Chapter 8. Behavioral Finance

JARROD W. WILCOX, PhD, CFA

President, Wilcox Investment Inc.

Abstract: Studies in individual and social psychology have amply demonstrated that investors are nothing like the idealized representative utility-based investor posited by equilibrium-based closed-form models of mathematical finance. The field of behavioral finance documents specific biases and attempts to link them to empirically observed pricing anomalies and expected return differences. These findings are supplemented by experiments in simple laboratory markets and with computer-based populations of artificial agents that demonstrate the emergence of opposing populations of thought that can produce efficient equilibria or in contrast, violent price swings and bursts of volatility characteristic of speculative bubbles. Detailed knowledge of both sets of mechanisms can be helpful in constructing active investment strategies.

Keywords: behavioral finance, satisficing, heuristics, stereotypes, representativeness, availability, anchoring, framing, cognitive dissonance, experimental economics, group norms, artificial markets, pricing anomalies, active investing

This chapter describes behavioral factors that affect investment decision making and resulting markets. It also briefly notes how a knowledge of their effects can help us be better investors.

THE MARKET AS A COLLECTION OF INDIVIDUAL BEHAVIORS

In 1986, the Journal of Business published a collection of papers presented at a conference titled ...

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