Behavioral Finance and Bubbles
Real investors are not perfectly rational. Overconfidence, loss aversion, and herding can push prices away from fundamentals, and limits to arbitrage let the mispricing persist. Behavioral finance explains the bubbles and crashes that a pure efficient-markets view struggles with.
Why it matters
If betting against a crowd is costly and risky, smart money cannot always correct an error quickly. Sentiment can then drive prices for a long stretch before the correction arrives.
Worked examples
During the dot-com boom, internet stocks traded far above any reasonable valuation. How does behavioral finance read this?
Optimism and herding fed on each other while short-selling the bubble was risky and expensive. Prices detached from fundamentals until sentiment turned and the market crashed.
Common mistakes
- ✗Behavioral finance disproves the efficient markets hypothesis. It documents systematic anomalies and episodes where prices detach from fundamentals, yet markets are still hard to beat consistently.
- ✗Known biases are an easy way to make money. Limits to arbitrage make betting against mispricing risky, so the biases are not a free lunch.
Revision bullets
- •Investors show overconfidence, loss aversion, and herding
- •Limits to arbitrage let mispricing persist
- •Explains bubbles and crashes
- •Markets are still hard to beat
Quick check
Why can mispricing from investor biases persist instead of being arbitraged away?
Connected topics
Sources
- Mishkin (2018), Ch. 7Mishkin, F. S. The Economics of Money, Banking, and Financial Markets. 12th ed. Pearson, 2018. ISBN 978-1-292-26885-9.Behavioral finance, limits to arbitrage, and departures from the efficient markets hypothesis.