Application to Modern Investment Theory to EMH

Application to Modern enthronization Theory to EMHThe modern investment theory and its application on the effective commercialises hypothesis1. groundworkThe Modern investment theory and its application is predicated on the in effect(p) trades Hypothesis (EMH), assumption that food food marts full and instantaneously integrate all in all avail qualified in take ination into market hurts. Underlying this comprehensive fancy is the assumption that market participants atomic number 18 perfectly intellectual, and always act in self-interest, reservation optimal finishs. These assumptions bring been challenged. It is difficult to achievement over the neo classical convention that has yielded oft(prenominal) insights as portfolio optimization, Capital As line up Pricing Model, Arbitr date Pricing Theory and Cox Ingersoll-Ross theory of the termination structure of interest rates, all of which atomic number 18 predicated on the EMH2 alternatively than d ingestside ri sks3. The theory of behavioural finance is pivotal to the traditional theory of Finance and deals with human emotions, sen sequencents, conditions, strokees on incarnate as well as individual posterior. doings finance theory is helpful in justifying late(prenominal) practices of investors and determining the false performance of the investors. sortal finance is a concept of finance which deals with pecuniary resource incorporating findings from psychological science and sociology. It is re great dealed that behavioural finance is generally based on individual air and pecuniary market let oncomes. There be umpteen pretendings explaining behavioral finance that explains investors behavior or market irregularities where thinking(prenominal) annoys fail to provide adequate schooling. Investors do not demand overmuch(prenominal) research to provide a method to resoluteness lots of m unitaryy from in efficacious fiscal markets quickly. According to Shiller (200 1) mienal finance has basically emerged from the theories of psychological science, sociology and anthropology where implications of these theories look to be signifi displacet for efficient market hypothesis, that is based on the positive notion that people behave rationally, maximize their avail. It is undercoat that in efficient market the principle of rational behavior is not always correct. Thus, the idea of analyzing frigid simulationing of human behavior has come up. Gervais (2001) further explains the concept where he says that people like to relate to the furrow market as a person having different moods, this person usher out be bad-tempered or high-spirited and can overreact one day or make fix the next. This person indicates human behavior which is unpredict sufficient and behaves differently in different situations. Lately m all researchers have suggested the idea that psychological analysis of investors whitethorn be very helpful in checking pecuniary mark ets better. To do so it is fundamental to understand behavioral finance inserting the concept of traditional theory overestimating moderateness of investors, their biases in decisions casting a cumulative dissemble on plus prices. To many researchers the believe of behavior in finance appe atomic number 18d to be a revolution. As it transforms peoples mentality and perception ab come forward markets and factors that influence the markets. The range of a function is shifting. People ar continuing to move across the border from the traditional to the behavioral camp. Gervais (2001, pp.2). On the perverted some people believe that whitethorn be its as well as early to call it a revolution. Gervais (2001) states that Fama in (1970) argued that behavioral finance has not really betokenn an impact on world prices, and that model contradict each other on different appoint of clock times. Giving very less account to behaviorist explanations of trends and the irregularities anomaly ( is any occurrence or object that is strange, unusual, or unique) to a fault argued that in order to make up patterns the info mining techniques ar much helpful. Other researchers have in like manner criticized the idea that behavioral finance models tend to replace the traditional models of market functions. several(prenominal) weaknesses in this bea, explained by Gervais (2001)are that generally overreaction and under reaction are major causes of market behavior. In these cases People take the behavior that seems to be easy for a grouchy study no matter of the fact that whether these biases are each primary factor of economic forces or not. Secondly, lack of trained and dear people. The field does not have enough trained professionals both in psychology or finance fields and at that placefore as a result the models presented by researchers are improvised.Gervais (2001) also focused on individual behavior impacting asset prices and explained that this field of b ehavioral finance is currently in its exploitational stage, in its way of cave inment it is facing a lot of disagreement which itself is a outputive one. He points out that if we apply the conceptual models of behavioral finance to the somatic finance, it can majorly dedicate off. If money managers are incorrectly rational, means they are probably not evaluating their investment strategies correctly. They might take wrong decisions in their majuscule structure decisions. It has been found that quite a a hardly a(prenominal)(prenominal) people foresee behavioral finance displacing the age old Efficient Markets theory. On the contrary underlying assumption that investors and managers are completely rational makes insightful sense to many people.2. conventional Finance and Empirical EvidenceFung, (2006) championshiped that Post Keynesian theory has criticized mainstream economic theory for utilise statistical methods to model the world in which historical market data cannot provide, In recent old age, two different lines of research experimental economics and behavioral finance have produced results that are at odds with the foresights of mainstream financial theory. This account argues that it is beneficial to the development of devout financial theory for Post Keynesian economists to engage in an exchange of ideas with the practitioners of these two lines of research. The battle of opinion originated when experimental economics and behavioral finance understood the difference between agents rationality in theory and in real world. Both had a same point of view regarding Post Keynesian economists where both of them refused to assume Post Keynesian economists assumption of economic actors existence always rational by maximizing expected inferior. rather of assuming rational economic actors who always act consistently, they often tap into insights provided by psychology to estimate to explain economic behavior. The use of psychology can be t raced back to Keynes, and, in fact, some of the papers in experimental economics and behavioral finance take a remark of Keynes on the psychology of economic actors as an inspiration for designing empirical tests of economic behavior. Indeed, some of these papers recognize that we lie with in an un definite world, and they examine the heuristics, or rules of thumb, that economic actors develop to guide their behavior in face of un definitety. When Keynes made his remark in 1936 (the original event date of the General Theory), there was not yet an efficient market hypothesis. But in 1970 Fama published his pioneering paper on efficient markets. In it, he defined an efficient market as a market in which prices always fully reflect uncommitted instruction. Traditional theory assumes that agents are rational and the practice of law of one price holds that is a perfect scenario. Where the law of One price5. And agents rationality explains the behavior of investor Professional and In dividual which is generally inconsistent with rationality or