Five Most Significant Breakthroughs in Behavioral Finance

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Limits of arbitrage

A key argument in behavioral finance is that mispricing will exist for long term since rational investors find it difficult to arbitrage even they find any mispricing.Therefore,the market price can not be adjusted back to fair level immediately(Mitchell, Pulvino and Stafford, 2002). Barberis and Thaler(2003) outline several limits to arbitrage. First, arbitrageurs are faced with fundamental risk since it’s hard to find close substitute to hedge their position. Second, even if a close substitute is available, the noise trader will keep increasing the mispricing, the arbitrageur may be unable to maintain the position in face of margin calls.Third, taking a short position is facing high transaction cost and usually prohibited by regulators. So the difficulties of short selling eliminated the arbitrage opportunity.

As one of the two building blocks in the field of behavioral finance, the theory of limits of arbitrage further overthrew the perfect market imagined by efficient market hypothesis: regardless of the form of investors irrationality, the market through the process of arbitrage could not prevent mispricings from closing immediately. By this token, share prices did not reflect all the available information as the Efficient Market Theory had predicted earlier.

Conclusion

Behavioral finance, a new school of thought, argues that the conventional financial theory ignores how real people make decisions. More and more economists come to interpret the market anomalies such as mispricing by “irrationalities” of investors: error information processing and behavioral biases.And the limits of arbitrage indicates that the mispricing will be on a sustained basis. Many financial economists are still concerning that the behavioral approach is too unstructured and it’s easy to reverse an explanation for any particular anomaly. However, the behavioral critique of full rationality in investor decision making is well accepted by public. Investors who are able to aware the potential trap in information processing and decision making should be better avoid such errors. Moreover, the insight of behavioral finance as violation of efficient market and warning of traders may help modify the market and make the dream of “efficient perfect market” much closer.

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