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Testing dominant theories and assumptions in behavioral finance

Article in The Journal of Risk Finance · May 2012

DOI: 10.1108/15265941211229262

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Moawia Alghalith Christos Floros

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The Journal of Risk Finance
Emerald Article: Testing dominant theories and assumptions in behavioral
finance
Moawia Alghalith, Christos Floros, Marla Dukharan

Article information:
To cite this document: Moawia Alghalith, Christos Floros, Marla Dukharan, (2012),"Testing dominant theories and assumptions in
behavioral finance", The Journal of Risk Finance, Vol. 13 Iss: 3 pp. 262 - 268
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JRF
13,3 Testing dominant theories and
assumptions in behavioral finance
Moawia Alghalith
262 Department of Economics, University of West Indies, St Augustine,
Trinidad and Tobago
Received September 2011 Christos Floros
Revised January 2012
Accepted February 2012
Department of Economics, University of Portsmouth, Portsmouth, UK, and
Marla Dukharan
Department of Economics, University of West Indies, St Augustine,
Trinidad and Tobago

Abstract
Purpose – The purpose of this paper is to empirically test dominant theories and assumptions in
behavioral finance, using data from the Standard & Poor’s 500 index.
Design/methodology/approach – The empirical analysis has three parts: to test the assumption of
risk aversion; to examine the dominant theory that the optimal portfolio depends on risk preferences;
and to test prospect theory that decision makers prefer certain outcomes over probable outcomes.
Finally, an alternative model to test prospect theory is introduced.
Findings – The proposed model is more flexible than prospect theory since it does not a priori
assume what value of the portfolio induces risk aversion/seeking, while it does not a priori preclude
linear preferences. Empirical results show that: investors are risk seeking; a change in the sign of
preferences does not necessarily imply a change in the sign of wealth/return and vice versa; and the
optimal portfolio does not depend on preferences.
Practical implications – These findings are helpful to risk managers dealing with models of
behavioural finance.
Originality/value – The contribution of this paper is that it successfully tests fundamental theories and
assumptions in behavioral finance by providing a better alternative to prospect theory in several ways.
Keywords Behavioural economics, Investors, Expectation, Financial forecasting, Risk aversion,
Dominant theory, Prospect theory, S&P500
Paper type Research paper