future prognostications. If a market achieves a perfect scenario where agents are rational and law of one price holds then the market is efficient. With the avail readiness of commodious add up of information, form of market changes. It is unlikely that market prices contain all private information. The presence of noise traders (traders, trading randomly and not based on information). Researches show that line of creditpile returns are typically unpredictable based on past returns where as future returns are predictable to some extent. According to Glaser et al. (2003) Few examples from the past literature explains the difficulty of preposterousity which occurs because of naive diversification, behavior influenced by framing, the tendency of investors of committing systematic errors while evaluating public information. Lately it has been found that investors attitude towards the riskiness of a stock in future and t he individual interpretation may explain the high(prenominal) level trading volume, which itself is a vast topic for insight. A problem of perception exist in the investors actions that stocks have a higher risk adjusted returns than bonds. Another issue with the investors is that these investors either care about a stock portfolio or just about the note shelter of each private security in their portfolio and thus ignore correlations. The concept of will power familiarity6 has been promoted in the recent years where people can take better care of their own lives and be better citizen too if they are both owner of financial assets and homeowners. As Shiller (2006) suggested that in order to im nurture lives of less advantaged people in our society is to teach them how to be capitalist, In order to put ownership society in its ripe(p) perspective, behavioral finance is needed to be understood. The concept of ownership society seems very attractive when people appear to make sc ratch from their investments. Behavioral finance is also very helpful in understanding and justifying regimen involvement in investing decisions of individuals. The failure of millions of people to save goodly for their future is also a core focus of behavioral finance.According to Glaser et al. (2003) there are two accesses towards behavioral finance, where both tend to have same goals. The goals tend to explain observed prices, market trading volume and Last just instantaneously not the least is the individual behavior better than traditional finance models. Belief found Model Psychology (Individual Behavior) Incorporates into Model Market prices and Transaction Volume. It includes findings such(prenominal) as overconfidence, Biased Self- Attrition, and Conservatism and Representativeness.Preference Based Model Rational Friction or from psychology Find explanations, Market detects irregularities and individual behavior. It incorporates Prospect Theory7, can money effect a nd other forms of mental account. Behavioral Finance and Rational debate the name by Heaton and Rosenberg (2004) highlights the debate between the rational and behavioral model over testability and predictive supremacy. And it was found that neither of them in reality offers either of these mea originals of success. The rational come on uses a particular type of rationalization methodology which goes on to form the founding of behavior finance predictions. A closer look into the rational finance model goes on to show that it employs ex post rationalizations of observed price behaviors. This allows them greater flexibility when pass explanations for economic anomalies. On the other hand the behavior paradigm criticizes rationalizations as having no concrete role in predicting prices accurately, that utility functions, information sets and transaction costs cannot be rationalized. Ironically they also reject the rational finances explanatory power which plays an essential role i n the chokes of merchandise, which really makes behavioral finance possible.Heaton Rosenberg (2004) presented Milton Friedmans theory that laid the basis of positive economics. His methodology focused on how to make a particular prediction it is ir pertinent whether a particular assumption is rational or irrational. According to this methodology, the rational finance model relies on a limited assumption space since all assumptions that are supposedly not rational have been eliminated. This is one of the major crusades throne the little success in rational finance predictions. despite the minimal results, adherents of this model have criticized the behavioral model as lacking quantifiable predictions that are based on mathematical models. Rational finance has targeted a more important looking in the structure of economy, i.e. Investor uncertainty, which further cause financial anomalies. In explaining these assertions, the behavioral approach emphasizes importance of taking l imits in arbitrage. provided his methodological approach falls into the category instrumentalism8, which basically states that theories are assholes for predictions and used to draw inferences. Whether an assumption is realistic or rational is of no assess to an instrumentalist. By narrowing what may or may not be possible, one go away inevitably eliminate certain strategies or behaviors which might in fact go on to maximize utility or returns based on their uniqueness. An assumption could be irrational even in the long run, but it is continuously rewrite and refined to make it into something useful. In opposition to this, many individuals have said that behaviouralists are not bound by any constraints thus making their explanations consistently irrational. Heaton Rosenberg (2004) further explains the concept of Rubinstein that how when everyone fails to explain a particular anomaly, suddenly a behavioral aspect to it will come up, because that can be based on completely abst ract irrational assumptions. To patronize rationality, he came up with two arguments. Firstly he went on to say that an irrational strategy that is profitable, will entirely attract copy cat firms or traders into the market. This is supported when a closer look is wedded towards limits to arbitrage. Secondly by means of the process of evolution, irrational decisions will last be eliminated in the long run. The major achievements characterized of the rational finance paradigm consist of the pursual the principle of no arbitrage market efficiency, the net present value decision rule, and derivatives valuation techniques Markowitzs (1952) mean-variance framework event studies multifactor models such as the APT, ICAPM, and the Consumption CAPM. Despite the number of top achievements that supporters of the rational model claim, the paradigm fails to answer some of the nearly basic financial economic questions such as What is the cost of capital for this firm? or What is its optima l capital structure? scarce because of their self imposed constraints. So far this makes it seem like rational finance and behavioral finance are coarsely exclusive. Contrary to this, they are actually interdependent, and overlap in several areas. Take for instance the concept of mispricing when there is no arbitrage. Behavior finance on the other hand suggests that this may not be the case irrational assumptions in the market will still lead to mispricing. Further even though certain arbitrageurs may be able to identify irrationality induced mispricing, because of the imperfect market information, they are unable to convince investors of its existence. Over here, the rational model is accepting the existence of anomalies which are touch both through the factors of risk and chance therefore coinciding with the perspective of behavioral finance. dickens instances are clear examples of how rationalization is an important limit of arbitrage i) the build-up and blow-up of the intern et bubble and ii) the superiority of value equity strategies.If we focus on the latter, we are able to see