Standard asset pricing theory — the CAPM, the APT — assumes investors are rational expected-utility maximisers. The anomalies documented in the previous lesson — momentum, post-earnings-announcement drift, long-run overreaction, the disposition effect — are hard to explain under this assumption. Behavioural finance offers an alternative: investors make predictable, systematic errors in how they process information and evaluate outcomes.
The field draws on cognitive psychology, primarily the research programme of Daniel Kahneman and Amos Tversky. Kahneman received the Nobel Prize in Economics in 2002 for this work. The central contribution is Prospect Theory (Kahneman and Tversky 1979), which replaces the standard utility function with a model that captures observed human behaviour under risk — including loss aversion, reference dependence, and the asymmetric weighting of gains versus losses.
This note covers the psychological foundations: the investor biases that have been documented, their theoretical basis, and the empirical evidence for them. The next lesson translates these biases into formal asset pricing models and connects them to the observed anomalies.
Learning objectives. By the end of this note you should be able to:
- describe the Prospect Theory value function (S-shape, reference dependence, loss aversion) and contrast it with expected utility theory;
- explain the disposition effect and connect it mechanically to Prospect Theory;
- define and distinguish: representativeness, anchoring, availability, and overconfidence;
- describe cognitive dissonance, mental accounting, and the diversification heuristic;
- state the two key unresolved problems with behavioural models in asset pricing.
In this lesson
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- Prospect Theory
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- The disposition effect
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- Cognitive heuristics (Kahneman and Tversky)
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- Further documented biases
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- Two unresolved problems in behavioural asset pricing
Before you start
The full lesson, with worked examples and exercise solutions, is for members.
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