Background
Traditional finance relies on rational investors and the efficient market hypothesis. Recurring bubbles, crashes and overreaction led researchers to bring in psychology, building on cognitive psychology.
Prospect theory and loss aversion
Kahneman and Tversky's prospect theory (1979) holds that people judge outcomes as gains or losses relative to a reference point and feel losses about twice as strongly as equal gains.
Common biases
- Overconfidence: overrating one's information leads to excessive trading.
- Disposition effect: selling winners too early and holding losers too long.
- Mental accounting: treating money differently by mental category.
- Herding: following others, which can inflate bubbles.
- Anchoring: judgments tied to an initial price.
Limits to arbitrage
Risk and costs can stop rational traders from correcting mispricing, so biases can persist in market prices.
References
- Kahneman, D., & Tversky, A. (1979). Prospect theory: An analysis of decision under risk. Econometrica, 47(2), 263-291.
- Shefrin, H., & Statman, M. (1985). The disposition to sell winners too early and ride losers too long. Journal of Finance, 40(3), 777-790.
- Barberis, N., & Thaler, R. (2003). A survey of behavioral finance. In Handbook of the Economics of Finance (Vol. 1, pp. 1053-1128). Elsevier.
- Shiller, R. J. (2000). Irrational Exuberance. Princeton University Press.