A Technical Approach

Behavioral Finance shares the same basic focus as the Keynesian idea of Castles in the Air.

Behavioral Finance seeks to understand the volatility of the Stock Market from several psychological and sociological standpoints.

The Efficiency Market and the Development of Behavioral Finance

The Efficient Markets Theory, which had its greatest dominance around the 1970s, focussed heavily on rational expectations, similar to the Fundamental Approach discussed earlier. This model assumed that "speculative asset prices such as stock prices always incorporate the best information about fundamental values and that prices change only because of good, sensible information meshed very well with theoretical trends of the time." (Shiller, October 2002)

This, idea, of course, gave a sense of forecastability in the stock market and in consumption. (If everyone made completely rational decisions with the best information available, this would give economists a much clearer view of how the financial world works). However, there have been quite a number of anomalies in the model when compared to actual data.

Robert J. Shiller, a famous economist at Yale University and Author of the Best Seller, "Irrational Exuberance," has studied these anomalies in great detail. In Shiller's work on stock markets, the anomalies found gave rise to a notion of excess volatility in the stock market which placed the efficient market theory on rather shaky ground. Shiller's focus in his original work was on the relationship between dividends and stock prices. However, he found that stock prices had more volatility than an efficiency model could explain.

Shiller thus began to turn away from econometric analysis of trends in the stock market towards a more Keynesian, psychological approach.

He discusses some of the ideas in this approach in his 1997 paper on "Human Behavior and the Efficiency of the Financial System.

• Prospect Theory

• Regret and Cognitive Dissonance

• Anchoring

• Mental Compartments

• Overconfidence

Other psychological factors that may affect investor decisions include "The Disjunction Effect, Gambling Behavior and Speculation, Magical and Quasi-Magical Thinking, Culture and Social Contagion, and The Global Culture." (Shiller 1997)