The Rise and Rise of Behavioural Finance

Abstract

Behavioural finance discards the assumptions of rational- ity and fair pricing, seeking to explain observed behaviour in finan- cial markets by using the principles of psychology. Irrationality can be attributed to behavioural biases, which are either cognitive or emo- tional, both of which can lead to poor and irrational financial decisions. Kahneman and Tversky provided the early psychological theories that constitute the foundation of behavioural finance, and they also devel- oped prospect theory that explains loss aversion. Irrationality is readily observable when, for example, people gamble against the odds or accept higher risk for lower return. Behavioural finance seeks to explain irra- tionality and the presence of market anomalies such as the calendar effects and profitable trading.