Investor Behavior: The Psychology of Financial Planning and Investing

CHAPTER 19

Emotions in the Financial Markets

Richard Fairchild

Senior Lecturer in Corporate Finance, School of Management, University of Bath

INTRODUCTION

Traditionally, research in finance has been based on the assumption of homo economicus—the rational choice model that assumes investors are completely rational, balanced, emotionless, self-interested maximizers of expected utility with stable preferences. The traditional approach also assumes that investors are a homogeneous group with identical information sets and expectations. This standard perspective resulted in the development of Markowitz' portfolio theory, the capital asset pricing model (CAPM), and the efficient market hypothesis (EMH), among others.

During the last 20 years, behavioral finance arose as a response to observed anomalies in the financial market, which were inconsistent with the traditional paradigm (Ricciardi and Simon 2000; Barberis and Thaler, 2002). Particularly, the EMH has come under increasing scrutiny amid growing evidence that market values often diverge dramatically from fundamentals and volatility is excessive. Furthermore, according to the EMH, stock prices follow a random walk. In the real world, financial markets exhibit patterns with short-run momentum and long-run reversals (De Bondt and Thaler 1985, 1987). This suggests that carefully devised trading strategies at times beat the market in contrast to the efficient market.

In contrast to the traditional homo economicus view, behavioral ...