Behavioural finance has since the 1980s emerged as a new paradigm within finance. It rejects crucial tenets of mainstream finance such as the Efficient Market Hypothesis on the basis that agents are less than fully rational and that arbitrage fails to eliminate mispricing. It posits that people misapply Bayes’ law and deviate from the traditional expected utility framework.
In this module, we will discuss psychological concepts and ideas most relevant to financial applications while at the same time emphasising the deviations from rational beliefs and rational preferences, and show how allowing for common human traits such as overconfidence, loss aversion, conservatism, anchoring, framing, representativeness, emotions, etc., and for limits to arbitrage provide a better understanding of financial markets and financial puzzles. We will consider applications in the context of the aggregate stock market, the cross-section of average returns, investor trading behaviour, financing and investment decisions of firms, savings behaviour, and behavioural investing amongst others.