Behavioural finance has since the 1980s emerged as a new paradigm within finance. On the one hand, it rejects crucial tenets of mainstream finance such as the Efficient Market Hypothesis (EMH) 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 (EU) framework. It proposes e.g. a prospect theory framework as an alternative to model investor preferences.
On the other hand, it identifies market anomalies or regularities that are at odds with the EMH. These include profitability of momentum, reversals, and value strategies, stock market bubbles and crashes, abnormal returns to non-risk factors, delayed reaction to financial news such as earnings announcements, and overreaction and eventual corrections to measures of media tone and attention amongst others.
Behavioural finance uses ideas from psychology and aspects of limits to arbitrage to explain these. 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, mental accounting, representativeness, emotions, etc., and limits to arbitrage give us a better understanding of financial markets and the trading strategies of investors. 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.