Behavioral Finance 3rd Edition Rolf J.

Daxhammer
pdf download

https://ebookgate.com/product/behavioral-finance-3rd-edition-
rolf-j-daxhammer/

Get Instant Ebook Downloads – Browse at https://ebookgate.com

Instant digital products (PDF, ePub, MOBI) available
Download now and explore formats that suit you...

Statistical Analysis of Extreme Values with Applications

to Insurance Finance Hydrology and Other Fields 3rd
Edition Rolf-Dieter Reiss
https://ebookgate.com/product/statistical-analysis-of-extreme-values-
with-applications-to-insurance-finance-hydrology-and-other-fields-3rd-
edition-rolf-dieter-reiss/
ebookgate.com

Behavioral Finance Investors Corporations and Markets 1st

Edition H. Kent Baker

https://ebookgate.com/product/behavioral-finance-investors-
corporations-and-markets-1st-edition-h-kent-baker/

ebookgate.com

Behavioral Economics 3rd Edition Edward Cartwright

https://ebookgate.com/product/behavioral-economics-3rd-edition-edward-
cartwright/

ebookgate.com

Experimental and behavioral economics J. Morgan

https://ebookgate.com/product/experimental-and-behavioral-economics-j-
morgan/

ebookgate.com
Corporate Finance 3rd Edition Welch

https://ebookgate.com/product/corporate-finance-3rd-edition-welch/

ebookgate.com

Securities Finance Frank J. Fabozzi

https://ebookgate.com/product/securities-finance-frank-j-fabozzi/

ebookgate.com

Behavioral Finance and Wealth Management How to Build

Optimal Portfolios That Account for Investor Biases Wiley
Finance 1st Edition Pompian
https://ebookgate.com/product/behavioral-finance-and-wealth-
management-how-to-build-optimal-portfolios-that-account-for-investor-
biases-wiley-finance-1st-edition-pompian/
ebookgate.com

■■■■■■■ 3rd Edition Rolf E. Hummel

https://ebookgate.com/product/%e6%9d%90%e6%96%99%e7%9a%84%e7%94%b5%e5%
ad%90%e7%89%b9%e6%80%a7-3rd-edition-rolf-e-hummel/

ebookgate.com

Finance The Basics 3rd Edition Erik Banks

https://ebookgate.com/product/finance-the-basics-3rd-edition-erik-
banks/

ebookgate.com
 3rd ed.
Over the last 50 years, neoclassical financial theory has been dominating
our perception of what is happening in financial markets. It has spurred
Rolf J. Daxhammer / Máté Facsar / Zsolt Papp
numerous valuable theories and concepts all based on the concept of

Behavioral Finance
Homo Economicus, the strictly rational economic man. However, humans
do not always act in a strictly rational manner.
For students and practitioners alike, our book aims at opening the door to
another perspective on financial markets: a behavioral perspective based
on a Homo Oeconomicus Humanus. This agent acts with limited ration-
Behavioral
Finance
ality when making decisions. He/she uses heuristics and shortcuts and
is prone to the influence of emotions. This sounds familiar in real life and
can be transferred to what happens in financial markets, too.

Limited Rationality in
Financial Markets

Daxhammer / Facsar / Papp

3 rd edition

Dr. Rolf J. Daxhammer is professor for Financial Markets at ESB

Business School, Reutlingen University.
Máté Facsar is Vice President Sales, Global Account Manager at
FactSet, a global provider of integrated financial information and
analytical applications.
Zsolt Papp, Managing Director, is a senior investment specialist in the
Global Fixed Income, Currency and Commodities group of J.P.Morgan
Asset Management, a global leader in asset management service.

ISBN 978-3-7398-3119-0

ut
Layo ut
Layo www.uvk.de
Dr. Rolf J. Daxhammer is professor for Financial Markets at ESB Business
School, Reutlingen University. His teaching and research interests are Inter-
national Financial Markets, Investment Banking and Behavioral Finance. In
his consulting work he is engaged in projects in Private Wealth Manage-
ment und Financial Nudging, amongst others.

Máté Facsar is Vice President Sales for Management Consulting & Profes-
sional Services Firms at FactSet, a global provider of integrated financial
information and analytical applications. His close cooperation with Leaders
in Asset and Wealth Management over the last decade enables him to
monitor the application of Behavioral Finance and to address the challenges
Portfolio Managers and Wealth Advisors face.

Zsolt Papp, Managing Director, is a senior investment specialist in Global

Fixed Income, Currency and Commodities group of J.P. Morgan Asset Mana-
gement, a global leader in asset management services. He has 30 years’
experience in the financial industry in the UK and Switzerland on the sell-
side and buy-side, with a special focus on emerging markets.
 Rolf J. Daxhammer
Máté Facsar
Zsolt Papp

Behavioral Finance
Limited Rationality in Financial Markets

3rd edition

UVK Verlag · München

Umschlagmotiv: © deli - Fotolia.com

Bibliografische Information der Deutschen Nationalbibliothek

Die Deutsche Nationalbibliothek verzeichnet diese Publikation in der
Deutschen Nationalbibliografie; detaillierte bibliografische Daten sind im
Internet über http://dnb.dnb.de abrufbar.

3rd Edition 2023

DOI: https://doi.org/10.24053/9783739881195
© UVK Verlag 2023
– ein Unternehmen der Narr Francke Attempto Verlag GmbH + Co. KG,
Dischingerweg 5 · D-72070 Tübingen

Das Werk einschließlich aller seiner Teile ist urheberrechtlich geschützt.

Jede Verwertung außerhalb der engen Grenzen des Urheberrechts-
gesetzes ist ohne Zustimmung des Verlages unzulässig und strafbar.
Das gilt insbesondere für Vervielfältigungen, Übersetzungen, Mikro-
verfilmungen und die Einspeicherung und Verarbeitung in elektronischen
Systemen.
Alle Informationen in diesem Buch wurden mit großer Sorgfalt erstellt.
Fehler können dennoch nicht völlig ausgeschlossen werden. Weder Verlag
noch Autor:innen oder Herausgeber:innen übernehmen deshalb eine
Gewährleistung für die Korrektheit des Inhaltes und haften nicht für
fehlerhafte Angaben und deren Folgen. Diese Publikation enthält
gegebenenfalls Links zu externen Inhalten Dritter, auf die weder Verlag
noch Autor:innen oder Herausgeber:innen Einfluss haben. Für die Inhalte
der verlinkten Seiten sind stets die jeweiligen Anbieter:innen oder
Betreibenden der Seiten verantwortlich.

Internet: www.narr.de
eMail: info@narr.de

CPI books GmbH, Leck

ISBN 978-3-7398-3119-0 (Print)

ISBN 978-3-7398-8119-5 (ePDF)
ISBN 978-3-7398-0586-3 (ePub)
Preface 3rd Edition
The most obvious adjustment in the 3rd edition of “Behavioral Finance” is its lan-
guage. This is the first time, that it is available in English, too. And with the addi-
tional language comes another author: Zsolt Papp. He brings the weight of thirty
years in the financial industry to the team, adding even more “reality check” to
the book’s blend of theoretical rigour and practical perspective.
As for all good economists the prime motivation for offering a product variation
is demand. Over the last ten years we have learnt that our approach to insights
into Behavioral Finance is not only appreciated by a German speaking audience,
but by an international one, too. So, the basic concept of the book remains un-
changed. In addition, we have added some up-to-date information especially in
chapter 5 on historic and recent speculative bubbles and in chapter 13 on latest
developments.
With all that we hope that the reader will enjoy this 3rd edition as much as the
previous ones.
December 2022: Rolf Daxhammer, Máté Facsar and Zsolt Papp

Online Knowledge Check available:

https://files.narr.digital/9783739831190/Check.zip
Dedication

To Gela Daxhammer
as well to Josef Daxhammer
and Katharina Daxhammer
To Fanny Facsar
and Gábor Facsar
To Mária Erzsébet and Sándor Papp
and Marcsi
Table of Content
Preface 3rd Edition ................................................................................................................ 5
Dedication .............................................................................................................................. 7
Introduction ......................................................................................................................... 15
Section I − The Homo Economicus in the center of Traditional Finance ... 21
1 How Neoclassical Theory shaped rational economic behavior ..... 21
1.1 From Traditional Finance to Emotional Finance ........................................... 22
1.2 Classical theories of Traditional Finance ........................................................ 29
1.2.1 The rational economic market participant according to Smith ................. 29
1.2.2 Random Walk Theory according to Bachelier ............................................... 31
1.2.3 Expected Utility Theory according to von Neumann & Morgenstern ..... 36
1.2.4 Information processing according to Bayes ................................................... 40
1.2.5 Efficient Market Hypothesis according to Fama ........................................... 42
Summary Chapter 1 ........................................................................................................... 48
2 Limitations of Traditional Finance ........................................................... 51
Models of Neoclassical Capital Market Theory ............................................. 51
Portfolio Selection Theory ................................................................................. 51
Capital Asset Pricing Model (CAPM) .............................................................. 58
Arbitrage Pricing Theory as an alternative to CAPM.................................. 62
2.2 Valuation methods as a basis for financial decisions ................................... 64
2.2.1 Fundamental Analysis......................................................................................... 65
2.2.2 Technical Analysis ............................................................................................... 70
2.3 Old vs. new reality ‒ the Black Swan .............................................................. 75
Summary Chapter 2 ........................................................................................................... 78
Concluding remarks Section I ......................................................................................... 79
Section II ‒ Recurring speculative bubbles ‒ triggered by the Homo
Economicus Humanus ........................................................................ 81
3 Investor behavior from the perspective of Behavioral Finance .... 81
3.1 Starting point and objective of Behavioral Finance...................................... 81
3.1.1 Evolving concept of rationality......................................................................... 84
3.1.2 Departure from the Expected Utility Theory ‒ Bounded Rationality ........ 88
3.2 Change of perspective within the framework of Behavioral Finance ...... 90
10 Table of Content

3.2.1 Comparison of neoclassical and behavioral capital market theory ...........90

3.2.2 Research methods of Behavioral Finance ........................................................94
3.2.3 The investor in the course of time ....................................................................97
Summary Chapter 3......................................................................................................... 100
4 Speculative bubbles as a sign of market anomalies.......................... 101
4.1 Causes of speculative bubbles and their intensification ........................... 101
4.1.1 Herding ................................................................................................................ 104
4.1.2 Limits of arbitrage ............................................................................................. 107
4.2 Anatomy of speculative bubbles according to Kindleberger & Minsky 111
4.3 Detailed review of bubbles and market anomalies..................................... 114
4.3.1 Significance of speculative bubbles for economies .................................... 115
4.3.2 Types of speculative bubbles ........................................................................... 116
4.3.3 Types of capital market anomalies ................................................................ 118
Summary Chapter 4......................................................................................................... 125
5 Speculative bubbles from the 17th to 21st century ............................. 127
5.1 Benoit Mandelbrot’s market characteristics ................................................ 128
5.2 Examples of significant speculative bubbles................................................ 130
5.2.1 The Tulip Mania of 1636 .................................................................................. 131
5.2.2 The Mississippi bubble of 1716 ....................................................................... 134
5.2.3 The stock market boom and crash of 1929................................................... 138
5.2.4 The dot-com speculative bubble of the late 1990s...................................... 141
5.2.5 The U.S. real-estate credit bubble between 2001 and 2006 ....................... 146
5.2.6 Speculative bubbles after the U.S. mortgage crisis ..................................... 153
5.3 Indications of speculative bubbles in Private Equity ................................. 162
Summary Chapter 5......................................................................................................... 168
Concluding remarks Section II...................................................................................... 169
Section III – The Homo Economicus Humanus within the information
and decision-making process ......................................................... 171
6 Information and Decision-Making Process .................................... 171
6.1 Phases of the information and decision-making process.......................... 171
6.1.1 Information perception .................................................................................... 172
6.1.2 Information Processing/Evaluation ............................................................... 176
6.1.3 Investment Decision.......................................................................................... 178
 Table of Content 11

6.2 Basis of decision-making from the perspective of Behavioral Finance .. 180

6.2.1 Decision-making based on Prospect Theory................................................ 180
6.2.2 Features of the valuation functions................................................................ 184
6.2.3 Valuation of securities based on the Prospect Theory ............................... 187
Summary Chapter 6 ......................................................................................................... 192
7 Limited rationality during information perception ........................ 193
7.1 Heuristics of cognitive origin .......................................................................... 195
7.1.1 Misperception of probabilities......................................................................... 195
7.1.2 Misinterpretation of information ................................................................... 202
7.2 Heuristics of emotional origin ........................................................................ 207
7.3 Assessment of the risk/return-harmfulness of reviewed heuristics ....... 210
Summary Chapter 7 ......................................................................................................... 212
8 Limited rationality during information processing ........................ 213
8.1 Heuristics of cognitive origin .......................................................................... 214
8.1.1 Misperception of probabilities......................................................................... 214
8.1.2 Misperception of information ......................................................................... 222
8.1.3 Misperception of objective reality .................................................................. 223
8.1.4 Misperception of one’s own abilities ............................................................. 228
8.2 Heuristics of emotional origin ....................................................................... 234
8.3 Assessment of the risk/return-harmfulness of the heuristics con-
sidered .................................................................................................................. 235
Summary Chapter 8 ......................................................................................................... 237
9 Limited rationality during decision-making...................................... 239
9.1 Heuristics of cognitive origin .......................................................................... 240
9.1.1 Misperception of objective reality .................................................................. 240
9.1.2 Misperception of own abilities ........................................................................ 242
9.2 Heuristics of emotional origin ........................................................................ 245
9.2.1 Misperception of objective reality .................................................................. 245
9.2.2 Misperception of one’s own abilities ............................................................. 254
9.3 Assessment of the risk-/return-harmfulness of the considered heuris-
tics ......................................................................................................................... 260
9.4 Overview of the heuristics considered in the information and decision-
making process ................................................................................................... 262
Summary Chapter 9 ......................................................................................................... 264
Concluding remarks Section III..................................................................................... 265
12 Table of Content

