Behavioral Finance for Private Banking, 2nd Edition

CHAPTER 1Introduction

Behavioral finance is an interdisciplinary research area that combines insights from psychology with finance to better understand investors' behavior and asset prices. It has managed to bridge the gap between theory and practice. Moreover, the psychological research that behavioral finance is based on recently got a foundation in biological differences found in the brain.

Traditional finance has focused on the ideal scenario of thoroughly rational investors in efficient markets. According to this standard paradigm in finance, individuals rationally search for information and know all available actions that serve their preferences. The latter are stable over time and robust to the occurrence of unanticipated events. As a result, rational investors searching for superior returns detect and eliminate any predictability in the asset prices—the market is efficient. According to traditional finance, the market remains efficient even if some investors behave irrationally. Indeed, rational investors will detect any mispricing generated by irrational investors and exploit it with the use of arbitrage strategies, which are assumed to be unlimited.¹ Consequently, any mispricing will very quickly be corrected, irrational investors will be driven out of the market, and the market will again quickly become efficient. A statistical consequence of prices being unpredictable is that returns are (log)‐normally distributed—which is the content of the central limit theorem—a ...