Introduction
Behavioural finance is a scaffold which augments some various sections of standard finance also known as the modern portfolio theory, and it ultimately replaces other parts. Behavioural finance best describes the behavior of managers and investors; it also describes various interaction outcomes between managers and investors in the capital markets and the financial markets. It also effectively prescribes best behavior for managers and investors (Baker & Nofsinger, 2010, p. 174).
Disposition Effect
In accordance to Forbes (2009, p. 56), the year 2008 saw many firms adapt the system of cutting losses as best practice in order to maximize their profits. The policy then was ‘Cut your losses and let your profits run’. This has had a detrimental effect to the firms. This was because the firms focused their sales strategies more on inventories that sold faster since it provided the most needed cash. Inventory that sold slower was not given the appropriate priority since it brought the firm less cash. This is what is referred to as Disposition Effect in behavioral finance. Thus, disposition effect is the tendency of investors selling stock whose prices have increased while keeping stock whose value has dropped.
The effects of the disposition effect are ultimately harmful to investors since it leads to an increase of costs to the investors. This is made possible because the investors have to pay more capital gains taxes which have an overall effect on the investor. The investors’ loss when the pay more taxes though it has a positive effect on the society. This is effectively a transfer of wealth from the investor to the society. The disposition effect is said to be due to various rational explanations which include transaction costs and portfolio rebalancing. Evidently, disposition effect imposes humongous costs on investors than necessary. The shift of investors to the purchase price interferes with the rational projection decision making which leads to inferior performance. Therefore, the disposition effect is harmful even without considering the capital gains taxes. A systematic disposition behavior by a lot of investors at the same time affects the trading volume, transaction costs and drives a wedge between fundamental values and the market prices (Forbes, 2009, p. 94).
Prospect Theory
The way people view wealth and value is said to significantly impact their attitude towards losses. The prospect theory is the main cause of the disposition effect. The prospect theory refers to the use of a reference point against which various investors would code their losses and gains. The converse is, however, not true. Reference points are also relevant outside the context of prospect theory. An investor who has preferences towards prospect theory becomes more risk averse. This takes place after having an experience of gains and also becomes risk seeking after a loss experience. This change in risk perception causes the disposition effect (Kahneman, Daniel & Amos, 1979, p. 263).
Subjective Expected Utility Theory
This is a decision theory method that explains how decisions are made by an investor in the presence of risk. It brings together two fundamental subjective concepts which are the personal probability distribution and the personal utility function. The theory proves that when a person believes that an uncertain situation has certain possible outcomes, and each has a utility for the person. Then the person’s choices can be said to have arisen from a function in which the person believed that there was a subjective probability for every outcome, and the subjective expected utility for the person is the expected value of the utility.
The subjective expected utility theory explains that the preference of a decision by a person would depend on which subjective expected utility is undoubtedly higher. Thus, different people make different decisions since they have different beliefs or utility functions regarding the probabilities of a number of different outcomes (Stenberg & Mio, 2009, p. 496).
Conclusion
In conclusion, the subjective expected utility theory suggests that choices are consistently and coherently made by weighing various outcomes (losses or gains) of actions and alternatives by their probabilities. The action or alternative that has the maximum utility is selected. According to Baker & Nofsinger (2010, p. 175), the subjective expected utility theory is based on three fundamental tenets on the processes that happen during decision making under uncertainty and risk. These include the steadiness of various preferences for alternatives, opinion of a fixed asset position and the appropriate linearity in passing on of various decision weights to possible alternatives. Based on these assumptions, the subjective expected theory projects the choosing of a better alternative always. Prospect theory states that people making decisions prefer to make simpler their choices cognitively where possible by satisfying rather than maximizing. In prospect theory, the ultimate choice made is a two-stage process which involves the first phase of framing whereby a number of alternatives are edited whereas values are linked to various weights and outcomes to probabilities. The second phase is similar to subjective expected utility theory, whereby the edited alternatives are evaluated (Wakker, 2010, p. 11).
References
Baker, H. K., & Nofsinger, J. R. (2010). Behavioral finance investors, corporations, and markets.
Hoboken, N.J., Wiley. http://public.eblib.com/EBLPublic/PublicView.do?ptiID=589050.
Forbes, W. (2009). Behavioural finance. New York, Wiley.
Kahneman, Daniel, & Amos, T. (1979). Prospect Theory: An Analysis of Decision under Risk, Econometrica, Vol.47(2), pp:263-291
Sternberg, R. J., & Mio, J. S. (2009). Cognitive psychology. Australia, Cengage Learning/Wadsworth.
Wakker, P. P. (2010). Prospect theory: for risk and ambiguity. Cambridge, Cambridge University Press.