behavioral finance literature that highlights the superiority of such strategies in the ability of analysts to extrapolate results for investors. This is possible when rationalization is taken as a limit to arbitrage. Similarly these strategies may also limit arbitrage against mispricing, through the great risk associated with stocks. In explaining most anomalies it is essential that analysts first conclude whether pricing is rational or not. To prove their hypothesis that irrationality induced mispricing exists behaviouralists may find it easier if they accepted the role of rationalization in limits of arbitrage. Slow information diffusion and short-sales constraints are other factors which explain mispricing. However these factors alone cannot form the basis of a strong and concrete explanation that will clarify pricing across firms and also across time. Those supporting the rational paradigm attack behavioral finance adherents in that their predictions for the financial markets have been made on irrational assumptions that are not supported by concrete mathematical or scientific models. In their view the lack of concrete discipline in the methodology adopted in behavior finance leads to the lack of testing in their forecasts. On the other hand the rational model is criticized for its lack of success in financial predictions. The behaviouralists claim that this limitation exists because the supporters of rational finance dismiss aspects of the economic market simply because it may not fall into explainable rational behavior. Both perspectives claim to get hold themselves with respect to the goals of testability and predictions, while at the same time run to offer evidence against the other model. In reality however, rather than being exclusively mutual both paradigms assist one another in making their predictions. give off (2006) examines a rude(a) genre of behavioral markets prediction markets and their remarkable ability to totality inside and expert information from around the world in order to accurately predict all types of economic and financial variables. To date it is said that the prediction markets are the most accurately efficient markets as they prove to show all three forms of market efficiency (weak, semi-strong, and strong), in contrast to regulated markets. farsightedness markets are also said to be decision markets. It ab initio evolved in 1988 with the first online betting market the Iowa Electronic Market. These online markets have proven their predictions accurately since the time they came into being. To be precise these prediction markets are behavioral markets with correctly statistical components that are able to predict the most likely values of future financial variables, variances around such values, and their correlations with other future financial variables. Ray (2006) says that being unregula ted, prediction markets are highly effective at flushing out and thereafter aggregating relevant information including inside and expert information regarding a particular event, globally extracting such information from savvy bettors who are eager to profit from their inside and expert information. These sorts of prediction markets have become so popular that now a days major companies use such behavioral markets to accurately forecast sales, earnings, product success, and many other financial and economic variables. The foremost tool for these markets is the wisdom of crowd. In order to accurately predict financial and economical variables he presented few conditions as a prerequisite, which included mainly having a material body of opinions, with no herd behavior, should be able to use their knowledge according to the information usable with them and last but not the least is the fact that prediction markets expectations are not self fulfilling prophecies. Prediction markets ar e a new genre of behavioral markets that continually reveal the thinking of confident insiders by suggesting them to profit from their inside and expert information. The inwrought evidence with a few statistical evidences corroborates the impressive ability of these markets to predict financial events of all types. The phenomenon exists from ages and effectively proves its performance in particular in worlds financial markets. The demonstrated accuracy of predictions in these markets can be of significant utility to traders, financial analysts, behavioral analysts, and many others intending to forecast and analyze financial data.A persons tendency to make errors is known as cognitive bias. These errors are based on the cognitive factors that include statistical judgments, social attribution and storage being common to all the humans in the world. Cognitive bias is the tendency of intelligent, intelligent people to consistently do the wrong thing. Crowell (1994, pp. 1). The reaso n behind this cognitive bias is that the Human brain is made for interpersonal relationships and not for processing statistics. He discussed the frailty of forecasts. Generally it is said that the world is divided into two groups People forecasting positively and people forecasting nixly. These forecasts exaggerate the reliability of their forecasts and trace it to the prank of validity which exists even when the illusionary character is recognized. Fisher and Statman, (2000) discussed quint cognitive bias, underlying the illusion of validity that are Overconfidence, Confirmation, Representativeness, Anchoring, and Hindsight. Shiller (2002) discusses, that irrational behavior may fell with more learning and a much more structure situation. History proves it that many of cognitive biases in human judgment value un sure enough will change they may be convinced if given proper instructions, on the part-experience of irrational behavior. The three most common themes of behavioral f inance are as follows Heuristics, Framing and Market Inefficiencies. People when decide on the basis of the rules of thumb regardless of rationalizing suffer from Heuristics. Some forms of Heuristics are Prospect theory, Loss Aversion, Status quo Bias, Gamblers Fallacy9, selfish bias and lastly Money illusion. Framing is basically a problem of decision making where the decision is based on the point where there is difference in how the case is presented to the decision maker. Cognitive framing, Mental accounting and Anchoring are the common forms of Framing3. Market InefficienciesAs observed, that market outcomes are totally opposite to rational expectations and efficient market hypothesis where mispricing, irrational decision making and return anomalies are examples of it. Fung (2006) introduced three forms of market efficiency foregoing presented by Fama in 1970. In the weak form, the information set contains nevertheless historical prices. In the semi strong form, information set contains all publicly available information. In the strong form, the information contains not only all publicly available information but also insider information not available to the public. This definition of efficient markets is too general to be testable empirically. To make the model testable, he proposed a process of price formation known as the expected return or fair game efficient markets model. In this model, when investors form expectations of security prices, they fully utilize all the information that is fully reflected in those prices. It is called a fair game model, because using only the information that is fully reflected in security prices, no trading system can have expected pelf or returns in excess of equilibrium expected profits or returns. These terms have been described as specific market anomaly from a behavioral point of view.Anomaly (economic behavior) Disposition effect endowment effect Inequity abomination Intertemporal consumption Present-biased taste sensations Momentum investing Greed and fear brood behaviorAnomalies (market prices and returns)Efficiency wage hypothesis