1. Introduction
It is widely accepted and empirically demonstrated that the rational expectations theory
and the efficient markets hypothesis do not generally hold for various suggested
reasons. Thus, there is a growing acceptance of alternative behavioral finance theories
(Ritter, 2003). If investors and traders were all rational beings whose investing decisions
were logically based on the information available, then a particular event would
precipitate predictable and unanimous reactions every time. But trading is not a precise
science. Each event causes varied reactions and predictions, which effectively amount to
The Journal of Risk Finance sheer speculation, or forecast error, where “permanent and widespread psychological
Vol. 13 No. 3, 2012
pp. 262-268 biases affect both the subjective probability of future economic events and their
q Emerald Group Publishing Limited
1526-5943
DOI 10.1108/15265941211229262 JEL classification – G11, G32
retrospective interpretation” (Bovi, 2009). Emotional and psychological factors often Theories in
override the rational expectations theory in financial decision making, affecting trading behavioral
performance (Lo et al., 2005), and only if risk aversion is pegged at unrealistically high
levels, does the efficient market hypothesis and rational expectations theory explain the finance
volatility of the market overall (Shiller, 2003).
The psychological factors that interfere with rational thinking include cognitive
biases such as heuristics, overconfidence, mental accounting, framing, 263
representativeness, the conservatism and disposition effect (Ritter, 2003), and the
overall emotional reactivity (Lo et al., 2005). There are also other factors that skew
decisions, such as misevaluations of financial assets (Ritter, 2003), lack of understanding
and miscalculation of basic financial measures, such as volatility (Goldstein and Taleb,
2007), and finally, the effect of word of mouth and media driven feedback (Shiller, 2003).
Unfortunately, “psychology is silent on the magnitude of the biases and on whether
the effects of the biases are constant over time and/or are homogeneous across
individuals” (Bovi, 2009), so that this inability to generalize hampers the opportunities
for a meaningful hypothesis testing in this regard.
In addition, the theoretical and empirical models based on the efficient market
hypothesis usually adopt the a priori assumption of risk aversion. Examples include
the capital asset pricing model (CAPM) and the mean variance model.
Prospect theory was introduced as an alternative to expected utility theory, rational
expectations theory and the efficient market hypothesis. Prospect theory postulates that
decision makers prefer certain outcomes over probable outcomes, called the certainty
effect, which gives rise to risk aversion when faced with sure gains and risk seeking
when faced with sure losses (Kahneman and Tversky, 1979). Indeed, the original
prospect theory and its later versions demonstrate that framing effects, nonlinear
preferences, source dependence, risk seeking and loss aversion, for example, repeatedly
override any rational choices (Tversky and Kahneman, 1992).
However, prospect theory does not suggest what the market’s reaction to
(or interpretation of) a specific economic event would be, since it argues that a person’s
risk attitude in any given situation depends on that individual’s specific economic
situation (or his interpretation of it) such that if the event is viewed positively, then the
individual tends to be risk averse, and vice versa (Bovi, 2009).
Moreover, prospect theory still adopts the expected utility theory’s definition of risk
aversion/seeking[1]. According to expected utility theory, risk aversion (seeking) is
synonymous with a diminishing (increasing) marginal utility. This is a major limitation
of expected utility theory and also prospect theory. Other limitations of prospect theory
are discussed by Alghalith (2010).
The contribution of this paper is that it successfully tests fundamental theories and
assumptions in behavioral finance. In particular, using a standard portfolio model and
data pertaining to the Standard and Poor’s 500 (S&P500) index, we first test the
assumption of risk aversion.
Second, we test the dominant theory that the optimal portfolio depends on risk
preferences. Third, we test prospect theory. Furthermore, we introduce a more flexible
and general alternative to prospect theory. The contribution of this paper is that it offers
a better alternative to prospect theory in several ways. First, the proposed model is more
flexible than prospect theory since it does not a priori assume what value of the portfolio
JRF induces risk aversion/seeking. Second, unlike prospect theory, our model does not a
priori preclude linear preferences.
13,3 The structure of the paper is as follows: Section 2 provides theoretical information,
while Section 3 shows estimating equations which we use to test theories and
assumptions. Section 4 describes the data, and finally, Section 5 summarizes and
concludes the paper.
264
2. Theory
We consider a standard investment model, which includes a risky asset or portfolio,
and a risk-free asset. We use a standard Brownian Motion {W1 s, W2 s, Fs} t # s # T
on the probability space (V, Fs, P), where {Fs} t # s # T RisT the augmentation of
r ds
filtration. The risky free asset price process is given by S 0 ¼ e t s where r s [ C 2b ðRÞ
is the rate of return.
The risky asset/portfolio price is given by:
dS s ¼ S s {ms ds þ ss dW s }; ð1Þ
where m is the average rate of return on the risky asset/portfolio, and s is the volatility
of such return.
The wealth process is given by:
Z T Z T
X pT ¼ x þ {r s X ps } þ ððms 2 r s Þps Þ}ds þ ps ss dW s ; ð2Þ
t t

where x is the initial wealth, {pt ; F s }t#s#T is the risky portfolio process with
RT 2
t ps ds , 1.
The trading strategy ðpsÞ [ AðxÞ is admissible (that is, X ps $ 0).
The investor’s objective is to maximize the expected utility of the terminal wealth:

 
V ðt; xÞ ¼ SupE u X pT jF t ð3Þ
pt

where V ð:Þ s the value function, and u(.) is a continuous bounded utility function.
Under regular conditions, the value function satisfies the Hamilton-Jacobi-Bellman
partial differential equation:  
1 2 2
V t þ r t xV x þ Sup pt st V xx þ ½ðmt 2 r t Þpt
V x ¼ 0;
pt 2 ð4Þ
V ðT; xÞ ¼ uðxÞ
where the subscripts x and xx denote the first and second partial derivative, respectively.
Hence the optimal portfolio is given by:
ðmt 2 r t ÞV x
p*t ¼ 2 ð5Þ
st2 V xx


