Erasmus Centre for Behavioural Finance

Erasmus Centre for Behavioural Finance

There has been a shift of paradigm in the financial economics literature over the past decades. Whereas financial decision making has been characterized under the normative assumption of full rationality since the 1970’s, we now observe a more positive approach. Studies have shown, for example, that individuals’ preferences are best described by prospect theory, and not by the (neo) classical assumption of expected utility theory. In addition, market participants are shown not to have perfect foresight, but to make systematic errors in expectation formation. 

The assumption of individual rationality aggregates to the “Efficient Market Hypothesis” (EMH) at the market level. Here as well, a large number of deviations from the normative EMH has been found that is difficult to explain within the neoclassical framework. For example, value stocks outperform growth stocks, and January remains the best month to invest in terms of expected return. The question that remains open is how the individual behaviour leads to patterns we observe at the market level.



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