Limits to arbitrage Dividend puzzle Equity premium puzzleBehavioral Economic Models are restricted to a certain observed market anomaly and it adjusts the neo classical models by explaining the phenomenon of Heuristics and framing to the decision makers. It is usually said that economics get along with in the neo classical framework, with just one restriction of the assumption of rationality. Loix et. Al (2005) in their paper Orientation towards Finances explains the individual financial trouble behavior, people relations with their financial means. They have analyzed the Non-specific financial behavior as already we see extensive research on the specific finance behavior such as saving, taxation, gambling and amassing debt, and gave a lot of importance to stock market, investors and households. The analysis of general publics behavior was done, where an ordinary man is not sure and simply act according to the guesses over their money related to issues. It was also found that people interested in economic and financial matters are much more active in collecting specific information than general public, stating that financial behavior of household is an important relevant topic that needs to be discussed in much more details. Household financial counseling is similar to the financial management. The construct of orientation towards finances was developed where the individual ORTO FIN focuses on competencies (interest and skills). Having stronger money attitude is an indication of stronger orientation towards finances and much more effective competencies. Therefore we expect some relevance and similarity between corporate and household management behavior as both overtop organizing, forecasting, planning and control.Loix et. al (2005) analyzed general publics behavior in basically dividing them into two groups, financial Inform ation and Personal financial planning. Also explaining some mulish and theoretical gaps in the area of psychology of money usage, they concluded that ORTOFIN (Orientation towards finance) indicates the involvement of individuals in managing their finances. Proving out the point that active interest in financial information and an urge to plan expenses are two main factors. A stronger ORTFIN indicates greater use of calculate accounts, higher savings account, wide variety of investments, greater sentiency of ones financial Intimate knowledge of the details of ones savings/deposit accounts obsessed by money, higher achievement and power in monetary terms, Further age is also inversely proportional. Shiller, (2006) in his article talked about the co-evolution of neo-classical and behavior finance that in 1937 when A. Samuelsson one of the great economists wrote about people maximizing the present value of utility subject to a present value. Another judgment he realized was time bein g consistent human behavior where if at any time t,0 4. Investing and Cognitive BiasMoney Managers and Money management is a very popular phenomenon. The performance in a stock market is measured at daily basis and waiting for a highly subjective annual review of ones performance by ones superior. Market grades you on a daily basis. The smarter one is, more confident one becomes of ones ability to succeed clients support them by trusting them that eventually helps their careers. But the truth is that few money managers put in sufficient amount of time and effort to figure out what works and develop a set of investment principles to guide their investment decisions Browne (2000). Further he discussed the importance of asset allocation and risk aversion, in order to understand why we do what we do regardless of whether it is rational or not. General public opts for money Managers to deal with their finances and these managers are categorized in three ways Value Managers, Growth Manage rs and Market Neutral Managers. The vast majority of money managers are categorized as either value managers or growth managers although a third category, market electroneutral managers, is gaining popularity these days and may soon rival the so-called strategies of value and growth. Some investment management firms even are being cautious by offering all styles of investments. What too few money managers do is analyze the fundamental financial characteristics of portfolios that build up long-term market beating results, and develop a set of investment principles that are based on those findings. Difference of opinion on the definition of value is the problem. The reasons for this are two-fold, one being the practical reality of managing large sums of money, and other related to behavior. As the assets under management of an advisor grow, universe of potential stocks shrinks. Analyzing why individual and professional investors do not change their behavior even when they face empir ical evidence, suggests that their decisions are less than optimal. An answer to this question is said to be that being a contrarian may simply be too risky for the average individual or professional. If a person is wrong on collective basis, where everyone else also had made a mistake, the consequences professionally and for ones own vanity are far less damaging than if a person is wrong alone. The herd spirit allows for comfort of safety in numbers. The other reason is that individuals try to behave same way and do not tend to change courses of action if they are happy. If the results are not too painful individuals can be happy with sub-optimal results. Moreover, individuals who tend to be unhappy make changes often and eventually end up being just as unhappy in their new circumstances. According to traditional view of investment management, fundamental forces drive markets, however many other investment firms are consider being active and basing their working on their experie nced Judgment. It is also believed that Judgmental overrides value and fundamental forces of markets can be lethal as well as a cause of financial disappointment. Historically it has been found that people override at wrong times and in most cases would be better off sticking to their investment disciplines and the reason to this behavior is the cognitive bias. According to Crowell (1994) and many other researchers, stocks of pocket-size companies with low price/ rule book ratios provide excess returns. Therefore, given a choice among small cheap stocks and large high priced stocks, magnanimous investors (financial analysts, senior company executives and company directors) will certainly prefer small cheap ones. But the fact is opposite to this situation where these prominent investors would opt for large high priced ones and so suffer from cognitive bias and further regret.The assumptions made by Crowell (1994, pp.2) were that pine term investment value should be negatively cor related with size since small stocks provide superior returns. Long term Investment value should have a negative correlation with Price/book since low Price/Book stocks provide superior returns. Whereas the results Crowells survey were contrary stating that Long Term Investment had a positive correlation with size and with Price/Book stocks. Crowell further stated that according to Shefrin and Statman, prominent investors overestimate the probability that a good company is a good stock, relying on the representative heuristics, concluding that superior companies make superior stocks. Discussing the concept of regrets, aversion to regret is different from aversion to risk Regret is intense when an individual must take indebtedness for the final outcome. Aversion to regret leads to a preference for stocks of good companies. The choice of the stocks of bad companies involves more personal responsibility and higher probability of regret. Therefore, two major Cognitive errors appear We have a ternary cognitive error good company always makes good stock (representativeness), and involves less responsibility(Less aversion