Therefore, the optimal portfolio depends on the parameters mt ; r t ; st2 and preferences
ðV x =V xx Þ. According to the traditional expected utility theory and prostpect theory,
the agent is risk averse (seeking) if V xx is negative (positive). Thus, a diminishing
(increasing) marginal utility is synonymous with risk aversion (risk seeking).
3. Estimating equations Theories in
We use the theoretical foundations in the previous section to derive estimating behavioral
equations which we use to test some finance and behavioral finance theories and
assumptions. Using equation (5) and letting P ; V x =V xx be the measure of risk finance
preferences, we obtain the following estimating equations:
c1
p*t ¼ 2 þ [1 ; ð6Þ 265
P
c2
P ¼ 2 þ [2 ; ð7Þ
p*t
ðmt 2 r t Þ
p*t ¼ 2 ; ð8Þ
c3 st2

where ci is the parameter that will be estimated, while p*t ; P; mt ; r t and s2t are observed
data, and ei is the estimation error. These equations can be estimated using a nonlinear
regression. Equations (6) and (7) attempt to measure the relationship between the value
of the portfolio and preferences, and hence the direction of influence is not known a
priori.
It is worth emphasizing that much of the theoretical and empirical literature assumes
that preferences determine the value of the portfolio (a fundamental postulate of
expected utility theory) and thus they preclude the possibility that the portfolio can
determine preferences. Consequently, we can test this dominant theory by
independently estimating equations (6) and (7). The third estimating equation (8)
provides an estimate for the average value of c3. A negative (positive) value for c3 implies
risk aversion (seeking), since Vx . 0 by the assumption of a positive marginal utility of
wealth.

4. Data description and methodology

We used the daily levels of the S&P500 500 index from January 2000 to March 2010.
This data series were used to compute the daily rates of return on S&P500, using a
simple percentage change in the index value from time t 2 1 to time t. The variance of
the daily rates of return (which is calculated on a daily basis) is used as the measure of
volatility. The US Treasury bill rates are used as the risk free rates.
We segmented the data according to the market trends of bull market, bear market,
market top and market bottom. Bull markets occurred between April 2003 to
September 2007, and March 2009 to March 2010. Bear markets occurred between
October 2000 to July 2002, and January to November 2008. Market tops occurred
between January to October 2000, and September 2007 to January 2008. Market
bottoms occurred between July 2002 to April 2003, and November 2008 to March 2009.
The original data were also segmented according to days of positive returns and those
of negative returns.
We used equation (5) and direct calculations to generate data series for ci.
Then, for each segment of the data as well as the unsegmented data, we estimated
equations (6)-(8) independently using nonlinear least squares regressions as follows:
c1
S&P500 ¼ 2 þ 11 ; ð9Þ
p
JRF c2
P¼2 þ 12 ; ð10Þ
S&P500
13,3
ðmt 2 r t Þ
S&P500 ¼ 2 ; ð11Þ
c3 st2
266
where S&P500 is the value of the stock index. We obtained estimates for c1, c2, and c3
for each segment of the data and the unsegmented data and reported the results in
Table I; further, the Appendix discusses the behaviour of S&P500 (levels) in
comparison with c3 estimates and daily returns of S&P500 index.

5. Final results and conclusions

We found that c3 . 0, which implies that, on average, investors are risk seeking. This
result holds for the whole data set as well as the segmented data such as the bull, bear,
peaking and bottoming market. This result questions the a priori assumption of risk
aversion, adopted by much of the theoretical (such as the mean-variance and the
CAPMs) and empirical literature in finance and economics.
When we separated the data into periods with negative returns (losses) and those
with positive returns (gains), investors are still risk seeking in the face of both losses
and gains. Clearly, these results contradict prospect theory, which states that when
faced with gains, agents display a risk averse behaviour.
We found c1 to be highly insignificant, but c2 is highly significant. This result has a
very important implication. It states that, contrary to the mainstream theory, the value
of the optimal portfolio determines preferences but the converse is not true. This result
is consistent with a recent theoretical contribution (Alghalith, 2010) that shows that,
under the correct assumptions, the optimal portfolio does not depend on preferences.
It is worth emphasizing that equation (10) offers a better alternative to prospect
theory in several ways. First, it is more flexible than prospect theory since it does not a
priori assume what value of the portfolio induces risk aversion/seeking. Second,
according to prospect theory, a change in the sign of the returns/wealth changes
preferences, but a (very large) change in the magnitude of gains/losses does not change
the sign of preferences. Clearly, this is unrealistic. Therefore, according to our model,
a change in the sign of preferences does not necessarily imply a change in the sign
of wealth/return and vice versa. Moreover, unlike prospect theory, our model does not a
priori preclude linear preferences.