Section IV – Applications of Behavioral Finance and Recent Develop-

ments ................................................................................................. 267
10 Applications of Behavioral Finance in Wealth Management....... 267
10.1 Overview of limited rational behavior in investment advice ..................... 268
10.2 Dealing with heuristics in investment advice ............................................. 273
10.2.1 Applied heuristics during information perception..................................... 275
10.2.2 Applied heuristics during information processing..................................... 277
10.2.3 Applied heuristics during decision-making ................................................. 280
Summary Chapter 10 ...................................................................................................... 284
11 Application of Behavioral Finance in corporate governance....... 285
11.1 Overconfidence in entrepreneurial investment decisions ........................ 285
11.2 Dividend policy from the perspective of Behavioral Finance .................. 291
11.3 Initial Public Offerings from the perspective of Behavioral Finance ..... 296
11.4 Corporate Governance from the perspective of Behavioral Finance ..... 298
11.5 Equity Premium Puzzle .................................................................................... 303
Summary Chapter 11 ...................................................................................................... 304
12 Financial Nudging ‒ behavioral approaches for better financial
decisions............................................................................................................. 307
12.1 Libertarian Paternalism .................................................................................... 307
12.1.1 Choice architecture ........................................................................................... 308
12.1.2 Freedom of choice and paternalism ............................................................... 309
12.1.3 Types and characteristics of nudging ............................................................ 310
12.1.4 Criticism of libertarian paternalism .............................................................. 315
12.2 Financial nudging approaches ........................................................................ 317
12.2.1 Behavioral science foundations of financial nudging ................................ 318
12.2.2 Personal Loans ................................................................................................... 320
12.2.3 Credit Cards ........................................................................................................ 321
12.2.4 Mortgages ............................................................................................................ 323
12.2.5 Pension provisions ............................................................................................ 324
12.2.6 Shares and bonds ............................................................................................... 328
Summary Chapter 12 ...................................................................................................... 331
13 Further development of Behavioral Finance ‒ a look into the
future .................................................................................................................. 333
13.1 Limits of Behavioral Finance........................................................................... 333
 Table of Content 13

13.2 Emergence of Neurofinance/Neuroeconomics ............................................ 335

13.2.1 Research on the human brain .......................................................................... 337
13.2.2 Decision processes from the perspective of Neurofinance ....................... 341
13.3 Origin of Emotional Finance ........................................................................... 347
13.3.1 Emotions as a basis for investment decisions .............................................. 349
13.3.2 Interpretation of market movements from an Emotional Finance
perspective ........................................................................................................... 353
Summary Chapter 13 ....................................................................................................... 358
Concluding remarks Section IV .................................................................................... 359
Glossary ........................................................................................................................... 361
Literature ........................................................................................................................ 373
Books ............................................................................................................................... 373
Journals and Essays ...................................................................................................... 379
Websites ........................................................................................................................... 393
Biographies ..................................................................................................................... 399
Index ................................................................................................................................. 401
Introduction
Thousands of business school students around the world are learning to assess the
risks of investments and calculate expected returns using Harry Markowitz’ port-
folio theory or William Sharpe’s capital asset pricing model. The Swedish Nobel
Committee has awarded many prizes for the underlying scientific achievements
and the concepts and models of neoclassical capital market theory are widely used
in the practice of portfolio managers and CFOs. What are these models based on?
To what extent are they able to reflect reality? Can market participants (primarily
buyers and sellers in the financial markets) really be expected to follow the con-
cepts and models and to include them in their financial decisions?
The concepts and models of traditional economics illustrate what the majority of
economists still assume: the existence of fundamentally efficient markets. Accord-
ing to this assumption, manias, panics, or crashes on the capital market cannot
occur, at least not systematically, because markets react to new information effi-
ciently and, thus, result in the best, pareto-efficient allocation of resources.
This view is increasingly questioned with the analysis of speculative bubbles in
the second section of this book. The cryptocurrency hype in 2020/2021 as the latest
major example of speculative market developments is an example of the existence
of fundamental limits to rational markets. Thus, over the course of the centuries,
time and again speculative bubbles developed, because the market participants fell
into “irrational exuberance” and bought, for example, even when they could al-
ready guess that the speculative objects were clearly overvalued.
Over the past 40 years, Behavioral Finance research has produced numerous re-
sults according to which, when making financial decisions, we are guided by our
emotions or simple rules of thumb rather than by strictly rational motives. Daniel
Kahneman, one of the best-known researchers in the field of Behavioral Finance,
received the Nobel Prize in 2002 for his insights into decisions under uncertainty.
With the help of magnetic resonance tomographs, it was shown that the cerebel-
lum is often the most active part of the brain when it comes to financial decisions
‒ it is linked to emotions and connects us evolutionarily, for example, with reptiles.
It is therefore not surprising that our brain occasionally takes shortcuts in order
to be able to make decisions more quickly more easily.
Behavioral Finance is based on the insight that market participants are only capa-
ble of limited rational behavior due to psychological, mental, and neural limita-
tions. This goes against the assumption of rationality in the theory of expected
utility. The concept of widespread limited rationality is a central component and
starting point of Behavioral Finance research. It also contradicts the assumption
that even if there was limited rational behavior of a few individuals it would be
neutralised due to the heterogeneity of market participants. Therefore, limited ra-
tionality should not be reflected in the market outcome. Rather, the proponents of
16 Introduction

Behavioral Finance expect a paradigm extension, which supplements the eco-

nomic concepts and principles of neoclassical capital market theory with psycho-
logical, sociological, and neurological aspects.
The first section of this book is devoted to the behaviors expected from market
participants within the framework of neoclassical theory. The study of the as-
sumptions on which the individual concepts and models of neoclassical capital
market theory are based is crucial in order to be able to apply them in the subse-
quent sections to classify and interpret the actual behavior of market participants.
The second section provides an overview of the development of Behavioral
Finance as a new field of research in order to be able to interpret and explain the
behavior of market participants (primarily investors on the financial markets). In
the sense of the paradigm expansion mentioned above, doubts are growing as to
whether the behavior of market participants can be explained using the traditional
theory alone.
In the third section it is to be clarified how the market participant, in the person
of the investor from the viewpoint of asset management, simplifies decisions by
using heuristics. In addition, it will be discussed which influences leading to
suboptimal decisions can have an impact on the investor in the decision-making
process. In this context, the limited rational behavior of market participants is ex-
amined from the perspective of wealth management (financial advice for high-
net-worth individuals) and, where appropriate, from the perspective of the private
equity investment process. The focus is on the phases of decision-making. It is
shown which heuristics are used by investors and investment advisors in the dif-
ferent phases of the decision-making process. The aim of the explanations given
is to point out limited rational behavior by findings which, according to the cur-
rent state of research, are responsible for the observable behavior of market par-
ticipants. It should be expressly pointed out that Behavioral Finance research in
this area in particular is subject to ongoing development.
The fourth and last section focuses on the application of the findings from Behav-
ioral Finance in selected subject areas. The focus here is on investment advice in
wealth management, the strategic decisions of corporate leaders and financial
nudging. In addition, the fourth section will provide an outlook on future research
directions and introduce new areas such as Neurofinance and Emotional Finance.
These two research areas have already contributed to the investigation of the
causes of limited rational behavior. They investigate amongst others processes
that have so far been running unconsciously, such as emotions, fantasies, and
fears. And they put them into the centre of financial market decisions.
The book is divided into a total of thirteen chapters. The following information
provides a first overview of the topics covered and the contents conveyed.
In the first chapter, the decision theories and concepts of rational decision-mak-
ing are at the forefront. After working through the chapter, you will learn about
the development of economic perspectives, starting from classical economics to
emotional finance. In the first subchapter you will be able to follow the ever-
changing integration of psychology into economics. In addition to looking at the
 Introduction 17

individual perspectives, you will learn about the fundamental decision theories
and concepts of neoclassical capital market theory. Here, the focus is on the con-
cept of homo economicus as well as on the behavioral patterns postulated based
on neoclassical capital market theory. When studying the decision theories and
concepts, you will recognize clear deviations from the actual behavior of market
participants, which can increasingly be viewed as a motivation for a paradigm
expansion through Behavioral Finance.
In the second chapter you will learn about the models of neoclassical capital
market theory that are used to determine the expected return and the risk of se-
curities. In addition, you will learn about the valuation approaches used in finan-
cial decisions based on fundamental and technical analysis. After working through
this chapter, you will understand the increasing criticism of the listed models and
you will also gain an insight into real market conditions that are difficult to re-
concile with neoclassical capital market theory.
The third chapter is devoted to the Homo Economicus Humanus ‒ the market
participant who symbolizes the paradigm shift towards Behavioral Finance. As
you work through this chapter, you will learn about the objectives and develop-
ment of Behavioral Finance. On the other hand, you will get to know the market
participant as an investor acting rationally only to a limited extent.
The fourth chapter focuses on speculative bubbles as signs of recurring and
persistent market anomalies. In addition to the origin and causes of the formation
of speculative bubbles, you will learn about the different phases and types of
speculative bubbles. Furthermore, you will be able to classify the role of the herd
instinct as the driving force of speculative bubbles in the structure of recurring
market anomalies. Finally, you will encounter other significant capital market
anomalies, some of which are short-lived, while others are medium- to long-term
capital market anomalies.
The fifth chapter is devoted to historical speculative bubbles. After working
through this chapter, you will know the most important speculative bubbles in the
history of the financial markets and you will understand typical characteristics of
the capital markets that can lead to turbulence. You will also be able to explain the
development of historical bubbles based on the Kindleberger/Minsky five-phase
model and you will apply it to current and future bubbles.
In the sixth chapter, you will learn the basis of the information and decision-
making process and you will understand which perceptual disturbances can pre-
vent market participants from absorbing and processing information. You will also
learn the basis of decision-making from the perspective of Behavioral Finance:
The Prospect Theory as the alternative to traditional expected utility theory. You
will understand how, on the one hand, the S-shaped value function is used to de-
scribe the market participant’s attitude to risk and, on the other hand, how the
weighting function is used to transform objective probabilities into subjective
ones. These two approaches will illustrate the valuation of securities based on
Prospect Theory and show the cognitive limitations of market participants.
18 Introduction

The seventh chapter focuses on the behavior of market participants during in-
formation perception, the first phase within the information and decision-making
process. You will learn about the cognitive and emotional heuristics that facilitate
the perception of information, but make it difficult for market participants to gain
an objective view of the capital market. In this and the following chapters 8 and 9
you will also be able to recognise the effects of the heuristics on the behavior of
the market participant and you will classify the risk-/return damaging effect of
each individual heuristic.
The eighth chapter deals with the second process stage in the information and
decision-making process: information processing. In this phase, too, market par-
ticipants use certain heuristics which can lead to limited rational behaviour. In this
chapter you will learn about the most important heuristics that facilitate but also
distort information processing and evaluation for the Homo Economicus Hu-
manus.
In the ninth chapter you will explore the third and final stage of the information
and decision-making process. You will learn about the essential heuristics used
during decision-making and you will be able to understand the limited rational
behavior of the Homo Economicus Humanus.
In the tenth chapter, you will recognize the intensity to which both financial
advisors and their clients can be influenced in their decision-making by the appli-
cation of heuristics. You will identify possibilities to limit risk-/return damaging
behavior depending on the wealth of the investor and the origin of the heuristics.
In addition, this chapter will present measures for each individual heuristic that
aim to increase the quality of advice (in the sense of a customer-oriented presen-
tation of returns and risks).
The eleventh chapter focuses on limited rational behavior in the context of cor-
porate decision-making. You will get to know the drivers of limited rational be-
havior, such as overestimating the self-confidence of corporate leaders, and you
will be able to classify their effects on the development of the overall profitability
of corporates. In addition, you will look at certain entrepreneurial activities from
the perspective of Behavioral Finance and thus recognize how strongly psycho-
logical influences can influence corporate decisions. In addition to dividend policy
and the initial issue of shares, the impact of different remuneration concepts
within the framework of corporate governance will also be considered. The chap-
ter is rounded off with a discussion of the “Equity Premium Puzzle" from a Behav-
ioral Finance perspective.
In the twelfth chapter, a rather new application of the Behavioral Finance find-
ings is presented. This involves identifying and presenting approaches to how,
from an economic policy perspective, people can be persuaded to make better de-
cisions about financial products and services. To this end, so-called nudges on
loans, credit cards, mortgages, retirement provisions and shares/bonds are ex-
plained. “Libertarian paternalism" forms the theoretical framework for this and is
therefore discussed in detail in the chapter.
 Introduction 19

In the thirteenth and closing chapter, an outlook on new research directions

within Behavioral Financial market research will be given. New ideas and corre-
spondingly new research results have already shifted the existing boundaries of
Behavioral Finance. In this sense, the chapter leads to the mentioned boundaries
and then presents two new research directions within Behavioral Finance re-
search. The focus is on Neurofinance, which aims to investigate the causes of lim-
ited rational behavior on the basis of brain research. In addition, Emotional Fi-
nance is presented as a new research area, in which unconscious mental processes
can be explored.
Note: Central core statements are framed in grey.
 Section I − The Homo Economicus in the center of Traditional
Finance

1 How Neoclassical Theory shaped rational

economic behavior

The first chapter explores the development of changing perspectives on mar-

ket participants from the Traditional Finance to Behavioral Finance. It pre-
sents an overview on the fluctuating influence of psychology in economics
on the one hand, and the normative decision theories and concepts of the
Neoclassical Theory on the other hand. The focus of this first chapter lies on
the concept of the Rational Economic Market Participant also called the
Homo Economicus. When exploring the decision theories and concepts, you
will recognize significant deviations from the expected behavior of market
participants, which can increasingly be interpreted as an impulse for a par-
adigm shift through the rapidly expanding field of Behavioral Finance.

Let us imagine a theatre stage play for investment decisions in the financial
markets. First, we see the proponents of traditional finance ‒ a group of rationally
acting protagonists also referred to as Homo Economicus; the emotional market
participant (also called Homo Economicus Humanus) does not appear in the stage
play.
Rather, the protagonists in this play make perfectly rational decisions, apply un-
limited analytical capacities to any available information and align their prefer-
ences according to the →Expected Utility Theory.
As such this play is likely to be met with a good dose of disbelief by the audience
who might be looking for a script with more credible protagonists. Here, the pro-
ponents of Behavioral Finance enter, are replacing the Homo Economicus with a
market participant who is more in line with reality, with observed decision-mak-
ing, and who occasionally succumbs to speculative fever. In short, the proponents
of Behavioral Finance are intending to put a more realistic play on stage. This
involves characters who seemingly are prone to repeat past errors. For instance,
some would compare the incredible rally in cryptocurrencies in 2020/21 to the
infamous tulip mania in the 17th century in the Netherlands, when investors sup-
posedly were willing to bet entire farms on rising tulip bulb prices (newest insights
in chapter 5 will help to reflect on a more realistic view of the tulip mania). Cryp-
tocurrencies will be reviewed in chapter 5 as well.
Richard Thaler, one of the central protagonists of Behavioral Finance1, recorded
the smouldering conflict about the real market participant at a conference of the

1 Also spelled Behavio(u)ral Finance in the literature

22 1 How Neoclassical Theory shaped rational economic behavior

National Bureau of Economic Research (NBER) with Robert Barro, advocate of the
traditional view, as follows:
„The difference between us is that you assume people are as smart as you are,
while I assume people are as dumb as I am.“ (Thaler, quoted after Robert Bloom-
field, 2010, p. 23)
Following the above quote, the aim of the first two chapters is to guide you
through the debate on the fundamental assumptions regarding the behavior of
market participants and at the same time to suggest possible starting points for
adjustments to the traditional framework of →Neoclassical Economics.

