Behavioral Finance

BehavioralFinance

BehavioralFinance

Thinkingof business as an individual is practical based on the manner inwhich it changes. It can be described as consisting of moods that canchange from crabby to euphoric. Further, under differentcircumstances, it could react hastily and change the next day. Theissue to be considered is the possibility of using psychology tocomprehend the financial markets. It is crucial to consider whetherit offers the hands-on stock choosing tactics. The paper will addressthe issues by considering the traditional standard rational models,behavioral finance theories and how they can be used to explain theflight-to-quality market financial phenomena.

Flight-to-qualityas an example of Financial Phenomena.

Flight-to-qualityis a situation where the investors cash in what they perceive to beat a higher risk and buy what they consider lower in risk or saferinvestments such as United States Treasuries or gold (Chater&amp Oaksford, 2003).The practice is regarded as a sign of anxiety in markets becausestockholders are ready for lower profits with reduced risk (Chater&amp Oaksford, 2003).The phenomena are accompanied by a high demand for government-backedassets and decrease in demand for the private-backed assets. In abroader perspective, flight-to-quality can refer to an abrupt changein investment behaviors in time of financial chaos resulting in ascenario where the investors consider to sell the assets seen asrisky in exchange for safer assets (Chater&amp Oaksford, 2003).The defining aspect is low risk taking applied by investors. Whiletoo much risk taking can cause financial turmoil, failure to do socan frantically disrupt credit as well as other financialtransactions when the financial turmoil hit the company or thebusiness.

StandardRational Model

Thefinancial phenomenon is inconsistent with the standard model asdecisions are not rational because they lead to severe financialturmoil instead of solving the problem (Chater&amp Oaksford, 2003).The model states that people are rational regarding decision making,and it assumes they are aware of options are available to them andfrequently choose the best choice. When presented with an array ofchoices people pick the best-ranked option (Chater&amp Oaksford, 2003).The model suggests that people not only work under speculations butact with full information, and they have specific known preferences.

BehavioralTheories

Behavioraltheories indicate peoples’ psychology can work against them when itcomes to making sound investment choices (Thaler,2005).The modern theories state that individuals can be irrational makinginvestment decisions (Thaler,2005).The current theories include the modern portfolio theory, arbitragepricing theory, and capital pricing theory. The theories assert thereis no efficient market, and the irrational behavior is a commonphenomenon in the finance sector. Financial outcomes affect emotionsof people thereby affecting their decision making resulting inexecutives becoming overconfident (Thaler,2005).For instance, if someone was to make a choice between taking a sure$50 and the flip of the coin with a possibility of either winning$100 or winning nothing, the chances are that the person picks thesure $50. Conversely, if the individual is offered a choice of sure$50 loss, or to flip a coin with a possibility of $100 or nothing theperson is likely to take the toss of a coin. In this situation, it isclear that people tend to recoup a loss more than a possibility ofgaining massive profits (Thaler,2005).In the flight-to-quality market finance phenomena, the same case isapplying where the companies have this notion of running away frompossible losses by selling the assets that put the company at therisk of financial turmoil. Here the executives are concerned withpreventing losses more than they are in making profits (Thaler,2005).So the decision of the managers sometimes can be irrational when theydecide to sell all the assets that they perceive dangerous to thecompany if they are maintained within the premises because lowrisk-taking sometimes leads to even greater losses (Thaler,2005).It is worthy to risk retaining the assets than selling them. Becauseof the same, executives cannot say they always make rationaldecisions by selling profitable assets and purchasing lower profitassets.

Conclusion

Whena firm’s investment and financing decisions are taken into account,rational managers should be driven by the belief in the efficiency ofthe markets according to the traditional way of thinking oftheorists. However, the modern thinking has raised questionsregarding the theories. It is argued that executives have a tendencyof making irrational decisions despite the markets not beingefficient as they seem to be. Flight-to-quality is a strategy appliedby some corporations to reduce the risk associated with assets wheregoods are sold and new ones that are less risky are purchased. Thestrategy is not perfect as it can lead to severe financial turmoil.

References

Chater,N., &amp Oaksford, M. (2003). Rationalmodels of cognition.John Wiley &amp Sons, Ltd.

Thaler,R. H. (Ed.). (2005). Advancesin behavioral finance(Vol. 2). Princeton University Press.