Innovative Approaches in Social, Human and Administrative Sciences

Abstract

Behavioral Finance studies on two topics regarding finance markets. First one is that investor’s psychology can be a barrier to act rationally. The other one is that investor’s arbitrage abilities might be limited for the overpricing situation. In accordance with both topics, financial crisis shall be examined within the scope of behavioral sciences including behavioral finance, behavioral economics and neuroeconomics.Financial crises occur periodically due to various reasons. However, speculative bubbles would be defined as the main reason. A bubble is that the price of an asset rises to a level that is higher than it would be in the absence of the rationality. Furthermore, a rational observer’s forecasting might not be a high short-term ROA (return on the asset) for this price level. For instance, in many discussions on 2008 recession the common idea was that a bubble occurred in real estate industry. After 2006, real estate prices had been increased unsustainably and reached to high levels. Whether a bubble is too swollen it would burst. In this case this price bubble burst and triggered widespread defaults on subprime mortgage. It lowered the value of banks’ subprime-linked holdings. Then banking system was highly affected beyond the foresights of the qualitative risk management. At this point the financial crisis is applied by behavioral economics and behavioral finance. Because these applied sciences are as new disciplines with the aim of examining the bubble formation by the improved responses to risk changes. These multidisciplinary fields consisting of psychology and economics. It aims to analyze investment decisions and investors’ behaviors. In this chapter financial crisis is caused the questioning the adequacy of the current economic approaches. Because the current economic approaches try to figure out the reasons of the crisis by rational expectations, maximization of utility function and information shocks.These approaches are not defined as adequate to predict the financial crisis or explain the reasons. The current approaches are inadequate because the human behavior cannot be predictable. Behavioral finance focuses on this point. It is based on the irrationality of human nature. The investors are human so while making decisions they would not act rationally. It means that the investor would not consider on the profit maximization, he can act with the effects of emotions. For example, even if the selling the stock is the rational option, investor might will to keep and retain it. Or even if it is not a rational option, it can be invested in the same stock as other investors show great interest. Explaining the situations like these with traditional theories would not be adequate. Bubbles are taken into the consideration by using behavioral analysis. Financial markets include both information and noise. Therefore, they are in complex forms. Information affects fundamental values. Noise is the opposite of information and means inaccuracy in ideas and data. Shortcuts, rules of thumb, or heuristics to process market signals are developed by risk managers in financial institutions. Behavioral finance investigates how risk managers gather, interpret, and process information and noise. Particularly, the process features perception and cognitive bias. Therefore, models can be built by influenced behavior and it can shape decisions. It means that the biases can change the decisions.Behavioral finance offers a new way of looking at the processes taking place in capital markets. By referring to psychology and examining on the imperfections of human mind, it makes clear to see the mistakes of both individual and professional investors.Two emotions guide people when investing. These are fear and greed. The fear is about losing the existing standards of living. Therefore, they tend to keep a portion of savings in very safe securities like treasury bonds. This type of securities is designed to preserve the real value of money in time. Greed is about the desire of jumping to a higher standard of living. This motivates investors to accept unnecessary risk with the hope of gaining high profits. Very safe and high risk instruments can be included in a portfolio without considering on the correlation between two. It is related with narrow framing consisting of analyzing problems in an isolated manner.In people’s mind, there is a mental accounting. This is created as separated account for the various types of expenses and incomes. For instance, the money won in lottery is easier to spend than hard-earned savings. As rationally, one dollar equals one dollar regardless of how easy or hard to be earned.

Besides greed, underestimated risk is another noteworthy point regarding the behavioral and physiological bias. Forgetting risk is often seen during the chase after higher and higher rates of return. An overconfidence occurs and it is a causative situation for underestimating risk.