to regret). (Crowell, 1994,pp.3) The Anti Cognitive bias actions would be admitting to your owned stocks, admitting earlier investment mistakes. Further, taking the responsibility for actions to improve their performance in future. The reasons for all the available discipApplication to Modern Investment Theory to EMHApplication to Modern Investment Theory to EMHThe modern investment theory and its application on the efficient markets hypothesis1. IntroductionThe Modern investment theory and its application is predicated on the Efficient Markets Hypothesis (EMH), assumption that markets fully and instantaneously integrate all available information into market prices. Underlying this comprehensive idea is the assumption that market participants are perfectly rational, and always act in self-interest, making optimal decisions. These assumptions have been challenged. It is difficult to tip over the neo classical convention that has yielded such insights as portfolio optimization, Capital Asset Pricing Model, Arbitrage Pricing Theory and Cox Ingersoll-Ross theory of the term structure of interest rates, all of which are predicated on the EMH2 rather than downside risks3. The theory of behavioral finance is opposite to the traditional theory of Finance and deals with human emotions, sentiments, conditions, biases on collective as well as individual basis. Behavior finance theory is helpful in explaining past practices of investors and determining the false performance of the investors. Behavioral finance is a concept of finance which deals with finances incorporating findings from psychology and sociology. It is reviewed that behavioral finance is generally based on individual behavior and financial market outcomes. There are many models explaining behavioral finance that explains investors behavior or market irregularities where rational models fail to provide adequate information. Investors do not expect such research to provide a method to make lots of money from inefficient financial markets quickly. According to Shiller (2001) Behavioral finance has basically emerged from the theories of psychology, sociology and anthropology where implications of these theories appear to be significant for efficient market hypothesis, that is based on the positive notion that people behave rationally, maximize their utility. It is found that in efficient market the principle of rational behavior is not always correct. Thus, the idea of analyzing other model of human behavior has come up. Gervais (2001) further explains the concept where he says that people like to relate to the stock market as a person having different moods, this person can be bad-tempered or high-spirited and can overreact one day or make amends the next. This person indicates human behavior which is unpredictable and behaves differently in differen t situations. Lately many researchers have suggested the idea that psychological analysis of investors may be very helpful in understanding financial markets better. To do so it is important to understand behavioral finance presenting the concept of traditional theory overestimating rationality of investors, their biases in decisions casting a cumulative impact on asset prices. To many researchers the study of behavior in finance appeared to be a revolution. As it transforms peoples mentality and perception about markets and factors that influence the markets. The paradigm is shifting. People are continuing to walk across the border from the traditional to the behavioral camp. Gervais (2001, pp.2). On the contrary some people believe that may be its too early to call it a revolution. Gervais (2001) states that Fama in (1970) argued that behavioral finance has not really shown an impact on world prices, and that model contradict each other on different point of times. Giving very les s account to behaviorist explanations of trends and the irregularities anomaly ( is any occurrence or object that is strange, unusual, or unique) also argued that in order to locate patterns the data mining techniques are much helpful. Other researchers have also criticized the idea that behavioral finance models tend to replace the traditional models of market functions. Some weaknesses in this area, explained by Gervais (2001)are that generally overreaction and under reaction are major causes of market behavior. In these cases People take the behavior that seems to be easy for a particular study regardless of the fact that whether these biases are either primary factor of economic forces or not. Secondly, lack of trained and expert people. The field does not have enough trained professionals both in psychology or finance fields and therefore as a result the models presented by researchers are improvised.Gervais (2001) also focused on individual behavior impacting asset prices and explained that this field of behavioral finance is currently in its developmental stage, in its way of development it is facing a lot of disagreement which itself is a plentiful one. He points out that if we apply the conceptual models of behavioral finance to the corporate finance, it can majorly pay off. If money managers are incorrectly rational, means they are probably not evaluating their investment strategies correctly. They might take wrong decisions in their capital structure decisions. It has been found that quite a few people foresee behavioral finance displacing the age old Efficient Markets theory. On the contrary underlying assumption that investors and managers are completely rational makes insightful sense to many people.2. Traditional Finance and Empirical EvidenceFung, (2006) claimed that Post Keynesian theory has criticized mainstream economic theory for using statistical methods to model the world in which historical market data cannot provide, In recent years, t wo different lines of research experimental economics and behavioral finance have produced results that are at odds with the predictions of mainstream financial theory. This paper argues that it is beneficial to the development of good financial theory for Post Keynesian economists to engage in an exchange of ideas with the practitioners of these two lines of research. The difference of opinion originated when experimental economics and behavioral finance understood the difference between agents rationality in theory and in real world. Both had a same point of view regarding Post Keynesian economists where both of them refused to assume Post Keynesian economists assumption of economic actors being always rational by maximizing expected utility. Instead of assuming rational economic actors who always act consistently, they often tap into insights provided by psychology to try to explain economic behavior. The use of psychology can be traced back to Keynes, and, in fact, some of the p apers in experimental economics and behavioral finance take a remark of Keynes on the psychology of economic actors as an inspiration for designing empirical tests of economic behavior. Indeed, some of these papers recognize that we live in an uncertain world, and they examine the heuristics, or rules of thumb, that economic actors develop to guide their behavior in face of uncertainty. When Keynes made his remark in 1936 (the original publication date of the General Theory), there was not yet an efficient market hypothesis. But in 1970 Fama published his pioneering paper on efficient markets. In it, he defined an efficient market as a market in which prices always fully reflect available information. Traditional theory assumes that agents are rational and the law of one price holds that is a perfect scenario. Where the law of One price5. And agents rationality explains the behavior of investor Professional and Individual which is generally inconsistent with rationality or future pr edictions. If a market achieves a perfect scenario where agents are rational and law of one price holds then the market is efficient. With