1.1 From Traditional Finance to Emotional Finance

The development of economic sciences and its fundamental assumptions about

human behavior has been shaped by the views of leading scientists. Depending on
the prevailing opinion, psychological influences on the decision-making of market
participants were followed with varying intensity. They played an important role
in the age of Classical Economics but were subsequently largely suppressed until
the emergence of Behavioral Finance. It is therefore not surprising that the theo-
retical framework of rational behavior developed in the era of Neoclassical Eco-
nomics is still reflected in the concepts and models applied today.

Development of Economic Sciences

Fig. 1: Development of Economic Sciences

18th - 19th Century – The Age of Classical Economics

In the middle of the 18th century, economists began to analyze human influences
on decision-making. These beginnings formed the basis for the emergence of be-
havioral research in financial markets. One tried to combine the economic benefits
 1.1 From Traditional Finance to Emotional Finance 23

of consumption with psychological approaches. Adam Smith2 was instrumental

in the development of Classical Economics. In his much-acclaimed essay “The The-
ory of Moral Sentiments" in 1759, he used social psychology to describe the foun-
dation of human morality, with the goal to moderate one’s behavior and preserve
harmony.
His book “An Inquiry into the Nature and Causes of the Wealth of Nations” in 1776
is perceived as one of the most influential books ever written and equated with
the beginning of Classical Economics. It laid the intellectual foundation of the
great 19th century era of free trade and economic expansion. Consequently, the
common sense of free trade is accepted worldwide even though this could be ques-
tioned today considering the various global trade disputes.
National wealth was defined in Smith’s days in terms of a country’s reserve of
gold and silver that shall not be reduced through importing goods from other
countries. Protectionism through taxes on imports and protection of domestic in-
dustries were common practice. Smith argued that markets were best kept free
from governmental influence and are guided by an invisible hand. The self-
regulation of market forces should almost automatically lead to equilibrium and
full employment. The basis of this way of thinking was human action, which was
based solely on economic motives and rational considerations. In addition, Smith
was of the opinion that a nation’s wealth is not the quantity of precious metals
but the total amount of its production and commerce – a term we call today GDP
or Gross Domestic Product (see Adam Smith Institute, 2021).
Psychology experienced its upswing in the 19th century, when science started to
be applied to it. Hermann Ebbinghaus3 pioneered in the development of exper-
imental methods and made outstanding contributions to the research of learning
and memory. He showed that memories have different life cycles. Some are short-
lived, others last for days or even weeks and remain stored in the long-term
memory. His research showed that scientific methods could be applied to the study
of the higher thought process (see Britannica, 2021).
In the middle of the 19th century, the widespread observation of animal behavior
followed, based on Charles Darwin’s4 assumption that mental characteristics of
mammals are similar to each other.
From the 20th Century on – The Age of Neoclassical Economics
In the course of the 20th century, Classical Economics was replaced by Neoclassi-
cal Economics. The central assumption of neoclassical economics was the model
of the Rational Economic Market Participant or better known as the Homo
Economicus, which presents market participants as rational, benefit oriented and
fully informed individuals (see chapter 1.2.1). As a result, the attempt to explain
the investment behavior of market participants through psychology was largely
suppressed.

2 Adam Smith | Scottish economist | 1723-1790

3 Hermann Ebbinghaus | German psychologist | 1850-1909
4 Charles Darwin | English biologist | 1809-1882
24 1 How Neoclassical Theory shaped rational economic behavior

Initially, however, investment decisions were not considered from a scientific

point of view, but rather as art. Even John M. Keynes5 saw investing in compa-
nies primarily as speculation and compared the stock market with a beauty con-
test.
„It is not a case of choosing those [faces] that, to the best of one’s judgment,
are really the prettiest, nor even those that average opinion genuinely thinks
the prettiest. We have reached the third degree where we devote our intelli-
gences to anticipating what average opinion expects the average opinion to
be. And there are some, I believe, who practice the fourth, fifth and higher
degrees.“ (Keynes, quoted after Montier, 2007, p. 91)
The beginning of the development of the Neoclassical Economics is associated
with the doctoral thesis “The Theory of Speculation” by Louis Bachelier6 in 1900.
Bachelier is credited to be the first person to model the stochastic process under
which equity prices evolve. His finding, that price movements follow a random
process was the basis for the Random Walk Theory (see chapter 1.2.2) ‒ the
theory according to which, stock prices move upwards or downwards without
“memory", i.e., independently of historic prices (see Gehrig/Zimmermann, 1999.
p. 5 and Mandelbrot/Hudson, 2004. p. 87).
Most of the decision-making theories and concepts used as a basis for rational
behavior had been developed during the Great Depression of 1929 followed by the
burst of the speculative bubble of the golden twenties (see chapter 5.2.4).
For example, the theory of efficient capital markets developed when Alfred
Cowles7 first systematically analyzed the predictability of security prices in the
1930s. The hypothesis that security prices are not predictable according to the
random walk theory was finally operationalized and empirically tested by
Holbrook Working8 in the 1940s. Today, with the vast amount of data and the
surge of artificial intelligence and machine learning, even the weakest signals are
explored to predict future price developments.
In 1936, another attempt to incorporate psychological influences into the decision-
making of market participants became apparent. In his work “General Theory of
Employment, Interest and Money", John M. Keynes9 argued that the economy is
not dominated by rational market participants alone, who pursue economic ad-
vantages as if guided by an invisible hand. While acknowledging that economic
action is largely determined by economic motives, he countered this by saying
that it is often also influenced by instincts. These instincts, which he referred to

5 John Maynard Keynes | British economist | 1883-1946

6 Louis Bachelier | French mathematician | 1870-1946
7 Alfred Cowles | American economist | 1891-1984
8 Holbrook Working | American economist | 1895-1985
9 When assigning the protagonists mentioned, the chronological aspect is in the foreground

and not necessarily the content-related assignment, as is quite obviously the case with John
M. Keynes.
 1.1 From Traditional Finance to Emotional Finance 25

as animal spirits, were an important cause of economic fluctuations and invol-

untary unemployment. Keynes was convinced that economies, which are left to
their own, were prone to excesses. Manias occur, which in turn lead to outbreaks
of panic. He believed that the state should play an appropriate role in regulating
the markets and counteract excesses caused by animal spirits.

From the 1960s – The Age of Keynesian Economics

Subsequently, and particularly in the 1960s and 1970s, Keynes’ General Theory was
“post-Keynesianized” in that Animal Spirits were almost completely removed. The
result was a theory that narrowed the differences between the General Theory
and the standard statements of Neoclassical Economics to such an extent that
there was hardly any room left for investment behavior based on instincts. The
neoclassics of the 1960s believed that instincts should be completely removed from
economic theory (see Shiller 2009, pp. 8).
Based on the findings of Louis Bachelier, Eugene F. Fama10 developed the Effi-
cient Market Hypothesis in the 1960s (see chapter 1.2.5). It describes a market
as efficient if share prices reflect all available information. Thus, consistent gen-
eration of alpha (excess returns) is impossible.
At the same time, however, the rationality of individuals was increasingly ques-
tioned by the experiments of Maurice Allais11 in 1953 and Daniel Ellsberg12 in
1961. The initial results of the experiments are as a matter of fact regarded as the
basis for Behavioral Finance. The experiments made it clear that individuals vio-
lated the axioms developed earlier in the 1940s by John von Neumann13 and
Oskar Morgenstern14 to underpin the Bernoulli Principle of rational investors
(see chapter 1.2.3).
In the area of collective rational behavior or collective rationality, the contribution
of John F. Muth15 are to be highlighted. He developed the concept of rational
expectations. Muth states in his article “Rational Expectations and the Theory of
Price Movements (1961)” that market participants use all available information to
form their expectations and learn from their expectation mistakes. Expectations
are created by constantly updating and reinterpreting the available information.
The Portfolio Selection Theory developed in 1952 by Harry M. Markowitz16
was acknowledged as a key milestone for the development of models in Neoclas-
sical Economics (see chapter 2.1.1). The core idea of the theory is the development
of efficient portfolios by considering the correlation of individual securities (see

10 Eugene Francis Fama | American economist | born 1939

11 Maurice Allais | French economist and Nobel Prize Winner 1988 | 1911-2010
12 Daniel Ellsberg | American economist | born 1931
13 John von Neumann | Hungarian-American mathematician | 1903-1957
14 Oskar Morgenstern | German economist | 1902-1977
15 John Fraser Muth | American economist | 1930-2005
16 Harry Max Markowitz | American economist and Nobel Prize Winner 1990 | born 1927
26 1 How Neoclassical Theory shaped rational economic behavior

Karlen, 2004, p. 13). However, Markowitz’ theory was only the beginning of a de-
velopment away from a purely descriptive to a normative capital market theory.
Building on Markowitz’s portfolio theory, William F. Sharpe17, John V. Lint-
ner18 and Jan Mossin19 independently developed the well-known Capital Asset
Pricing Model (CAPM) in the 1960s (see chapter 2.1.2). The model became a fun-
damental tool in the modern portfolio theory as it allowed to track the different
risks of investments back to an easily understandable, linear relationship (see
Garz/Günther/Moriabadi, 2002, pp. 17). It is a mathematical model with the goal
to describe how securities prices should be based on their relative riskiness com-
pared to the return on risk-free assets (see Baker/Nofsinger, 2010, p. 136.).
In 1976 the CAPM was challenged by the Arbitrage Pricing Theory (APT) de-
veloped by Stephen A. Ross20 (see chapter 2.1.3). In contrast to the CAPM, this
theory considers multiple risk factors of systematic nature and therefore is closer
to reality. According to its name, price information is derived from arbitrage op-
portunities (see Bank/Gerke, 2005, pp. 4).
A further milestone was the work of Franco Modigliani21 and Merton H. Mil-
ler22 in the field of Corporate Finance Theory in 1958, which showed that, as-
suming an efficient and perfect capital market, the capital structure from equity
and debt capitalization is irrelevant for the level of capital costs. The reason for
the irrelevance lies in the constant total capital costs, which do not change regard-
less of the amount of debt in a perfect and efficient market. With a higher level of
indebtedness, the cost of equity capitalization increases, but it only relates to a
smaller share of capital. At the same time, the share of debt capitalization in-
creases, and the lower and constant costs of debt financing compared to equity
relate to a higher share of capital and thus fully compensate for the higher costs
of equity capitalization. The respective costs of equity and debt capitalization as
well as their proportions change exactly in such a way that the effects compensate
each other and thus have no influence on the level of the total cost of capital in an
efficient and perfect market.
Finally, a ground-breaking innovation in the field of derivatives (options) valua-
tion was made by Fischer S. Black23, Myron S. Scholes24 and Robert C. Mer-
ton25 in the early 1970s with the development of the option pricing formula. The
three scientists based their findings on the research of Markowitz, Modigliani and

17 William Forsyth Sharpe | American economist | born 1934

18 John Virgil Lintner | American economist | 1916-1983
19 Jan Mossin | Norwegian economist | 1936-1987
20 Stephen Alan Ross | American economist | 1944-2017
21 Franco Modigliani | Italian-American economist & Nobel Prize Winner 1985 | 1918-2003
22 Merton Howard Miller | American economist & Nobel Prize Winner 1990 | 1923-2000
23 Fischer Sheffey Black | American economist | 1938-1995
24 Myron Samuel Scholes | Canadian-American economist & Nobel Prize Winner 1997 | born

1941
25 Robert Cox Merton | American economist & Nobel Prize Winner 1997 | born 1944
 1.1 From Traditional Finance to Emotional Finance 27

Miller by constructing a risky portfolio consisting of a loan and the underlying

security, mirroring the cash-flows associated with the option and thus ultimately
opening the door to valuing derivatives.

From the 1980s to present – The Age of Behavioral Finance/Economics

From around 1980, Behavioral Economics developed as a sub-field of economics.
This direction was instrumental in increasingly incorporating sociological and
psychological aspects to economic sciences. Behavioral Economics examines be-
havioral patterns of market participants that are inconsistent with the concept of
Homo Economicus ‒ for example, the rejection of utility maximisation.
Although most of the findings from research on the actual observable behavior of
market participants did not come to light until after 1980, two new fields of scien-
tific research developed as early as 1950 and are considered the basis of Behavioral
Finance. On the one hand, scientists in the field of Cognitive Psychology began
to analyze mental processes that seemed to be responsible for human behavior
(see chapters 6-9). The central component and starting point of Behavioral Finance
is the Theory of Bounded Rationality by Herbert A. Simon26 from the mid-
1950s onwards. According to this theory, market participants are only capable of
limited rational behavior.
On the other hand, decision-making under uncertainty received considerable atten-
tion when Daniel Kahneman27 and Amos N. Tversky28 developed the →Pro-
spect Theory (1979, 1992) which became the intellectual foundation for Behav-
ioral Finance (see Pompian, 2006, pp. 20). With their experiments, the two Israeli
psychologists attempted to classify the previously unexplainable deviations from
the ideal image of the Homo Economicus.
The increased focus on emotional and cognitive driven behavior of the market
participants, almost simultaneously gave birth to the emergence of Behavioral
Finance as a new specific field of research on the decision-making process of in-
dividuals. It attempts to explain what happens on the financial markets by taking
human behavior into account. It examines which factors lead to a different evalu-
ation of information and consequently to a deviating decision-making from the
assumptions made by traditional finance. Based on these insights, Behavioral Fi-
nance attempts, among others, to make forecasts about the future behavior of mar-
ket participants. Daniel Kahneman and Vernon L. Smith29 both share the No-
bel Prize in Economic Sciences in 2002. Amos N. Tversky died in 1996 and could
not receive the Nobel Prize posthumously (see Blechschmidt, 2007, pp. 11).
Another important contributor in the field of Behavioral Finance is the American
economist and Nobel Prize Winner of 2017 Richard H. Thaler30. His main inter-

26 Herbert Alexander Simon | American economist & Nobel Prize Winner 1978 | 1916-2001
27 Daniel Kahneman | Isreali psychologist and economist & Nobel Prize Winner 2002 | born
1934
28 Amos Nathan Tversky | Israeli psychologist | 1937-1996
29 Vernon Lomax Smith | American economist & Nobel Prize Winner 2002 | born 1927
30 Richard H. Thaler | American economist & Nobel Prize Winner 2017 | born 1945
28 1 How Neoclassical Theory shaped rational economic behavior

est was the investigation of decision anomalies as systematic deviations from ra-
tional behavior (see Wahren, 2009, p. 45).
Next, operant conditioning, in which the learning process is accomplished by trial
and error, resulted from the research findings of Edward L. Thorndike31 and
formed a further basis of Behavioral Financial market research. The psychology
of learning based on these experiments developed over time into →Behaviorism.
This allowed other approaches in the study of memory, as human and animal be-
havior could be investigated using scientific methods (see Schriek, 2009, pp. 20).

