Behavioural Finance

Behavioural Finance
Martin Sewell
University of Cambridge

February 2007 (revised April 2010)
Abstract An introduction to behavioural finance, including a review of the major works and a summary of important heuristics.

1

Introduction

Behavioural finance is the study of the influence of psychology on the behaviour of financial practitioners and the subsequent effect on markets. Behavioural finance is of interest because it helps explain why and how markets might be inefficient. For more information on behavioural finance, see Sewell (2001).

2

History

Back in 1896, Gustave le Bon wrote The Crowd: A Study of the Popular Mind, one of the greatest and most influential books of social psychology ever written (le Bon 1896). Selden (1912) wrote Psychology of the Stock Market. He based the book ‘upon the belief that the movements of prices on the exchanges are dependent to a very considerable degree on the mental attitude of the investing and trading public’. In 1956 the US psychologist Leon Festinger introduced a new concept in social psychology: the theory of cognitive dissonance (Festinger, Riecken and Schachter 1956). When two simultaneously held cognitions are inconsistent, this will produce a state of cognitive dissonance. Because the experience of dissonance is unpleasant, the person will strive to reduce it by changing their beliefs. Pratt (1964) considers utility functions, risk aversion and also risks considered as a proportion of total assets. Tversky and Kahneman (1973) introduced the availability heuristic: ‘a judgmental heuristic in which a person evaluates the frequency of classes or the probability of events by availability, i.e. by the ease with which relevant instances come to mind.’ The reliance on the availability heuristic leads to systematic biases. 1

In 1974, two brilliant psychologists, Amos Tversky and Daniel Kahneman, described three heuristics that are employed when making judgments under uncertainty (Tversky and Kahneman 1974):

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