the availability of large amount of information, form of market changes. It is unlikely that market prices contain all private information. The presence of noise traders (traders, trading randomly and not based on information). Researches show that stock returns are typically unpredictable based on past returns where as future returns are predictable to some extent. According to Glaser et al. (2003) Few examples from the past literature explains the problem of irrationality which occurs because of naive diversification, behavior influenced by framing, the tendency of investors of committing systematic errors while evaluating public information. Lately it has been found that investors attitude towards the riskiness of a stock in future and the individual interpretation may explain the higher level trading volume, which itself is a vast topic for i nsight. A problem of perception exist in the investors actions that stocks have a higher risk adjusted returns than bonds. Another issue with the investors is that these investors either care about a stock portfolio or just about the value of each single security in their portfolio and thus ignore correlations. The concept of ownership society6 has been promoted in the recent years where people can take better care of their own lives and be better citizen too if they are both owner of financial assets and homeowners. As Shiller (2006) suggested that in order to improve lives of less advantaged people in our society is to teach them how to be capitalist, In order to put ownership society in its right perspective, behavioral finance is needed to be understood. The concept of ownership society seems very attractive when people appear to make profits from their investments. Behavioral finance is also very helpful in understanding and justifying government involvement in investing decisi ons of individuals. The failure of millions of people to save properly for their future is also a core focus of behavioral finance.According to Glaser et al. (2003) there are two approaches towards behavioral finance, where both tend to have same goals. The goals tend to explain observed prices, market trading volume and Last but not the least is the individual behavior better than traditional finance models. Belief Based Model Psychology (Individual Behavior) Incorporates into Model Market prices and Transaction Volume. It includes findings such as Overconfidence, Biased Self- Attrition, and Conservatism and Representativeness.Preference Based Model Rational Friction or from psychology Find explanations, Market detects irregularities and individual behavior. It incorporates Prospect Theory7, House money effect and other forms of mental accounting. Behavioral Finance and Rational debate the article by Heaton and Rosenberg (2004) highlights the debate between the rational and behavi oral model over testability and predictive success. And it was found that neither of them actually offers either of these measures of success. The rational approach uses a particular type of rationalization methodology which goes on to form the basis of behavior finance predictions. A closer look into the rational finance model goes on to show that it employs ex post rationalizations of observed price behaviors. This allows them greater flexibility when offering explanations for economic anomalies. On the other hand the behavior paradigm criticizes rationalizations as having no concrete role in predicting prices accurately, that utility functions, information sets and transaction costs cannot be rationalized. Ironically they also reject the rational finances explanatory power which plays an essential role in the limits of arbitrage, which actually makes behavioral finance possible.Heaton Rosenberg (2004) presented Milton Friedmans theory that laid the basis of positive economics. H is methodology focused on how to make a particular prediction it is irrelevant whether a particular assumption is rational or irrational. According to this methodology, the rational finance model relies on a limited assumption space since all assumptions that are supposedly not rational have been eliminated. This is one of the major reasons behind the little success in rational finance predictions. Despite the minimal results, adherents of this model have criticized the behavioral model as lacking quantifiable predictions that are based on mathematical models. Rational finance has targeted a more important aspect in the structure of economy, i.e. Investor uncertainty, which further cause financial anomalies. In explaining these assertions, the behavioral approach emphasizes importance of taking limits in arbitrage. Further his methodological approach falls into the category instrumentalism8, which basically states that theories are tools for predictions and used to draw inferences. Whether an assumption is realistic or rational is of no value to an instrumentalist. By narrowing what may or may not be possible, one will inevitably eliminate certain strategies or behaviors which might in fact go on to maximize utility or profits based on their uniqueness. An assumption could be irrational even in the long run, but it is continuously revised and refined to make it into something useful. In opposition to this, many individuals have said that behaviouralists are not bound by any constraints thus making their explanations systematically irrational. Heaton Rosenberg (2004) further explains the concept of Rubinstein that how when everyone fails to explain a particular anomaly, suddenly a behavioral aspect to it will come up, because that can be based on completely abstract irrational assumptions. To support rationality, he came up with two arguments. Firstly he went on to say that an irrational strategy that is profitable, will only attract copy cat firms or traders into the market. This is supported when a closer look is given towards limits to arbitrage. Secondly through the process of evolution, irrational decisions will eventually be eliminated in the long run. The major achievements characterized of the rational finance paradigm consist of the following the principle of no arbitrage market efficiency, the net present value decision rule, and derivatives valuation techniques Markowitzs (1952) mean-variance framework event studies multifactor models such as the APT, ICAPM, and the Consumption CAPM. Despite the number of top achievements that supporters of the rational model claim, the paradigm fails to answer some of the most basic financial economic questions such as What is the cost of capital for this firm? or What is its optimal capital structure? simply because of their self imposed constraints. So far this makes it seem like rational finance and behavioral finance are mutually exclusive. Contrary to this, they are actually interdepende nt, and overlap in several areas. Take for instance the concept of mispricing when there is no arbitrage. Behavior finance on the other hand suggests that this may not be the case irrational assumptions in the market will still lead to mispricing. Further even though certain arbitrageurs may be able to identify irrationality induced mispricing, because of the imperfect market information, they are unable to convince investors of its existence. Over here, the rational model is accepting the existence of anomalies which are affected both through the factors of risk and chance therefore coinciding with the perspective of behavioral finance. Two instances are clear examples of how rationalization is an important limit of arbitrage i) the build-up and blow-up of the internet bubble and ii) the superiority of value equity strategies.If we focus on the latter, we are able to see behavioral finance literature that highlights the superiority of such strategies in the ability of analysts to e xtrapolate results for investors. This is possible when rationalization is taken as a limit to arbitrage. Similarly these