From early 2000 – The Age of Neuroeconomics

Increasing research using non-invasive computer tomography via fMRI – func-
tional Magnetic Resonance Imaging ‒ and the subsequent collaboration between
neuroscientists, psychologists and economists has led to the development of a new
area in economic science ‒ Neuroeconomics and the specific direction of Neu-
rofinance (see chapter 13.2). Technological developments in brain research are
providing opportunities to examine neuronal activities to help explain the actual
behavior of market participants. The goal is to determine how choices are re-
flected biologically and which neuronal processes are activated when decisions
under uncertainty are taken. Analyzing decision-making would no longer rely on
the traditional axiomatic approach only, but combined with brain imaging to bet-
ter understand why and how we react to a specific situation (see Elger/Schwarz,
2009, p. 36 and Bossaerts/Murawski, 2010).

From 2009 ‒ The Age of Emotional Finance

First approaches to the exploration of unconscious processes became visible
through the description of Keynes’ animal spirits. The research of unconscious
processes did not really surface until 2009 with the development of Emotional
Finance by Richard Taffler32 and David Tuckett33. Central elements of this
specific area of research are the effects of illusion and the desire for wish-fulfillment
(see chapter 13.3). The aim is to investigate the consequences of unconscious and
highly complex processes that lead market participants to emotionally driven be-
havior. Consequently, unconscious processes are to be brought into consciousness
in order to develop strategies for dealing with reoccurring emotional phenomena
(see Baker/Nofsinger, 2010, p. 95).

Traditional Finance presents the market participant as a rational indi-

viduum. Behavioral Finance, on the other hand, examines what happens on
the financial markets by taking human behavior into account. Finally, Neu-
rofinance uses findings to decipher the neuronal basis of decisions and hu-
man behavior based on the processes in the brain.

31 Edward Lee Thorndike | American psychologist | 1874-1949

32 Richard Taffler | Professor of Finance & Accounting, Warwick Business School
33 David Tuckett | Professor and Director of the Centre for the Study of Decision-Making

Uncertainty in the Faculty of Brain Sciences at University College London (UCL)

 1.2 Classical theories of Traditional Finance 29

1.2 Classical theories of Traditional Finance

The following chapter dives into the classical theories of traditional finance where
normative assumptions play a key role. In other words, this chapter highlights
how investors “should” make decisions. While this chapter might be somewhat
challenging from a general interest point of view, we aim to give a good overview
of the classical theories developed in traditional finance. Doing so, we reflect both
on challenges and possibilities they offer to evaluate risk return profiles of invest-
ments.
As such, the Neoclassical Capital Market Theory (or simply Neoclassical The-
ory) developed at the beginning of the 20th century from the old financial market
theory, which focused on accounting and →Fundamental Analysis. It evolved
around the premises of perfect rationality of market participants as well as perfect
financial markets. The resulting equilibrium theories are based on rational and at
the same time risk-averse market participants. In this sense, the processing of in-
formation according to the Bayes’ Theorem and decision-making within the
framework of the Expected Utility Theory represent important core elements
of the neoclassical theory. Besides these two theories, the neoclassical theory is
decisively influenced by the Efficient Market Hypothesis.
In the following subchapters, we will be focusing on the concept of the Rational
Economic Market Participant according to Smith (see chapter 1.2.1), the Random
Walk Theory of Bachelier (see chapter 1.2.2), the Expected Utility Theory of Mor-
genstern and von Neumann (see chapter 1.2.3), information processing according
to Bayes (see chapter 1.2.4) and lastly the Efficient Market Hypothesis of Fama
(see chapter 1.2.5).

1.2.1 The rational economic market participant according to Smith

The concept of the Rational Economic Market Participant34 forms the basis for the
neoclassical theory. The origin of this concept dates to the 18th century, the time
of classical economics. Scottish economist Adam Smith is regarded as its founder,
who, with the following quotation, points out the perfect self-interest as one of
three fundamental principles of the Rational Economic Market Participant also
referred to as the Homo Economicus:
"It is not from the benevolence of the butcher, the brewer, or the baker that we
expect our dinner, but from their regard to their own interest." (A. Smith, The
Wealth of Nations, 1776)
The term “Homo Economicus" may sound exaggerated, but the individual con-
cepts and models of the classical theories of traditional finance hardly allow for a
different view of the expected behavior of market participants. The concepts share
the core assumption that market participants are “rational maximizers”. It implies
a positive model of behavior with the aim of explaining and predicting economic

34 Occasionally referred to as Rational Economic Man (REM) in the literature

30 1 How Neoclassical Theory shaped rational economic behavior

and social developments and is governed by three fundamental principles in

any economic decision:
 Perfect Self-Interest, whereby one’s own goals and ideas are at the forefront
of one’s actions.
 Perfect Rationality, when making decisions: allowing optimal implementa-
tion of well-planned actions in which benefit-maximizing behavior with scarce
goods is aimed at.
 Perfect Information, since neither information asymmetries nor transaction
costs exist.
Due to these simplifications and the extremely high abstraction of the models un-
derlying these principles, the neoclassical theory can be represented very ele-
gantly by mathematical equations (see Bank/Gerke, 2005, p. 2).
It is the simplification of economic analysis, which is one of the two advantages
why economists like to use the concept of the Homo Economicus. The second
advantage is the possibility to quantify the findings (see Pompian, 2006, pp. 15).
The above advantages imply that reality and the complexity of human beings (the
way they take decisions, the implication of emotions etc.) is reduced to a mini-
mum. This reduction or simplification causes most criticism. Psychologists argue
that human behavior is less the product of perfect rationality but rather of subjec-
tive impulses such as greed & fear, love & hate or pleasure & pain, where any of
the impulses can cause significant valuation errors in asset prices.
Perfect self-interest stands in absolute contradiction to voluntary activities, to self-
lessness and to kindness religions stand for as much as over 2,000 years. Hence,
social engagements in our communities show that we sometimes think far less
only of ourselves than is assumed by the self-interest-oriented concept of the
Homo Economicus. Furthermore, the rapidly expanding areas in investment man-
agement (e.g., introduction of Artificial Intelligence (AI) and Machine Learning
(ML)) suggests that market participant cannot have perfect information or
knowledge on every subject. Despite the simplification of reality, the concept is,
in some areas, quite suitable for systematically analyzing reactions to changes in
the environment. Notwithstanding far-reaching concerns about the assumptions
of this concept, the behavior of market participants is to some extent similar to
that of the Homo Economicus, in that they also react systematically to changes in
their environment (see Mazanek, 2006, pp. 14).
Later, we will examine the extent to which market participants deviate from the
assumptions of the Homo Economicus. In chapter 3.2.3 the focus is explicitly on
the observable differences, leading to recurring speculative bubbles (see chapter
5) and to limited rational decisions (see chapters 7 to 9).

The concept of the Homo Economicus is a behavioral assumption with the

aim of explaining and predicting economic and social developments.
 1.2 Classical theories of Traditional Finance 31

1.2.2 Random Walk Theory according to Bachelier

The Random Walk Theory suggests that changes in security prices are independ-
ent of each other. In other words, yesterday’s price change has no effect on today’s
price change and today’s price change has no effect on tomorrow’s price change.
Based on the name of the theory, it proclaims that security prices follow a random
and hence unpredictable path, which is why predicting their price movements is
futile in the long run. Fundamental or technical analysis would be of no value,
hence passive overactive portfolio management is to be favored.
With the continued strong inflows into index-tracking funds (often packaged as
Exchange Traded Funds - ETFs), where an index is simply “followed” without an
active security selection, one could argue that the Random Walk Theory of secu-
rity prices is leveraged by financial institutions. According to fund data provider
Morningstar, assets in passive U.S. equity funds overtook those in active funds for
the first time in Augst 2019 (see Skypala, 2020). In addition, the significant variation
on the cost structure of passive versus active products can make ETFs more at-
tractive to the investment community. Having said that, there are many actively
managed funds that deliver excess returns (also called “alpha”), at least for a cer-
tain time.
A quick glance into the history of this theory: it is based on the dissertation of
French mathematician Louis Bachelier entitled “Théorie de la Spéculation” (1900).
In his work, Bachelier claimed that futures quotes for government bonds on the
Paris securities exchange in the 19th century followed a random pattern and there-
fore would not allow market participants to generate excess returns (see
Schredelseker, 2002, pp. 407). At that time, →Fundamental Analysis and the
growing importance of →Chart Analysis played a central role.
The basic idea of the Random Walk Theory evolves around the assumption that
security prices always change with the same probability ‒ analogous to the prob-
ability of a coin flip ("heads" or “tails") (see Mandelbrot/Hudson, 2004, pp. 9). The
magnitude of the price change can be measured. According to the theory, most
price changes of securities ‒ 68 percent ‒ are relatively small movements within
one →Standard Deviation (σ) from the mean value. The standard deviation il-
lustrates the →Volatility of an investment around its mean value, which is key
for assessing the risk of an investment.
Within +/- two standard deviations, 95 percent of all price changes take place, and
within +/- three standard deviations, 99 percent of all price changes would be
found. A few price changes however ‒ the remaining 1 percent ‒ represent partic-
ularly large deviations and are therefore, according to the theory, very unlikely.
If the price movements are connected, a bell curve shaped distribution appears.
The large number of small price movements are in the middle, the rare large price
movements at the two ends of the bell curve. The distribution of price movements
described here corresponds to the widely known normal distribution of Johann
Carl Friedrich Gauss35 ‒ also called Gaussian distribution (see Fig. 2).

35 Johann Carl Friedrich Gauss | German mathematician and physicist | 1777-1855

32 1 How Neoclassical Theory shaped rational economic behavior

Price movements according to the normal distribution

Fig. 2: Percentage of security price changes by standard deviation

We have become very aware of the importance of the normal distribution in the
wake of the SARS-CoV-2 (Covid-19) Pandemic 2020/21. While in the financial
world a flat bell curve is by no means preferred due to the higher volatility in the
form of a broader distribution of returns, during the Corona pandemic a flat bell
curve was very much desired and intended by social distancing and lock-downs
in order to avoid the sudden influx of infected people into hospitals in the case of
a tapered curve.
Covid outbreak leading to fastest sell-off in financial history

Fig. 3: Meltdown in days at specific market crash events, FactSet

 1.2 Classical theories of Traditional Finance 33

In the capital markets, however, contrary to the above description, sharp price
drops of over 5 percent and more can be observed time and again. Apparently,
such severe outliers as can be found at the outer ends of the bell curve occur more
often than expected by theory. For example, the fastest price decline in the history
of financial markets in the wake of the Corona pandemic from March 2020 is a
perfect example of why a risk analysis based on a normal distribution is not able
to simulate realistic results when rather a fat-tail approach would indicate the cor-
rect portfolio risk. The capital markets lost over 30 percent within a very short
period of time (approx. 30 trading days). In comparison, such losses in the past,
including the 1987 crash, lasted up to 180 trading days (see Fig. 3).
Despite the evidence of outlier events at the outer ends of the distribution (also
called fat-tail distribution) ‒ such as, for example, March 2020 when markets
dropped over 30 percent from their respective peaks, faster than in any other stock
market crash before in history ‒ the findings of Carl Friedrich Gauss gained great
attention in the field of financial markets. As a matter of fact, the former ten
deutsche mark banknotes of the Federal Republic of Germany showed the image
of Gauss as well as the bell curve (see Fig. 4).

Fig. 4: Ten-DM-banknote with bell-curve and Carl Friedrich Gauss

The Random Walk Theory as a fundamental concept of the neoclassical theory

already reveals one of the main problems of this economic approach, namely that
the conclusions drawn from empirical tests may not be valid, since the assump-
tions made can be falsified from the outset (see example 1.1). March 2020 is an-
other example why risk analysis based purely on normal distribution may not
capture all potential outcomes. Applying a fat-tail approach could improve ex-
ante risk analysis helping to capture the correct outcome.

Example 1.1: Lack of validity of empirical tests

The following chart of the S&P 500 illustrates extreme price developments in
the period from 2000 to 2021, which do not correspond to the assumptions of
the Random Walk Theory (see chapter 2.3).
Thus, market participants may face considerable losses if they rely on moderate
price fluctuations within a standard deviation under the assumption of the ran-
dom walk theory. Strong price fluctuations occur as a result of unexpected
events and lead to higher frequency of price movements found at the outer
34 1 How Neoclassical Theory shaped rational economic behavior

edges of the density function than would be expected under the assumption of
the random walk theory. However, in addition to substantial losses, enormous
gains can also be recorded if market participants can time entry/exit properly.

Extreme price movements between 2000 and 2022 – S&P 500

Fig. 5: S&P 500 Price chart (2000-2022); FactSet

Biography of Louis Bachelier

Louis Jean-Baptiste Alphonse Bachelier was born on
March 11, 1870 in the French port of Le Havre.
He began studying mathematics as a graduate student at the
Sorbonne at the age of 22. His doctoral supervisor was Henri
Poincaré, with whom Bachelier obtained his doctorate in 1900
with the thesis “Théorie de la Spéculation", in which he sought
a probabilistic approach to securities price movements.
Until the outbreak of the First World War, Bachelier financed his upkeep through
scholarships and as a lecturer at the Sorbonne. In 1919, after the end of his army
service, Bachelier found a position as an assistant professor in Besançon. Due to a
misinterpretation of one of his papers by Paul Lévy in 1926, he was blackballed
when he attempted to receive a permanent professorship in Dijon. Lévy, without
having read his entire work, accused him of making serious mistakes, which he
regretted later. Finally, in 1927 he was awarded a permanent position in Besançon.
His work was hardly noticed by the economists of his time. Only after his death
was the importance of his theory recognized. Bachelier is regarded as the founder
of financial mathematics and one of the pioneers of the theory of stochastic pro-
cesses in the field of financial markets. He died on 26 April 1946 in St-Servan-sur-
Mer, France (see Mandelbrot/Hudson, 2004, pp. 47).
 1.2 Classical theories of Traditional Finance 35

Deep Dive Random-Walk

Formally a random walk can be represented as:
Pt+1 = Pt + εt oder E[Pt+1] = Pt
P stands for the price of the security at times t or t+1.
The expression εt represents a random term that determines the form of the ran-
dom walk based on the assumptions made.
The strictest form of random walk would result if the random term εt is subject to
a normal distribution, independent of the past and has an expected value of zero
(see Mandelbrot/Hudson, 2004, pp. 10).
This would mean as stated in the beginning, that yesterday’s price change has no
effect on today’s price change and today’s price change has no effect on tomor-
row’s price change.
Normal distribution as the basis of the Random Walk Theory
Due to the central assumption that price changes and thus also the return of se-
curities can be approximately described by means of the normal distribution (see
Fig. 6), it is important to consider the characteristics of such a distribution, which
can be listed as follows (see Mandelbrot/Hudson, 2004, pp. 35):
 The area under the frequency function is always 100 percent.
 The height of the bell curve illustrates the most frequently occurring return ‒
this return is also referred to as the mean of the returns or the average return.
 The normal distribution is symmetrical, looks the same on the left and right of
the mean value.
 The probability of higher yields decreases more and more to the right of the
mean value, as does the probability of lower yields to the left of the mean value.
 The normal distribution is described by the mean value of the return μ and the
standard deviation in the form of the volatility σ.

