Four topics are reviewed in separate discussions. The topics are as follows: (a) psychological theories - institutional and agency factors; (b) the over-reaction and under-reaction hypothesis; (c) long-term excess stock market volatility and stock market bubbles; and (d) momentum patterns.
Psychological Theories - Institutional & Agency Factors
Behavioural finance provides psychological explanations of investor behaviours. Behavioural finance specifically challenges the mainstream assumption of financial theory that investor behaviour is characterized by extreme rationality. Thaler stated that some financial phenomena can be plausibly understood using models in which the behaviours of some agents are not fully rational.
Several psychological behaviours are associated with financial agents by behavioural finance theorists. Barberis and Thaler categorized these psychological motivations for investor behavior as (a) beliefs and (b) preferences. The relevant beliefs and preferences are as follows:
Overconfidence on the part of investors: evidence indicates that investors overestimate the probability of occurrence of outcomes they believe to be likely, while underestimating the probability of occurrence of outcomes they believe to be unlikely; additionally, investors hold an irrational belief related to the accuracy of their assessments
Unsupportable optimism (wishful thinking: Evidence indicates that most investors have unrealistic perceptions of their own abilities and judgment
Representativeness: evidence indicates that most investors are unable to adequately differentiate between data that are or are not relevant to their investment assessments
Conservatism: evidence indicates that investors the inability of most investors to differentiate between relevant and irrelevant data (representativeness) is aggravated by an innate conservatism that over-values that which they believe to be correct and under-values tha...