Expected Returns: An Investor's Guide to Harvesting Market Rewards

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Behavioral finance

• Behavioral finance states that investor irrationality causes systematic mispricings that rational arbitrageurs cannot fully offset due to scarce capital and riskiness of “arbitrage”.

• Irrationality reflects biased beliefs (heuristic shortcuts, such as representativeness and conservatism, and self-deception, such as overconfidence and hindsight) as well as nonclassical preferences (loss aversion, narrow framing, overweighting low-probability events, etc.).

• Behavioral finance literature is fun and offers stories for most observed empirical anomalies, perhaps too easily.

• The best known market-level mispricings are speculative bubbles—related to extrapolative expectations, overconfidence, and herding. The best known relative mispricings are value and momentum effects. There is an alternative rational explanation for each of these—and it is often impossible to discriminate empirically between the rational and irrational alternatives.

• Behavioral finance is often used as justification for active management. Yet, the limits-to-arbitrage literature stresses how difficult it is to exploit mispricings over any sustained time period.

Behavioral finance rests on two pillars:

(i) Some investors are irrational. Their biased beliefs and preferences influence their demand for assets and can move market prices, causing mispricings.

(ii) Various limits to arbitrage prevent rational arbitrageurs from fully offsetting the impact that such irrational investors have on market ...