Behavioral economics and the related field, behavioral finance, study the effects of social, cognitive, and emotional factors on the economic decisions of individuals and institutions and the consequences for market prices, returns, and the resource allocation. The fields are primarily concerned with the bounds of rationality of economic agents. Behavioral models typically integrate insights from psychology with neo-classical economic theory. In so doing they cover a range of concepts, methods, and fields. Behavioral analysts are not only concerned with the effects of market decisions but also with public choice, which describes another source of economic decisions with related biases towards promoting self-interest. There are three prevalent themes in behavioral finances:
• Heuristics: People often make decisions based on approximate rules of thumb and not strict logic. • Framing: The collection of anecdotes and stereotypes that make up the mental emotional filters individuals rely on to understand and respond to events.
• Market inefficiencies: These include mis-pricings and non-rational decision making.
Issues in behavioral economics
The central issue in behavioral finance is explaining why market participants make systematic errors. Such errors affect prices and returns, creating market inefficiencies. It also investigates how other participants take advantage (arbitrage) of such market inefficiencies.
Behavioral finance highlights inefficiencies such as under- or over-reactions to information as causes of market trends (and in extreme cases of bubbles and crashes). Such reactions have been attributed to limited investor attention, overconfidence, overoptimism, mimicry (herding instinct) and noise trading. Technical analysts consider behavioral finance, behavioral economics' academic cousin, to be the theoretical basis for technical analysis. Other key observations include the asymmetry between decisions to acquire or keep resources, known as the "bird in the bush" paradox, and loss aversion, the unwillingness to let go of a valued possession. Loss aversion appears to manifest itself in investor behavior as a reluctance to sell shares or other equity, if doing so would result in a nominal loss. It may also help explain why housing prices rarely/slowly decline to market clearing levels during periods of low demand.
Benartzi and Thaler (1995), applying a version of prospect theory, claim to have solved the equity premium puzzle, something conventional finance models have been unable to do so far. Experimental finance applies the experimental method, e.g. creating an artificial market by some kind of simulation software to study people's decision-making process and behavior in financial markets.
Quantitative behavioral finance
Quantitative behavioral finance uses mathematical and statistical methodology to understand behavioral biases. In marketing research, a study shows little evidence that escalating biases impact marketing decisions. Leading contributors include Gunduz Caginalp (Editor of the Journal of Behavioral Finance from 2001–2004) and collaborators including 2002 Nobelist Vernon Smith, David Porter, Don Balenovich, Vladimira Ilieva and Ahmet Duran, and Ray Sturm.
Some financial models used in money management and asset valuation incorporate behavioral finance parameters, for example:
• Thaler's model of price reactions to information, with three phases, underreaction-adjustment-overreaction, creating a price trend
One characteristic of overreaction is that average returns following announcements of good news is lower than following bad news. In other words, overreaction occurs if the market reacts too strongly or for too long to news, thus requiring adjustment in the opposite direction. As a result, outperforming assets in one period are likely to...