Fig. 6: Exemplary return development based on the normal distribution

36 1 How Neoclassical Theory shaped rational economic behavior

Depending on the mean and the standard deviation36, the normal distribution can
take on different forms, which simultaneously indicate the expected return and
volatility (see Fig. 7).

Fig. 7: Forms of the normal distribution

Three distributions are shown in Fig. 7 (A, B and C). The distributions A and B
have the same mean and are located at the same place, measured by the mean. The
distribution C has a higher mean and is therefore located further to the right on
the x-axis. In terms of volatility, distributions A and C are equally volatile. The
distribution B, on the other hand, shows a higher volatility. This can be seen from
the fact that the distribution is flatter than the other two. In distributions A and
C, far more observations are close to the mean value, while in distribution B, more
observations are at more extreme values. So, the flatter a distribution is, the higher
is the risk ‒ measured as standard deviation.

1.2.3 Expected Utility Theory according to von Neumann & Morgen-

stern

The neoclassical capital market theory describes market participants as “rational”

if they formulate realistic expectations and implement them according to the ex-
pected utility theory. In contrast to this view, the behaviorally biased market par-
ticipant is prone to unrealistic expectations and consequently disregards the ex-
pected utility theory explained below.
The Expected Utility Theory has the objective to analyze rational decisions, when the
decision-maker is facing risky outcomes or in other words, faces different choices
with respective probabilities of outcome (see Bank/Gerke, 2005, pp. 35). Together
with the Bayes’ Theorem (see chapter 1.2.4) of information processing, the ex-

36 Standard Deviation is a statistic metric that measures the dispersion of a dataset relative

to its mean. It is calculated as the square root of the variance (σ2), which measures how far
each number in the set is with respect to the mean. The higher the deviation from the data
set, the more spread out the data and thus the higher the standard deviation. It can be used
to improve the portfolio construction and with that the overall asset allocation.
 1.2 Classical theories of Traditional Finance 37

pected utility theory forms the basis for the Efficient Market Hypothesis. In
the case of the expected utility theory, there are two types to differentiate:
 Objective Expected Utility Theory by Oscar Morgenstern & John von
Neumann (1947) – the distribution function of possible consequences is
known.
 Subjective Expected Utility Theory by Leonard J. Savage37 (1954) – the dis-
tribution function of the consequences is unknown; the decision-maker must
determine the probability of the consequences through subjective estimation.
This subchapter focuses on the Objective Expected Utility Theory. For Morgen-
stern and von Neumann, it was a normative model of how a rational person should
make decisions when facing alternative outcomes and not a descriptive model
about how decisions are really made. The theory is anchored in certain axioms
which, however, are often violated when considering the actual behavior of mar-
ket participants. These violations and doubts about the validity of the assumptions
spurred the emergence of →Behavioral Finance, taking on the challenging task
of uncovering why and how market participants choose as they do (see Forbes,
2009, p. 26). To do so, the Prospect Theory (see chapter 6.2) was developed as a
descriptive and alternative theory to the Expected Utility Theory. It was developed
by the psychologists Daniel Kahneman and Amos Tversky and assumes that
market participants assess their investment results relative to a reference point
rather than looking at their final assets. Therefore, depending on the reference
point, the results can be positive (gains) or negative (losses).

The objective of the expected utility theory is to analyze rational behavior

under uncertainty. The central object of the investigation is the making of
decisions without their results/consequences being known in advance.

Biographies of Morgenstern and von Neumann

Oskar Morgenstern was born on January 24, 1902 in Gör-
litz/Germany. In 1925 he received his doctorate in political
science from the University of Vienna. Shortly afterwards he
received a scholarship from the Rockefeller Foundation. In
1929 he returned to Vienna from the U.S. and accepted a pro-
fessorship at the University of Vienna. During his time at the
university, he belonged to the so-called “Austrian Circle”, a
group of Austrian economists. In 1938 he emigrated to the U.S. and became pro-
fessor at Princeton University, where he developed the game theory together with
von Neumann.
In addition to game theory, they also developed the Expected Utility Theory as a
method of evaluating decisions under uncertainty.

37 Leonard J. Savage | American mathematician | 1917-1971

38 1 How Neoclassical Theory shaped rational economic behavior

Morgenstern was appointed Distinguished Professor of Game Theory and Mathe-

matical Economics by the New York University. He died in Princeton on July 26,
1977.
John von Neumann was born in Budapest/Hungary on De-
cember 28, 1903. His high intelligence was already evident at
the age of six, when he was able to divide eight-digit num-
bers.
After graduating from high school, he attended various uni-
versities in Europe and obtained his diploma in chemical en-
gineering at the ETH Zurich. In addition, he studied mathe-
matics and obtained his doctorate from the University of Budapest in 1926. In 1928,
he habilitated at the University of Berlin with his work Allgemeine Eigenwertthe-
orie symmetrischer Funktionaloperatoren.
In 1933 he became professor of mathematics at the newly founded Institute for
Advanced Study in Princeton, New Jersey. In 1933 von Neumann became co-editor
of the Annals of Mathematics and in 1935 of Compositio Mathematica. Together
with Oskar Morgenstern he wrote The Theory of Games and Economic Behavior in
1944, with which he became the founder of game theory. He also wrote a book on
quantum mechanics and participated in the development of axiomatic set theory.
During World War II von Neumann was an advisor to the U.S. Army. From 1943
he worked on the Manhattan Project in Los Alamos on the development of atomic
bombs.
Neumann received numerous honors for his scientific achievements, including the
Medal of Merit, the Medal for Freedom, and the Albert Einstein Commemorative
Award. In addition, the John von Neumann Institute for Computing in Jülich was
named after him. He died on 8 February 1957 in Washington D.C.

Deep Dive Expected Utility Theory

Basic idea of the objective Expected Utility Theory
The central element is a utility function u, whose expected value can be used to
represent preferences. The determination of the expected value plays a special role
in the calculation of the expected benefit EU.
n
Formally, the utility function can be represented as follows: EU(a) = Σ pi * u(ai)
i=1
The term u(ai) represents the respective benefit of state i of alternative a. pi is the
corresponding probability of the occurrence of this state.
The sum of the probabilities of all states Σ pi is 1.
i=n1
In consequence, two alternatives a and b emerge. If a has a higher expected utility
than b, alternative a is preferred over b, i.e., a > b, if EU(a) > EU(b).
Based on the above, the expected utility of an alternative is the key element for a
rational decision, whereby the market participant chooses the alternative that has
the highest expected utility (see Kottke, 2005, p. 8).
 1.2 Classical theories of Traditional Finance 39

Axioms for rational behavior

For the respective preference statements (alternative a versus alternative b) to re-
sult in rational behavior, the preferences must fulfil three specific axioms listed
below. Behavioral Finance research shows, that these axioms are not always ful-
filled.
Complete order
The axiom “complete order” consists of two partial axioms ‒ completeness and
transitivity. Both properties must be fulfilled within the “complete order” axiom.
Completeness means that all alternatives are considered in a decision. For each
alternative, a > b or b > a must apply accordingly. Transitivity is the property that
exists when all alternatives satisfy the condition that if a > b and b > c, then in
consequence a > c.
The violation of this axiom and thus the departure from the rational behavior of
the market participant can be explained by various →Biases (also called heuris-
tics or rules of thumbs) identified through Behavioral Finance research. Although
they reduce the degree of complexity of the decision when confronted with un-
certainty, they may lead to biased or poor choices under uncertainty. Nonetheless
market participants seem to consistently rely on these shortcuts to reduce the al-
ternatives at hand (see Elton/Gruber/Brown and Goetzmann, 2007, p. 488).
For example, the range of alternatives can be limited if the market participant is
subject to home bias. In this case, domestic investments are preferred over foreign
ones, as domestic investments are associated with higher security.
Continuity
The axiom “continuity” is fulfilled if the alternatives, b, c behave to each other in
such a way that a > b > c and a probability p [p∈0,1] ensures that the term
p * a + (1-p) * c equals b. The axiom of continuity thus requires that an indifference
can be established between alternative b and a combination of a and c. In other
words, an original preference between two alternatives should not change if both
alternatives are extended by the same third alternative.
In the context of Behavioral Finance research, we observe however, that market
participants assign higher probability to an alternative over another alternative
who is less available/familiar. This phenomenon, known as →Availability Bias,
can lead to a biased subjective perception of the objective probability of the alter-
native in question.
Independence
The axiom “independence” formulates the condition that an original preference
between two alternatives is not changed if further decision possibilities are
brought into play. If one starts from a > b and the two alternatives are supple-
mented by the alternative c, then the axiom of independence is fulfilled if p [p∈0,1]
applies to all probabilities:
40 1 How Neoclassical Theory shaped rational economic behavior

p * a + (1-p) * c > p * b + (1-p) * c

A further characteristic of the independence axiom is the possibility of substitut-
ing one alternative for another if the decision-maker is indifferent between the
two alternatives. However, the substitution should not affect the preference of the
decision-maker.
If we now look at the decision-making process from a psychological point of view,
it becomes clear that market participants may also feel emotional unease when
choosing between two alternatives. This situation arises when the alternative not
chosen or an additionally chosen alternative (in this case alternative c) has char-
acteristics that are in contrast to the investor’s existing values and decisions. In
this case, according to the →Theory of Cognitive Dissonance (see chapter
6.1.3) by Leon Festinger38, an emotional imbalance arises, which can be reduced
by suppressing the contradicting and highlighting the confirming information to
make an investment decision. In that aspect, market participants start to limit the
amount of information available through →Selective Perception (see chapter
7.1.2). If a decision has already been made, an attempt is made to ensure the con-
tinuation of the investment decision through →Selective Decision-Making (see
chapter 9.1.1).

1.2.4 Information processing according to Bayes

The theorem developed by Thomas Bayes and published by Richard Price after
his death in 1763 is another important basic assumption of rational behavior.
As in the expected utility theory, the alternatives for a decision and their prior or
ex-ante probabilities of occurrence are also known in the Bayes’ Theorem. If there
is a change with regards to the information at hand, the original probabilities of
occurrence should ex-post adapt to the new situation. However, if the necessary
adaptation is not made, decision-makers are not in a position to make the optimal
(rational) decision.
The following example illustrates the extent to which market participants should
change their original assessment of the future development of a security based on
analysts’ estimates. According to the Bayes’ theorem, market participants would
be expected to reassess the future performance of their shares based on additional
information.

Example 1.2: Adjustment of the probability assessment based on the Bayes’

Theorem
The types of possible recommendations (buy, hold or sell) stand for the uncer-
tain states. The probability of a buy recommendation is assumed to be 60 per-
cent of all recommendations, 30 percent for hold and 10 percent for sell recom-
mendations. The ex-ante probability of holding a winner share, i.e., before pro-
cessing a new recommendation, is assumed to be 50 percent.

38 Leon Festinger | American social psychologist | 1919-1989

 1.2 Classical theories of Traditional Finance 41

Now the question is: What is the ex-post probability of each recommendation
type associated with holding a winner share?
A further assumption comes into play: the estimated probability that a recom-
mendation will actually lead to rising prices. We assume that a buy recommen-
dation foretells a winning share in 70 percent of the time [p(buy|winner) = 0.7],
a hold recommendation foretells a winning share in 25 percent of the time
[p(hold|winner) = 0.25] and a sell recommendation foretells a winning share in
5 percent of the time [p(sell|winner) = 0.05].

p(winner|recomi) * p(recomi)
p(recomi|winner) =
Σi p(winner|recomi) * p(recomi)

0.7 x 0.6 0.42

p(buy|winner) = = = 0.84
(0.7 x 0.6) + (0.25 x 0.3) + (0.05 x 0.1) 0.5

0.25 x 0.3 0.075

p(hold|winner) = = = 0.15
(0.7 x 0.6) + (0.25 x 0.3) + (0.05 x 0.1) 0.5

0.05 x 0.1 0.005

p(sell|winner) = = = 0.01
(0.7 x 0.6) + (0.25 x 0.3) + (0.05 x 0.1) 0.5

The example just calculated illustrates a change in the probability assessment

based on the recommendations by analysts. The original probability that the
share will rise (50 percent) has risen to 84 percent due to a buy recommenda-
tion. However, if a hold recommendation is issued, the ex-post probability that
the share will nevertheless rise falls to 15 percent. With a sell recommendation,
this probability drops to just one percent.
If the recommendations were now repeated, the probability that the share
would rise with successive buy recommendations would reach even higher val-
ues. With six buy recommendations published in succession, market partici-
pants could count on almost 100 percent probability of rising prices. In the case
of the hold or sell recommendations, however, the probability assessment of
rising prices would continue to fall until it reaches almost 0 percent after just
three published hold recommendations (see Forbes, 2009, pp. 70).

Observations of market participants reveal a differentiated picture. Studies by

Victor L. Bernard39 and Jacob K. Thomas40 (1990) show that analysts, for ex-
ample, do not promptly adjust their estimations to the information provided. As a

39 Victor L. Bernard | American Professor of Accounting | 1952-1995

40Jacob K. Thomas | American Professor of Accounting and Finance, Yale School of Man-
agement
42 1 How Neoclassical Theory shaped rational economic behavior

result, their recommendations to the new information are adjusted with a delay.
Consequently, market participants can generate excess returns if they take ad-
vantage. Bernard and Thomas confirmed this phenomenon as the post-earnings-
announcement drift. First detected 1968 (see chapter 4.4.3) ‒ it explains that a
security can experience further gains if research analysts start to upgrade recom-
mendations and further losses if they start to downgrade recommendations after
earnings announcements. The reason for this behavior can be seen in the fact that
the previously communicated analysts’ recommendations are gradually adjusted
based on the new information.
The post-earnings announcement drift clearly shows once again that the Homo
Economicus Humanus is not in a position to instantly incorporate all information
into the valuation of the security prices. This is due to certain cognitive and emo-
tional limitations, which are described in detail from chapter 6 onwards.

Biography of Thomas Bayes

Bayes was born in London in 1702. He was the oldest of seven
children. In 1719 Bayes enrolled at the University of Edin-
burgh for Logic and Theology. After his studies he was or-
dained a Presbyterian clergyman like his father and initially
worked with him.
His theory of probability “Essay towards solving a problem in
the doctrine of chances” was published posthumously in the Philosophical Trans-
actions in 1763. His considerations were first adopted by Pierre Simon Laplace in
1781, rediscovered by Marie-Jean Condorcet and remained unchallenged until
George Boole critically questioned them in his “Laws of Thought” and developed
them into their present form.
In 1742 Bayes was elected a fellow of the Royal Society, although he had no math-
ematic publication under his name. He died on April 17, 1761 at Tunbridge Wells,
England.

