to three Comm Company in the stakeholders future date. This strategy shows that investors valued three Comm Company in asset value at less than $0, which is an example of mispricing and waste of time to the ultimate distribution of shares to three Comm Company shareholders (Marquis, Raynard, 2015).

At the very end, the main reason for the existence of behavioural finance is because not every investor can invest in the same kind of information (Mehta, 2012). Investors will read different information on various stock market businesses that everybody will be entitled to make their decisions differently. It is due to such indifference that creates finance business, in which investors make wrong estimates on the probability of share values outcomes tied to the structured financial products, although there are ways to share the information on products to avoid misleading the investors. There are some biases as listed below:

Follow trends

Rely on the point of reference

Rely on family and friends

Be averse to losses

Play it safe with regards to risk

Invest differently based on income source

Invest in instruments which are familiar

Make decisions based on readily available information

Momentum and Contrarian Value Investment

One of the critical issues that behavioural finance has unearthed is the current momentum in the stock exchange market. A theory was created to explain the occurrence of energy through the market based on psychological biases identified in various academic works (Sorge, 2004). Such preferences include investors overconfidence and self-attribution. It is proven that overconfidence investors always overweigh the data they get and as a result make the stock prices to shift from the fundamental values to the position that they can make their own wise decisions (Davidson Frame, 2014). However, when self- attributed investors invest in the efficient market system, their results do not come easy. There is the tendency for investors to rely upon issues that are actively associated with their understanding and skills while ignoring knowledge not aligned to their skills as mere information. Apart from overconfidence and imposed self-attribution, public information can create overreaction from a private signal. In conclusion, this two-factor model can describe patterns than empirically affect stock market research (Chibba, 2012).

On the matter of contrarian and value investing which is also known as buying beaten stock and hoping for them to rebound is a common idea (Farrell, 2003). It is fair to say that the success of this strategy has always been debated. Contrarian portfolio with a time over a year can create significant profit (Lecouteux, 2015). Since contrarian results are so dramatic, the idea that value stocks are inherently risky but rather exploitive of previous effects can lead to momentum stocks gaining profits and value stock exchange going downwards (Moody's,2015).

Predicting Future Prices

One of the fundamental issues that business finance has put in the efficient market is the ability to predict the bubbles in the stock market. Business finance can foretell a significant collapse in stock prices that is commonly known as a technical bubble (Esty, 2004). Business finance can accurately predict future doom and destruction of the stock market. It is fair to say that efficient market hypothesis cannot argue that finance variation ratios are not able to predict future changes in price (Murmann, 2015).

Much of finance theory is created in the laboratories where it is easy for investors to control their choices through mathematical equations. However, the actual test of business finance is always applied in a real-world situation (Pugno, 2014). Several biases can complicate matters in the real world such as overconfidence, hindsight biases, short and long views and overreaction to chance events. Upon realizing financial bias, incorporating business strategies may be easy since analyzing clients tendencies and discussing the reasons towards business biases as well as getting ways to go around them to increase success in the business finance field (Arnold, 2016).

Business Finance Influence on Project Finance Investment

Project finance investment is usually be set up by sponsors to implement finance investment projects. In such a scenario, Investors would have to borrow loan by following the financial agreements to avoid bad debts. The loan provided by lenders is referred as senior debt, which forms the most substantial funding of the project finance investment company (Nayak, 2010). The sponsors would give the other part of the funding in the form of grants. Grants which are an effect of public sector equity may contribute to financing investment (Esty, 2002). Business finance always helps investors determine that constant flow of cash service in the efficient market system to avoid incurring losses (Mueller, 2004). It also helps ensure that there is a legal structuring of the finance project so that senior investors have the upper hand over junior investors (Andrikopoulos, 2005). Business finance provides that in case of a limited flow of cash; a lender can seek additional credit to hedge against risks of the project failing to generate sufficient cash flow (Too and Weaver, 2014).

The financing project investment is all about senior debts and equity. It may also include other forms of debt such as high and pure debt (Oprean, 2014). Busin...