Theory As Rational Investors example essay topic

1. Introduction The neo-classical finance theory which is onset of Markowitz!'s portfolio selection theory (1952) is mostly based on the following assumptions: The investors! behavior are completely rational, the actions of all the investors are guided by the criterion of maximizing expected utility; And simultaneously the markets are efficient (EMH). As Frisson (1994) asserted, based upon the normative assumptions and the EMH, rational and fully informed investors (i. e., representative agents) quickly eliminate any tendency of a class of securities to deviate, on a risk-adjusted basis, from a market rate of return and thereby forcing their prices to resume or converge to their equilibrium level which reflect their true fundamental values. Based on these two assumptions, the neo-classical finance theories try to use decision-making model to explain what is the best decision and to discuss the investors! behavior during the decision- making procedure. However, in reality, the assumption of rational investors follow the optimality principle seems not strong enough. In this paper, I critically discuss the validity of this approach and its potential to serve as a normative theory of asset allocation.

The remainder of this paper is organized as follows. Section 2 presents the nature of human being and discusses why investors are not rational. Section 3 presents the reason of human!'s irrationality. Section 4 summarizes the main results and presents conclusions. 2. Is the human being rational or not In the Markowitz!'s portfolio selection theory (1952), he assumed that the investor is risk averse, for any desired level of mean return, the investor wants to minimize risk, measured by portfolio variance or standard deviation.

But in reality, this assumption might never be true. As we know that, human being is a thoughtful emotional and rational synthesis. When we are making decision, not only the emotion often becomes the main power, but also the rationality cannot help us to solve all the problems. Because the problems we meet are so complicated and the information we get is incomplete and anisomerous, we cannot get rational conclusions of every thing we observed. Instead, we get wrong cognize by applying simplified rules. The result is that we may use more subjective methods to make decision.

People like to believe that good decision-making is a consequence of the use of reason, and that any influence that the emotions might have is antithetical to good decisions. What is not appreciated by Mises and others who similarly rely on the primacy of reason in the theory of choice is the constructive role that the emotions play in human action. (Vernon L. Smith, Reflections on Human Action after 50 years. Cato Journal, Vol. 19, No, 2 Fall 1999, Cato Institute., P 203.) In the research of Shleifor (1998), he found that influenced by the emotion of regret, fear and short-sight, investors usually undervalue the stock prices of the companies which were recently in the trouble. In the same reason, investors usually overvalue the stock prices of the companies that they believe would grow up very fast. However, the investors don! t know whether these companies would become better or not.

So, people are ultimately driven by their emotions, not their logic, they are often irrational in making investment decision. 3. The asymmetry of information In the classical economic theory, it states that markets require buyers and sellers to agree upon a price before a transaction can occur! a certainly not that sellers are irrational if they do not sell at the price that buyers are willing to pay. And the markets become efficient (EMH).

But it depends on that the sellers and buyers all know the actual prices of the goods. This means they have the same information and the some knowledge of the goods to make decision. However, In fact, people cannot know everything around them. As Will Rogers once said, "Everybody is ignorant, only on different subjects". So the!

^0 sellers! +/- and! ^0 buyers! +/- in classical economic theory don! t usually exit in reality. University of Chicago economist Richard Thaler conducted a famous experiment in which he gave one group of his student coffee mugs and a second group money, then offered to buy mugs from the first and sell mugs to the second. Classical theory would predict that students selling the mugs would ask for about the same prices as the buyers would be willing to pay. But, in fact, the sellers asked for twice as much.

Apparently, humans have an instinctive and "irrational" predisposition to hoard material wealth. And because of this! ^0 irrational! +/-, it would be difficult for the! ^0 buyers! +/- and the! ^0 sellers! +/- to get the some cognition of the price.

Let!'s Look back to the neo-classical finance theory. According to the theory, as rational investors, if given a certain return, the portfolio with least risk is desirable; if given a certain level of risk, the portfolio with highest return is most desirable. Rational investors are easy to get unanimous cognition of the assets price and they are easy to own the same portfolios with different risk assets. If one of the investors thinks the risk of the portfolio is too high, he can add a risk free asset into his investment portfolio and likewise if he thinks he could accept higher risk, he can borrow the money with risk free rate and invest the money in the risk assets.

However, in the reality, it is impossible. Because of the asymmetry of information, every investor choose their familiar assets in to their investment portfolio. The result is that there are no some portfolios in the world. For example, most stocks of US companies are owned by American and most stocks of Chinese companies are owned by Chinese. So the assumption of efficient markets in neo-classical finance theory is hard to stand. 4.

Conclusion As Kahneman said, the failure of the rational model is not because it has logical problem but the human brain it suggested doesn! t exist in the world. If there is a brain that can work as the theoretical model requests, then who can design it. If it is true, one of us should know everything with no mistake. In other words, the assumptions of classical finance theory were not built on the! ^0 real human being! +/-.

Furthermore, by the criterion of classical finance theory, under the uncertainty, when people make decisions, their irrational behaviors would be inevitable. Nevertheless, though the behavior of human being is not always rational, it is reasonable. So we can also predict the result of people!'s decision without the assumption of rational investor or efficient market. Other than neo-classical finance theory, behavioral Finance theory uses the more mundane empirical observations and the experimental results of extensive studies in other social science disciplines such as psychology, sociology, and political science. Behavioral Finance theory assumes the preferences of investors are diversified and changeable and such preferences usually form during the process of the decision-making. Investors would make different decisions under different circumstances.

The portfolios they adopted may be not the best but which could satisfy them. So what the Behavioral Finance theory discussed is more close to the reality. This year the Nobel prize in economics was awarded to Daniel Kahneman and Vernon Smith. These two economists have been probing the validity of popular economic theories regarding peoples choices. They wined the prize because of their great contribution to the behavioral finance study. The two Nobel laureates are regarded as pace setters in the way economics will evolve in the future.

The fact that these economists have begun to question the validity of various popular theories is a welcome move. And we can expect that the behavioral finance theory would become the focus in the field of finance.