The Bayes’ Theorem illustrates how a market participant’s probability as-

sessment should change when new information is received. This involves
the adjustment from ex-ante probabilities to ex-post probabilities.

1.2.5 Efficient Market Hypothesis according to Fama

To complete the classical theories of traditional finance, we need to take a look at

the Efficient Market Hypothesis (EMH). It is mainly based on the assumption of a
rational information processing and decision-making behavior of market partici-
pants. The basis for the Efficient Market Hypothesis are decisions on the basis of
the Expected Utility Theory (see chapter 1.2.3) and the processing of information
in the sense of the Bayes’ Theorem (see chapter 1.2.4).
 1.2 Classical theories of Traditional Finance 43

The starting point for the EMH is the consideration that if it were possible to pre-
dict future developments from past price developments, there would be the possi-
bility of achieving an excess return.
However, the excess return would be quickly neutralized, as many market partic-
ipants would try to exploit this for their own benefit, as well. In essence, prices
would quickly reach their “right" level. Consequently, new information would not
only be reflected in future prices, but already in today’s prices. On the basis of this
development, it would have to be assumed that the prices follow a random walk.
This would be the case only if new information would have a direct impact on the
price development. In line with Bachelier’s theory described above, no excess re-
turns can be achieved by observing past prices (see Karlen, 2003, pp. 15).
Eugene Fama was also inspired by this consideration when he developed the Ef-
ficient Market Hypothesis in 1970. The hypothesis describes a market as efficient
when security prices fully reflect all available information:
“A market in which prices always fully reflect available information is called
efficient.” (Fama, 1970, p. 383)
This finding implies that investors cannot gain an information processing ad-
vantage for themselves in order to generate excess returns (see Garz/Günther/Mo-
riabadi, 2002, p. 82). An information-efficient market can be described by the fol-
lowing three characteristics (see Rau, 2010, p. 334):
[1] All market participants are rational. They value a security on the basis of
discounted future dividends or cash flows. They use all available information
to determine the fundamental value of the security. If it is higher than the
current price, the demand for the security increases. In the opposite case,
market participants sell the securities or use the possibility of short selling.
[2] Some market participants are irrational. Their uncorrelated false valua-
tions neutralize each other. If an “optimist” feels that the security is under-
valued and a “pessimist” feels that the security is overvalued, these two mar-
ket participants will neutralize their mispricing among themselves. The price
of the security would remain unchanged.
[3] Arbitrage is unlimited. Arbitrageurs are market participants with “unlim-
ited” liquidity. If a mispricing occurs in the short-term, they compensate for it
by trading a large number of the corresponding securities. Even if some mar-
ket participants are systematically irrational, a large number of arbitrageurs
can thus achieve a return to fundamental valuation.
As already indicated in point 3, the influence of irrational market participants on
price formation can be compensated by two mechanisms (see Shleifer, 2000, p. 2):
 Arbitrage: The concept of arbitrage is based on the simultaneous purchasing
and selling of an identical security, commodity, or currency, across two differ-
ent markets while exploiting price differences. The transactions aim to bring
the valuations back in line with the fundamental values.
44 1 How Neoclassical Theory shaped rational economic behavior

Example 1.3: Arbitrage as a possibility to limit irrational market behavior

Assuming that the common shares of BMW are traded at the same time in Mu-
nich at EUR 87.00 and on the Frankfurt Stock Exchange at EUR 87.26 (a differ-
ence of EUR 0.26 per share). If the simultaneous purchase and sell order of, for
example, 1,000 shares is executed, the buyer makes a profit of EUR 260. So, the
capital outlay for the buyer in this example is still EUR 87,000 plus the purchase
fees and charges. This transaction would realign the two notations to each
other and consequently offset the effects of irrational market behavior.
In most cases, however, the order costs are so high that the profit from the arbi-
trage transaction cannot cover these costs. In practice, only large financial insti-
tutions or hedge funds can take advantage of arbitrage opportunities. In addi-
tion, the interest rate differences between credit and deposit interest rates can
reduce excess return as well, so that credit-financed arbitrage is rare, in real life.

 Natural selection by market forces. This refers to incurred losses in the

course of irrational “purchase high, sell low” or, in other words, transactions
when securities are overvalued and over time undergo a price correction. As a
result, the returns of these investors are lower than normal and they are forced
out of the market over time, according to Milton Friedman41:
“They must become much less wealthy and eventually disappear from the
market.” (Friedman, quoted after Shleifer, 2000, p. 4)
Furthermore, Fama considers information that is already known as “old or useless”
information. He defines three types of useless information, which then leads to
the three known forms of the efficient market hypothesis (see Shleifer, 2000, p. 5).
The extent to which arbitrageurs are actually able to compensate for the effects of
“irrationally” acting market participants is discussed in chapter 4.1.2. Numerous
obstacles make it difficult or impossible for arbitrageurs to intervene in the form
described above. In addition to certain risks, the costs of arbitrage also mean that
institutional investors do not always intervene. Moreover, in some cases investors
are not interested in returning prices to fundamental valuation. Rather, they may
be interested in profiting from the mispricing (see chapter 4.1.2).

Three-step concept of the Efficient Market Hypothesis (EMH)

In the three-step concept, Fama distinguishes between the weak, semi-strong and
strong form of market efficiency (see Shleifer, 2003, pp. 6):
The weak form of market efficiency characterizes a market in which the price
histories of the traded securities are included in the current prices. In essence, this
form of efficiency corresponds to Bachelier’s →Random Walk Theory. This
means that the information on past prices do not lead to any excess returns and
therefore the →Technical Analysis (see chapter 2.2.2) is of no use (see
Schredelsker, 2002, p. 418):

41 Milton Friedman | American Economist and Nobel Prize winner (1976) | 1912-2006
 1.2 Classical theories of Traditional Finance 45

Example 1.4: Weak form of market efficiency

If a technical analyst discovers that prices are rising in January, the analyst tries
to profit from the price increases in January by buying in December. However,
this phenomenon is also observed by other market participants, who also bet
on rising prices in January. Thus, prices rise in December due to the demand of
the technical analyst without additional increases in January – thus the discov-
ery through chart analysis destroys the anticipated excess return by itself.

Nevertheless, technical analysis is still used by a good portion of the market

participants to make decisions. In this respect, the confidence in this form of
financial market analysis illustrates limited rationality among market participants.
Research results of Behavioral Finance illustrate the psychological reasons for the
trust in technical analysis. For example, there are indications that certain
→Biases implicate that the knowledge of past prices can certainly be used to
achieve an excess return.
For example, the economists Werner de Bondt and Richard Thaler (1985) have
pointed out that the future, long-term development of securities can be partially
predicted by looking at past developments. This phenomenon known as the
→Winner-Loser Effect is described in more detail in chapter 4.3.3.
 The semi-strong form of market efficiency is based on the idea that all
other publicly available information is also priced into the valuation of securi-
ties. If a market is information-efficient in the semi-strong sense, fundamental
analysis based on public information (newspaper reports, annual accounts, etc.)
does not lead to excess returns.

Example 1.5: Semi-strong form of market efficiency

If an analyst discovers in the annual report of a company that the company’s
debt is too high, he or she could achieve an excess return by recognizing this
and by reacting accordingly. In an efficient market, however, the development
of corporate debt is also noticed by other analysts ‒ the price falls as a result,
since the information is priced into the security prices in the shortest possible
time. So, it is only the fastest market participants, who can generate an excess
return by reacting to that information.

