Lesson 7 of 7 · 14 min
Behavioural finance and market efficiency
Behavioural finance uses investors' biases (loss aversion, herding, overconfidence, information cascades and others) to explain some anomalies, but markets can still be efficient as long as the market as a whole is rational and nobody can consistently beat it on a risk-adjusted basis.
In short
- Behavioural finance studies how people actually decide, without assuming they use all information, maximise utility and update beliefs by Bayes' formula. Biases are offered as explanations of anomalies.
- Efficiency requires only that the market is rational, not every individual: others spot irrational trades and act against them.
- Loss aversion: losses hurt more than equal gains please (an asymmetric dislike of risk). It can explain overreaction, but underreaction is just as common.
- Herding (trading together, ignoring one's own information) can cause under- or overreaction. Overconfidence causes temporary mispricing, mainly in higher-growth companies.
- Information cascades: early movers' decisions are imitated. They can be rational and improve efficiency, or lead to overreaction; they are stronger when information quality is poor.
- Whether markets are efficient depends on the definition: if rational investors are required, no; if it means no one can consistently beat the market risk-adjusted, the evidence says yes.
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