David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

12.6 Efficient asset markets
II
Behavioural
Behavioural finance
finance is the study of the influence of psychology on the behaviour of financial
practitioners and the subsequent effect on markets.
'People make barmy decisions about the future. The evidence is all around, from their investments in
the stock.markets to the way their run their businesses. In fact, people are consistently bad at dealing
with uncertainty, underestimating some kinds of risk and overestimating others.
Daniel Kahneman, now a professor at Princeton, noticed as a young research psychologist in the 1960s
that the logic of decision science was hard for people to accept. [ . .. ] In the past decade the fields of
behavioural finance and behavioural economics have blossomed, and in 2002 Mr Kahneman shared
a Nobel prize in economics for his work:
(The Economist, 22 January 2004)
So far, the economics that we have examined assumes that people are completely rational and that the cost of
acquiring information is either free or can be modelled in simple ways. This leads to an incredibly powerful
set of economic tools that help us understand many complicated situations. But it is not the whole story. Here
is a glimpse of how we could complicate our analysis.
Suppose there is a fixed cost of either acquiring information or of taking the time to make a decision. This
leads to 'bounded rationality: It is no longer optimal to examine every possible decision in great detail - you
would incur too many fixed costs - so instead you incur costs once, have a good think, and then come up with
a simple decision rule that you implement automatically until it no longer fits the facts, at which point you
incur some more thinking costs and try to improve your rule. Simple rules may explain why people extrapolate
the recent past rather than conduct extensive research all the time.
Such behavioural rules are a large part of the concern of psychologists, who have conducted a lot of empirical
research on how accurate these rules are. Often, people err in systematic ways, over time because they have
not updated their old rules, and across people because they are using similar short cuts that are making the
same mistake. For example, most people's optimism rises the longer the time horizon. Forty per cent of
Americans think they will some day be in the top 1 per cent of income earners! Recently, economists have
applied these ideas to financial markets, in the search for systematic mistakes in asset pricing.
One reason that economists have been sceptical about applications that make use of departures from full
rationality is that there is only one way to be rational but a million ways in which to be irrational. Anyone can
explain a particular event by invoking a particular kind of irrationality - it then takes a lot of data to establish
whether there is anything systematic in this irrationality or whether it was just a coincidence invoked by
someone trying to be wise after the event.
Thus one interpretation of why some investors do better than others is pure chance. This story could even
explain why some investors have above-average returns for several years in a row. Even with a fair coin there
is roughly one chance in a thousand of tossing ten consecutive heads. Even if there is no systematic way to
beat the market, there are thousands of investors, and someone is going to have a lucky streak for ten years.
But there is also a more subtle interpretation. When a piece of new information first becomes available,
someone has to decide how share prices should be adjusted. The price does not change by magic. And there
is an incentive to be quick off the mark. The first person to get the information, or to calculate correctly
where the market will soon be setting the price, may be able to buy a share just before everyone else catches
on and the share's price rises.
The non-specialist investor cannot use past information to make above-average profits. But specialist
investors, by reacting very quickly, can make capital gains or avoid capital losses within the first few hours
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