strategies may also limit arbitrage against mispricing, through the great risk associated with stocks. In explaining most anomalies it is essential that analysts first conclude whether pricing is rational or not. To prove their hypothesis that irrationality induced mispricing exists behaviouralists may find it easier if they accepted the role of rationalization in limits of arbitrage. Slow information diffusion and short-sales constraints are other factors which explain mispricing. However these factors alone cannot form the basis of a strong and concrete explanation that will clarify pricing across firms and also across time. Those supporting the rational paradigm attack behavioral finance adherents in that their predictions for the financial markets have been made on irrational assumptions that are not supported by concrete mathematical or scientific models. In their view the lack of concrete discipline in the methodology adopted in behavior finance leads to the lack of testing in their forecasts. On the other hand the rational model is criticized for its lack of success in financial predictions. The behaviouralists claim that this limitation exists because the supporters of rational finance dismiss aspects of the economic market simply because it may not fall into explainable rational behavior. Both perspectives claim to align themselves with respect to the goals of testability and predictions, while at the same time continue to offer evidence against the other model. In reality however, rather than being exclusively mutual both paradigms assist one another in making their predictions. Ray (2006) examines a new genre of behavioral markets prediction markets and their remarkable ability to aggregate inside and expert information from around the world in order to accurately predict all types of economic and financial variables. To date it is said that the prediction markets are the most accurately efficient markets as they prove to show all three forms of market efficiency (weak, semi-strong, and strong), in contrast to regulated markets. Prediction markets are also said to be decision markets. It initially evolved in 1988 with the first online betting market the Iowa Electronic Market. These online markets have proven their predictions accurately since the time they came into being. To be precise these prediction markets are behavioral markets with powerful statistical components that are able to predict the most likely values of future financial variables, variances around such values, and their correlations with other future financial variables. Ray (2006) says that being unregulated, prediction markets are highly effective at flushing out and thereafter aggregating relevant information including inside and expert information regarding a particular event, globally extracting such information from savvy bettors who are eager to profit from their inside and expert information. These sorts of prediction markets have become so popular that now a days major companies use such behavioral markets to accurately forecast sales, earnings, product success, and many other financial and economic variables. The foremost tool for these markets is the wisdom of crowd. In order to accurately predict financial and economical variables he presented few conditions as a prerequisite, which included mainly having a variety of opinions, with no herd behavior, should be able to use their knowledge according to the information available with them and last but not the least is the fact that prediction markets expectations are not self fulfilling prophecies. Prediction markets are a new genre of behavioral markets that continually reveal the thinking of confident insiders by suggesting them to profit from their inside and expert information. The subjective evidence with a few statistical evidences corroborates the imp ressive ability of these markets to predict financial events of all types. The phenomenon exists from ages and effectively proves its performance especially in worlds financial markets. The demonstrated accuracy of predictions in these markets can be of significant utility to traders, financial analysts, behavioral analysts, and many others intending to forecast and analyze financial data.A persons tendency to make errors is known as cognitive bias. These errors are based on the cognitive factors that include statistical judgments, social attribution and memory being common to all the humans in the world. Cognitive bias is the tendency of intelligent, well-informed people to consistently do the wrong thing. Crowell (1994, pp. 1). The reason behind this cognitive bias is that the Human brain is made for interpersonal relationships and not for processing statistics. He discussed the frailty of forecasts. Generally it is said that the world is divided into two groups People forecasting positively and people forecasting negatively. These forecasts exaggerate the reliability of their forecasts and trace it to the illusion of validity which exists even when the illusionary character is recognized. Fisher and Statman, (2000) discussed five cognitive bias, underlying the illusion of validity that are Overconfidence, Confirmation, Representativeness, Anchoring, and Hindsight. Shiller (2002) discusses, that irrational behavior may disappear with more learning and a much more structured situation. History proves it that many of cognitive biases in human judgment value uncertainly will change they may be convinced if given proper instructions, on the part-experience of irrational behavior. The three most common themes of behavioral finance are as follows Heuristics, Framing and Market Inefficiencies. People when decide on the basis of the rules of thumb regardless of rationalizing suffer from Heuristics. Some forms of Heuristics are Prospect theory, Loss Aversion, Status quo Bias, Gamblers Fallacy9, Self-serving bias and lastly Money illusion. Framing is basically a problem of decision making where the decision is based on the point where there is difference in how the case is presented to the decision maker. Cognitive framing, Mental accounting and Anchoring are the common forms of Framing3. Market InefficienciesAs observed, that market outcomes are totally opposite to rational expectations and efficient market hypothesis where mispricing, irrational decision making and return anomalies are examples of it. Fung (2006) introduced three forms of market efficiency earlier presented by Fama in 1970. In the weak form, the information set contains only historical prices. In the semi strong form, information set contains all publicly available information. In the strong form, the information contains not only all publicly available information but also insider information not available to the public. This definition of efficient markets is too general to be testable empirically. To make the model testable, he proposed a process of price formation known as the expected return or fair game efficient markets model. In this model, when investors form expectations of security prices, they fully utilize all the information that is fully reflected in those prices. It is called a fair game model, because using only the information that is fully reflected in security prices, no trading system can have expected profits or returns in excess of equilibrium expected profits or returns. These terms have been described as specific market anomaly from a behavioral point of view.Anomaly (economic behavior) Disposition effect Endowment effect Inequity aversion Intertemporal consumption Present-biased preferences Momentum investing Greed and fear Herd behaviorAnomalies (market prices and returns)Efficiency wage hypothesis Limits to arbitrage Dividend puzzle Equity premium puzzleBehavioral Economic Models are restricted to a certain observed market ano maly and it adjusts the neo classical models by explaining the phenomenon of Heuristics and framing to the decision