Data/markets/returns c3 (11) c1 (9) c2 (10)

All data 0.67 (0.014) 2 0.02 (0.08) 2277.35 (8.10)

Bull markets 0.75 (0.015) 0.06 (0.107) 2419.05 (12.7)
Bear markets 0.18 (0.01) 2 0.25 (0.15) 2135.29 (4.38)
Market bottoms 0.22 (0.03) 0.18 (0.17) 238.8 (4.65)
Market tops 0.34 (0.015) 2 47.07 (11.3) 426.52 (19.87)
Table I. Positive returns 9.79 (0.94) 0.11 (0.13) 2570.44 (70.4)
Results Negative returns 1.55 (0.04) 2 13.45 (1.41) 2737.29 (25.9)
Note Theories in
1. An investor with prospect theory preferences becomes more risk averse after experiencing behavioral
gains, and risk seeking after experiencing losses (Kaustia, 2010).
finance
References
Alghalith, M. (2010), “Limitations of prospect theory and the expected utility theory:
a new theory”, Atlantic Economic Journal, Vol. 38 No. 2, pp. 243-4. 267
Bovi, M. (2009), “Economic versus psychological forecasting: evidence from consumer confidence
surveys”, Journal of Economic Psychology, Vol. 30 No. 4, pp. 563-74.
Goldstein, D.G. and Taleb, N.N. (2007), “We don’t quite know what we are talking about when we
talk about volatility”, Journal of Portfolio Management, Vol. 33 No. 4, pp. 84-6.
Kahneman, D. and Tversky, A. (1979), “Prospect theory: an analysis of decision under risk”,
Econometrica, Vol. 47 No. 2, pp. 263-91.
Kaustia, M. (2010), “Prospect theory and the disposition effect”, Journal of Financial and
Quantitative Analysis, Vol. 45 No. 3, pp. 791-812.
Lo, A.W., Repin, D.V. and Steenbarger, B.N. (2005), “Fear and greed in financial
markets: a clinical study of day-traders”, The American Economic Review, Vol. 95 No. 2,
pp. 352-9.
Ritter, J.R. (2003), “Behavioral finance”, Pacific-Basin Finance Journal, Vol. 11 No. 4,
pp. 429-37.
Shiller, R.J. (2003), “From efficient markets theory to behavioral finance”, The Journal of
Economic Perspectives, Vol. 17 No. 1, pp. 83-104.
Tversky, A. and Kahneman, D. (1992), “Advances in prospect theory: cumulative representation
of uncertainty”, Journal of Risk and Uncertainty, Vol. 5 No. 4, pp. 297-323.

(The Appendix follows overleaf.)

JRF Appendix
To allow for simultaneous depiction of both the S&P500 and P on the left vertical axis of the chart
13,3 (Figure A1), we have divided the S&P500 levels by 1,000. The right vertical axis measures the
daily rate of return on the S&P 500 index (Daily Return). The horizontal axis measures time.
A positive c3 indicates a risk seeking attitude, while a negative c3 indicates risk aversion. From
visual inspection, one would notice that c3 is largely positive, indicating an overwhelming
268 dominance of risk seeking behaviour. It is also apparent that extreme movements in c3, as depicted
by the longest spikes in either direction, seem to coincide with turning points in the trend of the
S&P 500 index. Also, there is a strong positive correlation between the rate of return and c3.

S$P500 vs C3 & Daily Return

2 0.1500

C3 S&P500 Daily Return

0.1000
1.5

0.0500
1

0.0000

0.5
–0.0500

0
Figure A1. –0.1000
01

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10

S&P500 vs c3 and
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20
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1/

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1/

1/

1/

1/

daily return
/0

/0

/0

/0

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/0

/0

/0

/0

/0

0.5 –0.1500
03

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Corresponding author
Christos Floros can be contacted at: [email protected]

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