Behavioral Finance

Better Essays
Behavioral Finance
Jay R. Ritter
Cordell Professor of Finance
University of Florida
P.O. Box 117168
Gainesville FL 32611-7168
(352) 846-2837

Published, with minor modifications, in the
Pacific-Basin Finance Journal Vol. 11, No. 4, (September 2003) pp. 429-437.

This article provides a brief introduction to behavioral finance. Behavioral finance encompasses research that drops the traditional assumptions of expected utility maximization with rational investors in efficient markets. The two building blocks of behavioral finance are cognitive psychology (how people think) and the limits to arbitrage (when markets will be inefficient).
The growth of behavioral
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This is especially true when one is dealing with a large market, such as the Japanese stock market in the late 1980s or the U.S. market for technology stocks in the late 1990s. Arbitrageurs that attempted to short Japanese stocks in mid1987 and hedge by going long in U.S. stocks were right in the long run, but they lost huge amounts of money in October 1987 when the U.S. market crashed by more than the Japanese market (because of Japanese government intervention). If the arbitrageurs have limited funds, they would be forced to cover their positions just when the relative misvaluations were greatest, resulting in additional buying pressure for Japanese stocks just when they were most overvalued!
2. Cognitive Biases
Cognitive psychologists have documented many patterns regarding how people behave.
Some of these patterns are as follows:
Heuristics, or rules of thumb, make decision-making easier. But they can sometimes lead to biases, especially when things change. These can lead to suboptimal investment decisions.
When faced with N choices for how to invest retirement money, many people allocate using the
1/N rule. If there are three funds, one-third goes into each. If two are stock funds, two-thirds goes into equities. If one of the three
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