makers. It is usually said that economics get along with in the neo classical framework, with just one restriction of the assumption of rationality. Loix et. Al (2005) in their paper Orientation towards Finances explains the individual financial management behavior, people dealing with their financial means. They have analyzed the Non-specific financial behavior as already we see extensive research on the specific finance behavior such as saving, taxation, gambling and amassing debt, and gave a lot of importance to stock market, investors and households. The analysis of general publics behavior was done, where an ordinary man is not sure and simply act according to the guesses over their money related issues. It was also found that people interested in economic and financial matters are much more active in collecting specific information than general public, stating th at financial behavior of household is an important relevant topic that needs to be discussed in much more details. Household financial management is similar to the financial management. The construct of orientation towards finances was developed where the individual ORTO FIN focuses on competencies (interest and skills). Having stronger money attitude is an indication of stronger orientation towards finances and much more effective competencies. Therefore we expect some relevance and similarity between corporate and household management behavior as both require organizing, forecasting, planning and control.Loix et. al (2005) analyzed general publics behavior in basically dividing them into two groups, Financial Information and Personal financial planning. Also explaining some practical and theoretical gaps in the area of psychology of money usage, they concluded that ORTOFIN (Orientation towards finance) indicates the involvement of individuals in managing their finances. Proving ou t the point that active interest in financial information and an urge to plan expenses are two main factors. A stronger ORTFIN indicates greater use of debit accounts, higher savings account, wide variety of investments, greater awareness of ones financial Intimate knowledge of the details of ones savings/deposit accounts obsessed by money, higher achievement and power in monetary terms, Further age is also inversely proportional. Shiller, (2006) in his article talked about the co-evolution of neo-classical and behavior finance that in 1937 when A. Samuelsson one of the great economists wrote about people maximizing the present value of utility subject to a present value. Another judgment he realized was time being consistent human behavior where if at any time t,0 4. Investing and Cognitive BiasMoney Managers and Money management is a very popular phenomenon. The performance in a stock market is measured at daily basis and waiting for a highly subjective annual review of ones perfo rmance by ones superior. Market grades you on a daily basis. The smarter one is, more confident one becomes of ones ability to succeed clients support them by trusting them that eventually helps their careers. But the truth is that few money managers put in sufficient amount of time and effort to figure out what works and develop a set of investment principles to guide their investment decisions Browne (2000). Further he discussed the importance of asset allocation and risk aversion, in order to understand why we do what we do regardless of whether it is rational or not. General public opts for money Managers to deal with their finances and these managers are categorized in three ways Value Managers, Growth Managers and Market Neutral Managers. The vast majority of money managers are categorized as either value managers or growth managers although a third category, market neutral managers, is gaining popularity these days and may soon rival the so-called strategies of value and grow th. Some investment management firms even are being cautious by offering all styles of investments. What too few money managers do is analyze the fundamental financial characteristics of portfolios that produce long-term market beating results, and develop a set of investment principles that are based on those findings. Difference of opinion on the definition of value is the problem. The reasons for this are two-fold, one being the practical reality of managing large sums of money, and other related to behavior. As the assets under management of an advisor grow, universe of potential stocks shrinks. Analyzing why individual and professional investors do not change their behavior even when they face empirical evidence, suggests that their decisions are less than optimal. An answer to this question is said to be that being a contrarian may simply be too risky for the average individual or professional. If a person is wrong on collective basis, where everyone else also had made a mista ke, the consequences professionally and for ones own self-esteem are far less damaging than if a person is wrong alone. The herd instinct allows for comfort of safety in numbers. The other reason is that individuals try to behave same way and do not tend to change courses of action if they are happy. If the results are not too painful individuals can be happy with sub-optimal results. Moreover, individuals who tend to be unhappy make changes often and eventually end up being just as unhappy in their new circumstances. According to traditional view of investment management, fundamental forces drive markets, however many other investment firms are consider being active and basing their working on their experienced Judgment. It is also believed that Judgmental overrides value and fundamental forces of markets can be lethal as well as a cause of financial disappointment. Historically it has been found that people override at wrong times and in most cases would be better off sticking to their investment disciplines and the reason to this behavior is the cognitive bias. According to Crowell (1994) and many other researchers, stocks of small companies with low price/book ratios provide excess returns. Therefore, given a choice among small cheap stocks and large high priced stocks, prominent investors (financial analysts, senior company executives and company directors) will certainly prefer small cheap ones. But the fact is opposite to this situation where these prominent investors would opt for large high priced ones and so suffer from cognitive bias and further regret.The assumptions made by Crowell (1994, pp.2) were that Long term investment value should be negatively correlated with size since small stocks provide superior returns. Long term Investment value should have a negative correlation with Price/book since low Price/Book stocks provide superior returns. Whereas the results Crowells survey were contrary stating that Long Term Investment had a positive corr elation with size and with Price/Book stocks. Crowell further stated that according to Shefrin and Statman, prominent investors overestimate the probability that a good company is a good stock, relying on the representative heuristics, concluding that superior companies make superior stocks. Discussing the concept of regrets, aversion to regret is different from aversion to risk Regret is acute when an individual must take responsibility for the final outcome. Aversion to regret leads to a preference for stocks of good companies. The choice of the stocks of bad companies involves more personal responsibility and higher probability of regret. Therefore, two major Cognitive errors appear We have a double cognitive error good company always makes good stock (representativeness), and involves less responsibility(Less aversion to regret). (Crowell, 1994,pp.3) The Anti Cognitive bias actions would be admitting to your owned stocks, admitting earlier investment mistakes. Further, taking th e responsibility for actions to improve their performance in future. The reasons for all the available discip