Behavioral Economics For Dummies®

Chapter 15

Deciphering Behavioral Finance

In This Chapter

Defining behavioral finance

Exploring efficient markets

Introducing irrational exuberance

Examining bubbles and busts as a preface to inefficient markets

The conventional finance point of view assumes that financial markets are efficient — asset prices (the prices of bonds and stocks, for example) reflect the fundamental economic values (the nuts and bolts of the real-world economy) that they represent. It also assumes that individuals typically behave in a manner that’s consistent with asset prices, reflecting their fundamental values. Only this type if behavior is considered to be rational.

Behavioral finance challenges this perspective, arguing that asset prices don’t necessarily reflect the fundamentals in financial markets and, therefore, can be highly inefficient, with asset prices persistently deviating from their fundamental values. This can be reflected in booms and busts.

In this chapter, I discuss how financial markets can be inefficient and how such inefficiency can be a product of what some behavioral economists ...