Besides the weak form, the semi-strong form of market efficiency is also empiri-
cally doubted. For example, an initially cautious attitude towards corporate earn-
ings reports can empirically be observed. As already noted in chapter 1.2.4 (Infor-
mation processing according to Bayes), this results in further, extended gains in the
case of positive information and further losses in the case of negative information
based on a gradual, cautious adjustment of the previous estimates. This post-
earnings-announcement drift illustrates the possibility of potentially achieving
an excess return by knowing all public information (see Shefrin, 2000, p. 96).
 The strong form of market efficiency includes the correct processing of all
conceivable information into securities prices (in addition to price histories and
 Another Random Document on
Scribd Without Any Related Topics
$25 (wholesale) in St. Louis and was given as a wedding present.
Three months later it stopped and was taken to a watchmaker well
known to be skillful and who had a fine run of expensive watches
constantly coming to him. He cleaned the clock, took it home and it
ran three hours! It came back to him three times; during these
periods he went over the movement repeatedly; every wheel was
tested in a depthing tool and found to be round: all the teeth were
examined separately under a glass and found to be perfect; the
pinions were subjected to the same careful scrutiny; the depthings
were tried with each wheel and pinion separately; the pivots were
tested and found to be right; the movement was put in its case and
examined there; it would run all right on the watchmaker’s bench,
but not in the home of its owner. It would stop every time it was
moved in dusting the mantel. He became disgusted and took the
clock to another watchmaker, a railroad time inspector; same results.
In this way the clock moved about for three years; whenever the
owner heard of a man who was accounted more than ordinarily
skillful he took him the clock and watched him “fall down” on it.
Finally it came into the hands of an ex-president of the American
Horological Society. He made it run three weeks. When he found the
clock had stopped again he refused pay for it. Three months later he
called and got the clock, kept it for three weeks, brought it back
without explanation and lo, the clock ran! It would even run
considerably out of beat! When asked what he had done to the
clock, he merely laughed and said “Wait.”
A year later the clock was still going satisfactorily and he
explained. “That was the first time I ever got anything I couldn’t fix
and it made me ashamed. I kept thinking it over. Finally one night in
bed I got to considering why a clock wouldn’t run when there was
nothing the matter with it. The only reason I could see was lack of
power. Next morning I got the clock and put in new mainsprings, the
best I could find. The clock was cured! None of these other men
who had the clock took out the springs. They came to me all
gummed up, while the rest of the clock was clean, bright and in
perfect order. I cleaned the springs and returned the clock; it ran
three weeks. When I took it back I put in stronger springs, because
I found them a little soft on testing them. If any of your friends have
French clocks that won’t go, send them to me.”
Three-quarters of the trouble with French clocks is in the spring
box; mainspring too weak, gummy or set; stop works not properly
adjusted, or left off by some numskull who thought he could make
the clock keep time without it when the maker couldn’t; mainspring
rough, so that it uncoils by jerks; spring too strong, so that the small
and light pendulum cannot control it. These will account for far more
cases than the “flat wheel” story that so often comes to the front to
account for a failure on the part of the workman. Of course he must
say something to his boss to account for his failure and the “wheels
out of round” and “the faulty depthing” have been standard excuses
for French clocks for a century. Of course they do occur, but not
nearly as often as they are credited with, and even then such a clock
may be made to perform creditably if the springs are right.
Another source of trouble is buckled springs, caused by some
workman taking them out or putting them in the barrel without a
mainspring winder. There are many men who will tell you that they
never use a winder; they can put any spring in without it. Perhaps
they can, but there comes a day when they get a soft spring that is
too wide for this treatment and they stretch one side of it, or bend,
or kink it, and then comes coil friction with its attendant evils. These
may not show with a heavy pendulum, but they are certain to do so
if it happens to be an eight-day movement with light pendulum or
balance, and this is particularly true of a cylinder.
All springs should be cleaned by soaking in benzine or gasoline
and rubbing with a rag until all the gum is off them before they are
oiled. Heavy springs may be wiped by wrapping one or two turns of
a rag around them and pushing it around the coils. The spring
should be well cleaned and dried before oiling. A quick way of
cleaning is to wind the springs clear up; stick a peg in the escape
wheel; remove the pallet fork; plunge the whole movement into a
pail of gasoline large enough to cover it; let it stand until the
gasoline has soaked into the barrels; remove the peg and let the
trains run down. The coils of the spring will scrub each other in
unwinding; the pivots will clean the pivot holes and the teeth of
wheels and pinions will clean each other. Then take the clock apart
for repairs. Springs which are not in barrels should be wound up and
spring clamps put on them before taking down the clock. About six
sizes of these clamps (from 2½ inches to ¾ inch) are sufficient for
ordinary work.
Rancid oil is also the cause of many “come-backs.” Workmen will
buy a large bottle of good oil and leave it standing uncorked, or in
the sun, or too near a stove in winter time, until it spoils. Used in
this condition it will dry or gum in a month or two and the clock
comes back, if the owner is particular; if not, he simply tells his
friends that you can’t fix a clock and they had better go elsewhere
with their watches.
For clock mainsprings, clock oil, such as you buy from material
dealers, is recommended provided it is intended for French
mainsprings. If the lubricant is needed for coarse American springs,
mix some vaseline with refined benzine and put it on liberally. The
benzine will dissolve the vaseline and will help to convey the
lubricant all over the spring, leaving no part untouched. The liquid
will then evaporate, leaving a thin coating of vaseline on the spring.
It is best to let springs down, with a key made for the purpose. It
is a key with a large, round, wooden handle, which fills the hand of
the watchmaker when he grasps it. Placing the key on the arbor
square, with the movement held securely in a vise, wind the spring
until you can release the click of the ratchet with a screwdriver, wire
or other tool; hold the click free of the ratchet and let the handle of
the key turn slowly round in the hand until the spring is down. Be
careful not to release the pressure on the key too much, or it will get
away from you if the spring is strong, and will damage the
movement. This is why the handle is made so large, so that you can
hold a strong spring.
 It is of great importance, if we wish to avoid variable coil friction,
that the spring should wind, from the very starting, concentrically; i.
e., that the coils should commence to wind in regular spirals,
equidistant from each other, around the arbor. In very many cases
we find, when we commence to wind a spring, that the innermost
coil bulges out on one side, causing, from the very beginning, a
greater friction of the coils on that side, the outer ones pressing hard
against it as you continue to wind, while on the outer side of the
arbor they are separated from each other by quite a little space
between them, and that this bulge in the first coil is overcome and
becomes concentric to the arbor only after the spring is more than
half way wound up. This necessarily produces greater and more
variable coil friction. When a spring is put into the barrel the
innermost coil should come to the center around the arbor by a
gradual sweep, starting from at least one turn around away from the
other coils. Instead of that, we more often find it laying close to the
outer coils to the very end, and ending abruptly in the curl in the
soft end that is to be next the arbor. When this is the case in a
spring of uniform thickness throughout, it is mainly due to the
manner of first winding it from its straight into a spiral form. To
obviate it, I generally wind the first coils, say two or three, on a
center in the winder, a trifle smaller than the regular one, which is to
be of the same diameter of the arbor center in the barrel. You will
find that the substitution of the regular center, afterwards, will not
undo the extra bending thus produced on the inner coils, and that
the spring will abut by a more gradual sweep at the center, and wind
more concentrically.
The form of spring formerly used with a fusee in English carriage
clocks and marine chronometers is a spring tapering slightly in
thickness from the inner end for a distance of two full coils, the
thickness increasing as we move away from the end, then continuing
of uniform thickness until within about a coil and a half from the
other end, when it again increases in thickness by a gradual taper.
The increase in the thickness towards the outer end will cause it to
cling more firmly to the wall of the barrel. The best substitute for
this taper on the outside is a brace added to some of the springs
immediately back of the hole. With this brace, and the core of the
winding arbor cut spirally, excellent results are obtained with a
spring of uniform thickness throughout its entire length. Something,
too, can be done to improve the action of a spring that has no
brace, by hooking it properly to the barrel. The hole in the spring on
the outside should never be made close to the end; on the contrary,
there should be from a half to three-quarters of an inch left beyond
the hole. This end portion will act as a brace.
When the spring is down, the innermost coil of it should form a
gradual spiral curve towards the center, so as to meet the arbor
without forcing it to one side or the other. This curve can be
improved upon, if not correct, with suitably shaped pliers; or it can
be approximated by winding the innermost coils first on an arbor a
little smaller in diameter than the barrel arbor itself.
Another and very important factor in the development of the
force of the spring is the proper length and thickness of it. For any
diameter of barrel there is but one length and one thickness of
spring that will give the maximum number of turns to wind. This is
conditioned by the fact that the volume which the spring occupies
when it is down must not be greater nor less than the volume of the
empty space around the arbor into which it is to be wound, so that
the outermost coil of the spring when fully wound will occupy the
same place which the innermost occupies when it is down. In a
barrel, the diameter of whose arbor is one-third that of the barrel,
the condition is fulfilled when the measure across the coils of the
spring as it lays against the wall of the barrel, is 0.39 of the empty
space, or, taking the diameter of the barrel as a comparison, 0.123
of the latter; in other words, nearly one-eighth of the diameter of
the barrel. This is the width that will give the greatest number of
turns to wind, whatever may be the length or thickness of any
spring. If now we desire a spring to wind a given number of turns,
there is but one thickness and one length of it that will permit it to
do so. The thickness remaining the same, if we make the spring
longer or shorter, we reduce the number of turns it will wind; more
rapidly by making it shorter, less so by making it longer. It is
therefore not only useless, but detrimental, to put into a barrel a
greater number of coils, or turns, than are necessary, not only
because it will reduce the number of turns the barrel will wind, but it
will produce greater coil friction by filling up the space with more
coils than are necessary.
A mainspring in the act of uncoiling in its barrel always gives a
number of turns equal to the difference between the number of coils
in the up and the down positions. Thus, if 17 be the number of coils
when the spring is run down, and 25 the number when against the
arbor, the number of turns in uncoiling will be 8, or the difference
between 17 and 25.
The cause of breakage is usually, that the inner coils are put to
the greatest strain, and then the slightest flaw in the steel, a speck
of rust, grooves cut in the edges of the spring by allowing a
screwdriver to slip over them, or an unequal effect of change of
temperature, causes the fracture, and leaves the spring free to
uncoil itself with very great rapidity.
Now this sudden uncoiling means that the whole energy of the
spring is expended on the barrel in a very small fraction of a second.
In reality the spring strikes the inner side of the rim of the barrel, a
violent blow in the direction the spring is turning, that is, backwards;
this is due to the mainspring’s inertia and its very high mean
velocity. The velocity is nothing at the outer end, where the spring is
fixed, but rises to the maximum at the point of fracture, and the
kinetic energy at various points of the spring could no doubt be
calculated mathematically or otherwise.
For instance, take a going barrel spring of eight and a half turns,
breaking close up to the center while fully wound. A point in the
spring at the fracture makes eight turns in the opposite direction to
which it was wound, a point at the middle four turns, and a point at
the outer end nothing, an effect similar to the whole mass of the
spring making four turns backwards. At its greatest velocity it is
suddenly stopped by the barrel, wheel teeth engaging its pinion; this
stoppage or collision is what breaks center pinions, third pivots,
wheel teeth, etc., unless their elasticity, or some interposed
contrivance, can safely absorb the stored-up energy of the
mainspring, the spring being, as every one knows, the heaviest
moving part in an ordinary clock, except where the barrel is
exceptionally massive.
Stop Works.--Stop works are devices that are but little understood
by the majority of workmen in the trade. They are added to a
movement for either one or both of two distinct purposes: First, as a
safety device, to prevent injury to the escape wheel from over
winding, or to prevent undue force coming on the pendulum by
jamming the weight against the top of the seat board and causing a
variation in time in a fine clock; or, second, to use as a compromise
by utilizing only the middle portion of a long and powerful spring,
which varies too much in the amount of its power in the up and
down positions to get a good rate on the clock if all the force of the
spring were utilized in driving the movement.
With weight clocks, the stop work is a safety device and should
always be set so that it will stop the winding when the barrel is filled
by the cord; consequently the way to set them is to wind until the
barrel is barely full and set the stops with the fingers locked so as to
prevent any further action of the arbor in the direction of the
winding and the cord should then be long enough to permit the
weight to be free. Then unwind until within half a coil of the knot in
the cord where it is attached to the barrel and see that the weight is
also free at the bottom of the case, when the stops again come into
action. This will allow the full capacity of the barrel to be used.
When stop work is found on a spring barrel, it may be taken for
granted that the barrel contains more spring than is being wound
and unwound in the operation of the clock and it then becomes
important to know how many coils are thus held under tension, so
that we may put it back correctly after cleaning. Wind up the spring
and then let it slowly down with the key until the stop work is
locked, counting the number of turns, and writing it down. Then
hold the spring with the letting down key and take a screw driver
and remove the stop from the plate; then count the number of turns
until the spring is down and also write that down. Then take out the
spring and clean it. You may find such a spring will give seventeen
turns in the barrel without the stop work on, while it will give but ten
with the stop work; also that the arbor turned four revolutions after
you removed the stop. Then the spring ran the clock from the fourth
to the fourteenth turns and there were four coils unused around the
arbor, ten to run the clock and three unused at the outer end around
the barrel. This would indicate a short and light pendulum or
balance, which is very apt to be erratic under variations of power,
and if the rate was complained of by the customer you can look for
trouble unless the best adjustment of the spring is secured. Put the
spring back by winding the four turns and putting on the stop work
in the locked position; then wind. If the clock gains when up and
loses when down, shift the stop works half a turn backwards or
forwards and note the result, making changes of the stop until you
have found the point at which there is the least variation of power in
the up and down positions. If the variation is still too great a thinner
spring must be substituted.
There are several kinds of stop work, the most common being
what is known as the Geneva stop, a Maltese cross and a finger such
as is commonly seen on watches. For watches they have five
notches, but for clocks they are made with a greater number of
notches, according to the number of turns desired for the arbor. The
finger piece is mounted on a square on the barrel arbor and the star
wheel on the stud on the plate. In setting them see that the finger is
in line with the center of the star wheel when the stop is locked, or
they will not work smoothly.
There is another kind of stopwork which is used in some
American clocks, and as there is no friction with it, and no fear of
sticking, nor any doubt of the certainty of its action, it is perhaps the
most suitable for regulators and other fine clocks which have many
turns of the barrel in winding. This stop is simple and sure. It
consists of a pair of wheels of any numbers with the ratio of odd
numbers as 7 and 6, 9 and 10, 15 and 16, 30 and 32, 45 and 48,
etc.; the smaller wheel is squared on the barrel arbor and the larger
mounted on a stud on the plate. These wheels are better if made
with a larger number of teeth. On each wheel a finger is planted,
projecting a little beyond the outsides of the wheel teeth, so that
when the fingers meet they will butt securely. The meeting of these
fingers cannot take place at every revolution because of the
difference in the numbers of the teeth of the wheels; they will pass
without touching every time till the cycle of turns is completed, as
one wheel goes round say sixteen times while the other goes fifteen,
and when this occurs the fingers will engage and so stop further
winding. When the clock has run down sixteen turns of the barrel
the fingers will again meet on the opposite side, and so the barrel
will be allowed to turn backwards and forwards for sixteen
revolutions, being stopped by the fingers at each extreme. When in
action the fingers may butt either at a right or an obtuse angle, only
not too obtuse, as this would put a strain on, tending to force the
wheels apart. If preferred the fingers may be made of steel, but this
is not necessary.

Fig. 83.
Maintaining Powers.--Astronomical clocks, watchmaker’s regulators
and tower clocks are, or at least should be, fitted with maintaining
power. A good tower clock should not vary in its rate more than five
to ten seconds a week. Many of them, when favorably situated and
carefully tended, do not vary over five to ten seconds per month. It
requires from five to thirty minutes to wind the time trains of these
clocks and the reader can easily see where the rate would go if the
power were removed from the pendulum for that length of time;
hence a maintaining power that will keep nearly the same pressure
on the escape wheel as the weight does, is a necessity. Astronomical
clocks and fine regulators have so little train friction, especially if
jeweled, that when the barrel is turned backwards in winding the
friction between the barrel head and the great wheel is sufficient to
stop the train, or even run it backwards, injuring the escape wheel
and, of course, destroying the rate of the clock; therefore they are
provided with a device that will prevent such an occurrence.
Ordinary clocks do not have the maintaining power because only the
barrel arbor is reversed in winding, and that reversal is never for
more than half a turn at a time, as the power is thrown back on the
train every time the winder lets go of the key to turn his hand over
for another grip.

Fig. 84.
 Fig. 85.
Figs. 83, 84 and 85 show the various forms of maintaining
powers, which differ only in their mechanical details. In all of them
the maintaining power consists of two ratchet wheels, two clicks and
either one or two springs; the springs vary in shape according to
whether the great wheel is provided with spokes or left with a web.
If the great wheel has spokes the springs are attached on the
outside of the large ratchet wheel so that they will press on opposite
spokes of the great wheel and are either straight, curved or coiled,
according to the taste of the maker of the clock and the amount of
room. If made with a web a circular recess is cut in the great wheel,
see Fig. 83, wide and deep enough for a single coil of spring wire
which has its ends bent at right angles to the plane of the spring
and one end slipped in a hole of the ratchet and the other in a
similar hole in the recess of the great wheel. A circular slot is cut at
some portion of the recess in the great wheel where it will not
interfere with the spring and a screw in the ratchet works back and
forth in this slot, limiting the action of the spring. Stops are also
provided for the spokes of the great wheel in the case of straight,
curved or coiled springs, Figs. 84 and 85. These stops are set so as
to give an angular movement of two or three teeth of the great
wheel in the case of tower clocks and from six to eight teeth in a
regulator. The springs should exert a pressure on the great wheel of
just a little less than the pull of the weight on the barrel; they will
then be compressed all the time the weight is in action, and the
stops will then transmit the power from the large ratchet to the
great wheel, which drives the train. Both the great wheel and the
large ratchet wheel are loose on the arbor, being pinned close to the
barrel, but free to revolve. A smaller ratchet, having its teeth cut in
the reverse direction from those of the larger one, is fast to the end
of the barrel. A click, called the winding click, on the larger ratchet
acts in the teeth of the smaller one during the winding, holding the
two ratchets together at all other times. A longer click, called the
detent click, is pivoted to the clock plate, and drags idly over the
teeth of the larger ratchet while the clock is being driven by the
weight and the maintaining springs are compressed. When the
power is taken off by the reversal of the barrel in winding, the
friction between the sides of the two ratchets and great wheel would
cause them to also turn backward, if it were not for this detent click,
with its end fast to the plate, which drops into the teeth of the large
ratchet and prevents it from turning backward. We now have the
large ratchet held motionless by the detent click on the clock plate
and the compressed springs which are carried between the large
ratchet and the great wheel will then begin to expand, driving the
loose great wheel until their force has been expended, or until
winding is completed, when they will again be compressed by the
pull of the weight. In some tower clocks curved pins are fixed to
opposite spokes of the great wheel and coiled springs are wound
around the pins, Fig. 85; eyes in the large ratchet engage the outer
ends of the pins and compress the springs.
 Fig. 86.
The clicks for maintaining powers should not be short, and the
planting should be done so that lines drawn from the barrel center
to the click points and from the click centers to the points, will form
an obtuse angle, like B, Fig. 86, giving a tendency for the ratchet
tooth to draw the click towards the barrel center. The clicks should
be nicely formed, hardened and tempered and polished all over with
emery. Long, thin springs will be needed to keep the winding clicks
up to the ratchet teeth. The ratchet wheel must run freely on the
barrel arbor, being carried round by the clicks while the clock is
going, and standing still while the weight is being wound up. It is
retained at this time by a long detent click mounted on an arbor
having its pivots fitted to holes in the clock frame. The same remark
as to planting applies to this click as well as the others, and to all
clicks having similar objects; but as this click has its own weight to
cause it to fall no spring is required. To prevent it lying heavily on
the wheel, causing wear, friction and a diminution of driving power, it
is as well to have it made light. There is no absolute utility in fixing
the click to its collet with screws, but if done, it can be taken off to
be polished, and the appearance will be more workmanlike. This
click should have its point hardened and tempered, as there is
considerable wear on it.

Fig. 87.
If the great wheel has spokes the best form for the two springs
for keeping the train going whilst being wound is that of the letter U,
as shown to the left of Fig. 84, one end enlarged for the screw and
steady pin and the blade tapering all along towards the end which is
free. The springs may be made straight and bent to the form while
soft, then hardened and tempered to a full blue. They are best when
as large as the space between two arms of the main wheel will
allow. When screwed on the large ratchet the backs of both should
bear exactly against the respective arms of the mainwheel, and a
pair of pins is put in the ratchet, so that any opposite pair of the
mainwheel arms may rest upon them when the springs are set up by
the clock weight. The strength of the springs can be adjusted by
trial, reducing them till the weight of the clock sets them up easily to
the banking pins.
There are two methods of keeping the loose wheels against the
end of the barrel, while allowing them to turn freely during winding;
one is a sliding plate with a keyhole slot, Fig. 87, to slip in a groove
on the arbor, as is generally adopted in such house clocks as have
fuzees, as well as on the barrels of old-fashioned weight clocks; the
other is a collet exactly the same as on watch fuzees. They are both
sufficiently effective, but perhaps the latter is the best of the two,
because the collet may be fitted on the arbor with a pipe, and being
turned true on the broad inside face, gives a larger and steadier
surface for the mainwheel to work against, whereas the former only
has a small bearing on the shoulder of the small groove in the arbor,
which fitting is liable to wear and allow the main and the other loose
wheel to wobble sideways, displacing the contact with the detent
click and causing the mainwheel to touch the collet of the center
wheel if very near together; so, on the whole, a collet, as on a watch
fuzee, seems the better arrangement, where there is plenty of room
for it on the arbor.
There is an older form of maintaining power which is sometimes
met with in tower clocks and which is sometimes imitated on a small
scale by jewelers who are using a cheap regulator and wish to add a
maintaining power where there is no room between the barrel and
plates for the ratchets and great wheel.
The maintaining power, Fig. 88, consists of a shaft, A, a straight
lever, B, a segment of a pinion, C, a curved, double lever, D, a
weight, E. The shaft, A, slides endwise to engage the teeth of the
pinion segment with the teeth of the great wheel. No. 2, the straight
lever has a handle at both ends to assist in throwing the pinion out
or in and a shield at the outer end to cover the end of the winding
shaft, No. 3, when the key is not on it.
The curved lever is double, and the pinion segment turns loosely
between the halves and on the shaft, A; it is held up in its place by a
light spring, F; the weight, E, is also held between the two halves of
the double lever.
 Fig. 88. Maintaining Power.
The action is as follows: The end of the lever, B, covers the end
of the winding shaft so that it is necessary to raise it before putting
the key on the winding shaft; it is raised till it strikes a stop, and
then pushed in till the pinion segment engages with the going wheel
of the train, when the weight, E, acting through the levers, furnishes
power to drive the clock train while the going weight is being wound
up. Of course the weight on the maintaining power must be so
proportioned to the leverage that it will be equal to the power of the
going barrel and its weight, a simple proposition in mechanics.
The number of teeth on the pinion segment, C, is sufficient to
maintain power for fifteen minutes, at the end of which time the
lever, B, will come down and again cover the end of the winding
shaft; or, it may be pumped out of gear and dropped down. In case
it is forgotten, the spring, F, will allow the segment to pass out of
gear of itself and will simply allow it to give a click as it slips over
each tooth in the going wheel; if this were not provided for, it would
stop the clock.
 CHAPTER XVI.
MOTION WORK AND STRIKING TRAINS.

Motion work is the name given to the wheels and pinions used to
make the hour hand go once around the dial while the minute hand
goes twelve times. Here a few preliminary observations will do much
toward clearing up the operations of the trains. The reader will
recollect that we started at a fixed point in the time train, the center
arbor which must revolve once per hour, and increased this motion
by making the larger wheels drive the smaller (pinions) until we
reached sixty or more revolutions of the escape wheel to one of the
center arbor. This gearing to increase speed is called “gearing up”
and in it the pinions are always driven by the wheels. In the case of
the hour hand we have to obtain a slowing effect and we do so by
making the smaller wheels (pinions) drive the larger ones. This is
called “gearing back” and it is the only place in the clock where this
method of gearing occurs.
We drew attention to a common usage in the gearing up of the
time trains—that of making the relations of the wheels and pinions 8
to one and 7.5 to one; 7.5 × 8 = 60. So we find a like usage in our
motion work, viz., 3 to one and 4 to one; 3 × 4 = 12. Say the
cannon pinion has twelve teeth; then the minute wheel generally
has 36, or three to one, and if the minute wheel pinion has 10, the
hour wheel will have 40, or four to one. Of course, any numbers of
wheels and pinions may be used to obtain the same result, so long
as the teeth of the wheels multiplied together give a product which
is twelve times that of the pinions multiplied together; but three and
four to one have been settled upon, just as the usage in the train
became fixed, and for the same reasons; that is, these proportions
take up the least room and may be made with the least material.
Also, the pinion with the greatest number of teeth, being the larger,
is usually selected as the cannon pinion, as it gives more room to be
bored out to receive the cannon, or pipe. If placed outside the clock
plate, the minute wheel and pinion revolve on a stud in the clock
plate; but if placed between the frames, they are mounted on arbors
like the other wheels. The method of mounting is merely a matter of
convenience in the arrangement of the train and is varied according
to the amount of room in the movement, or convenience in
assembling the movement at the factory, little attention being paid
to other considerations.

Fig. 89. Fig. 90.

The cannon pinion is loose on the center arbor and behind it is a
spring, called the center spring, or “friction,” Figs. 89 and 90, which
is a disc that is squared on the arbor at its center and presses at
three points on its outer edge against the side of the cannon pinion;
or it may be two or three coils of brass wire. This center spring thus
produces friction enough on the cannon to drive it and the hour
hand, while permitting the hands to be turned backward or forward
without interfering with the train. In French mantel clocks the center
spring is dispensed with and a portion of the pipe is thinned and
pressed in so as to produce a friction between the pipe and the
center arbor which is sufficient to drive the hands; this is similar to
the friction of the cannon pinion in a watch.
 Fig. 91.
In some old English house clocks with snail strike, the cannon
pinion and minute wheel have the same number of teeth for
convenience in letting off the striking work by means of the minute
wheel, which thus turns once in an hour. Where this is the case the
hour wheel and its pinion bear a proportion to each other of twelve
to one; usually there is a pinion of six leaves engaging a wheel of 72
teeth, or seven and eighty-four are sometimes found.
In tower clocks, where the striking is not discharged by the
motion work, the cannon pinion is tight on its arbor and the motion
work is similar to that of watches. See Fig. 91.
The cannon pinion drives the minute wheel, which, together with
its pinion, revolves loosely on a stud in the clock plate, or on an
arbor between the frames. The meshing of the minute wheel and
cannon pinion should be as deep as is consistent with perfect
freedom, as should also that of the hour wheel and minute pinion in
order to prevent the hour hand from having too much shake, as the
minute wheel and pinion are loose on the stud and the hour wheel is
loose on the cannon, so that a shallow depthing here will give
considerable back lash, which is especially noticeable when winding.
The hour wheel has a short pipe and runs loosely on the cannon
pinion in ordinary clocks. In quarter-strike cuckoos a different train is
employed and the wheels for the hands are both on a long stud in
the plate and both have pipes; the minute wheel has 32 teeth and
carries four pins on its under side to let off the quarters. The hour
wheel has 64 teeth and works close to the minute wheel, its pipe
surrounding the minute wheel pipe, and held in position by a screw
and nut on the minute pipe. A wheel of 48 and a pinion of 8 teeth
are mounted on the sprocket arbor with a center spring for a
friction, the wheel of 48 meshing with the minute wheel of 32 and
the 8-leaf pinion with the hour wheel of 64. It will be recollected that
the sprocket wheel takes the place of the barrel in this clock and
there is no center arbor as it is commonly understood. The sprocket
arbor in this case turns once in an hour and a half, hence it requires
48 teeth to drive the minute wheel of 32 once in an hour, as it turns
one-third of a revolution (or 16 teeth) every half hour. The sprocket
arbor, turning once in an hour and a half, makes eight revolutions in
twelve hours and its pinion of eight leaves working in the hour wheel
of 64 teeth turns the hour hand once in twelve hours.
In ordinary rack and snail striking work the snail is generally
mounted on the pipe of the hour wheel, so that it will always agree
with the position of the hour hand and the striking will thus be in
harmony with the position of the hands.
Striking Trains.--It is only natural, after finding certain fixed
relations in the calculations of time trains and motion work, that we
should look for a similar point in striking trains, well assured that we
shall find it here also. It is evident that the clock must strike the sum
of the numbers 1, 2, 3, 4, 5, 6, 7, 8, 9, 10, 11, 12, or 78 blows of
the hammer, in striking from noon to midnight; this will be repeated
from midnight to noon, making 156 blows in 24 hours, and if it is a
30-hour clock, six hours more must be added; blows for these will
be 21 more, making a total of 177 blows of the hammer for a 30-
hour strike train. The hammer is raised by pins set in the edge of a
wheel, called the pin wheel, and as one pin must pass the hammer
tail for every blow, it is evident that the number of pins in this wheel
will govern the number of revolutions it must make for 177 blows, so
that here is the base or starting point in our striking train. If there
are 13 pins in the pin wheel, it must revolve 13.5 times for 177
blows; if there are 8 pins, then the wheel must revolve 22.125 times
in giving 177 blows; consequently the pinions and wheels back to
the spring or barrel must be arranged to give the proper number of
revolutions of the pin wheel with a reasonable number of turns of
the spring or weight cord, and it is generally desirable to give the
same, or nearly the same, number of turns to both time and striking
barrels.
If it is an eight-day clock the calculation is a little different. There
are 156 blows every 24 hours; then as the majority of “eight-day”
clocks are really calculated to keep time for seven and a half days,
although they will run eight, we have: 156 × 7.5 = 1,070 blows in
7.5 days. With 13 pins we have 1,070 ÷ 13 = 80 and ⁴⁄₁₃ths
revolutions in the 7.5 days. If now we put an 8-leaf pinion on the pin
wheel arbor and 84 teeth in the great wheel or barrel, we will get
10.5 turns of the pin wheel for every turn of the spring or barrel;
consequently eight turns of the spring will be enough to run the
clock for the required time, as such clocks are wound every seventh
day.
Figuring forward from the pin wheel, we find that we shall have
to lock our striking train after a stated number of blows of the
hammer each hour; these periods increase by regular steps of one
blow every hour, so that we must have our locking mechanism in
position to act after the passage of each pin, whether it is then used
or not; so the pinion that meshes with the pin wheel, and carries the
locking plate or pin on its arbor must make one revolution every
time it passes a pin. If this is a 6-leaf pinion, the pins on the pin
wheel must therefore be 6 teeth apart; or an 8-leaf pinion must have
the pins 8 teeth apart; and vice versa. For greater convenience in
registering, the pins are set in a radial line with the spaces of the
teeth in the pin wheel, as this allows us to measure from the center
of the pinion leaf.
It will thus be seen that the calculation of an hour striking train is
a simple matter; but if half hours are also to be struck from the
train, it will change these calculations. For a 30-hour train 24 must
be added to the 156 blows for 24 hours, 180 blows being required to
strike hours and half hours for 24 hours. These blows may be
provided for by more turns of the spring, or different numbers of the
wheels and pinions, which would then also vary the spacing of the
pins.
Half hours may also be struck directly from the center arbor, by
putting an extra hammer tail on the hammer arbor, further back,
where it will not interfere with the hammer tail for the pin wheel,
and putting a cam on the center arbor to operate this second
hammer tail. This simplifies the train, as it enables the use of a
shorter spring or smaller wheels while providing a cheap and certain
means of striking the half hours. Half-hour trains are frequently
provided with a separate bell of different tone for the half hours, as
with only one bell the clock strikes one blow at 12:30, 1 and 1:30,
making the time a matter of doubt to one who listens without
looking, as frequently happens in the night.
 Fig. 92. Eight Day Hour and Half Hour Strike.
Fig. 92 shows an eight-day, Seth Thomas movement, which
strikes the hours on a count wheel train and the half hours from the
center arbor. All the wheels, pinions, arbors, pins, levers and hooks
are correctly shown in proper position, but the front plate has been
left off for greater clearness. The reader will therefore be required to
remember that the escape wheel, pallets, crutch, pendulum and the
stud for the pendulum suspension are really fixed to the front plate,
while in the drawing they have no visible means of support, because
the plate is left off.
 The time train occupies the right-hand side of the movement and
the striking train the left hand. Running up the right-hand from the
spring to the escape wheel, we find an extra wheel and pinion which
is provided to secure the eight days’ run. We also see that what
would ordinarily be the center arbor is up in the right corner and
does not carry the hands; further, the train is bent over at a right
angle, in order to save space and get the escape wheel in the center
at the top of the movement. The striking train is also crowded down
out of a straight line, the locking cam being to the right of the pin
wheel and the warning wheel and fly as close to the center as
possible. This leaves some space between the pin wheel and the
intermediate wheel of the time train and here we find our center
arbor, driven from the intermediate wheel by an extra pinion on the
minute wheel arbor, the minute wheel meshing with the cannon
pinion on the center arbor. This rearranging of trains to save space is
frequently done and often shows considerable ingenuity and skill; it
also will many times serve to identify the maker of a movement
when its origin is a matter of doubt and we need some material, so
that the planting of trains is not only a matter of interest, but should
be studied, as familiarity with the methods of various factories is
frequently of service to the watchmaker.
Fig. 93 is the upper portion of the same striking train, drawn to a
larger scale for the sake of clearness. It also shows the center arbor,
both hammer tails and the stop on the hammer arbor, which strikes
against the bottom of the front plate to prevent the hammer-spring
from throwing the hammer out of reach of the pins. The pin wheel,
R, and count wheel, E, are mounted close together and are about
the same size, so that they are shown broken away for a part of
their circumferences for greater clearness in explaining the action of
the locking hook, C, and the locking cam, D.
Fig. 94 shows the same parts in the striking position, being
shown as just about to strike the last blow of 12. Similar parts have
similar letters in both figures.
 The count wheel, E, is loose on a stud in the plate, concentric
with the arbor of the pin wheel, R. The pivot of R runs through this
stud. The sole office of the count wheel is to regulate the distance to
which the locking hook C, is allowed to fall. The count hook, A, and
the locking hook, C, are mounted on the same arbor, B, so that they
move in unison. If A is allowed to fall into a deep slot of the count
wheel, C will fall far enough to engage the locking face of the cam D
and stop the train, as in Fig. 93. If, on the contrary, A drops on the
rim of the wheel, C will be held out of the locking position as D
comes around (see Fig. 94), and the train will keep on running. It
will be seen that after passing the locking notch, D, Fig. 94, will in its
turn raise the hook C, which will ride on the edge of D, and hold A
clear of the count wheel until the locking notch of D is again
reached, when a deep notch in the wheel will allow C to catch, as in
Fig. 93, unless C is stopped by A falling on the rim of the wheel, as
in Fig. 94.
Fig. 93. Upper Portion of Striking Train Locked.
 Fig. 94. Striking Train Unlocked and Running.
One leaf, F, of the pinion of the locking arbor sticks out far
enough to engage with the count wheel teeth and rotate the wheel
one tooth for each revolution of D, so that F forms a one-leaf pinion
similar to that of a rack striking train. Here we have our counting
mechanism; F and D go around together; F moves E one tooth every
revolution. A holds C out of action (Fig. 94) until A reaches a deep
slot, when C stops the train by engaging D (Fig. 93).
The count wheel, E, must have friction enough on its stud so that
it will stay where the pin F leaves it, when F goes out of action and
thus it will be in the right position to suitably engage F on the next
Welcome to Our Bookstore - The Ultimate Destination for Book Lovers
Are you passionate about books and eager to explore new worlds of
knowledge? At our website, we offer a vast collection of books that
cater to every interest and age group. From classic literature to
specialized publications, self-help books, and children’s stories, we
have it all! Each book is a gateway to new adventures, helping you
expand your knowledge and nourish your soul
Experience Convenient and Enjoyable Book Shopping Our website is more
than just an online bookstore—it’s a bridge connecting readers to the
timeless values of culture and wisdom. With a sleek and user-friendly
interface and a smart search system, you can find your favorite books
quickly and easily. Enjoy special promotions, fast home delivery, and
a seamless shopping experience that saves you time and enhances your
love for reading.
Let us accompany you on the journey of exploring knowledge and
personal growth!

ebookgate.com