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The Theory of Judgment and its Application to Behavioral Finance

Returns of stock prices often exhibit cycles of momentum and reversal. During various phases of the cycles, trading volumes and trading behaviors of investors of different sizes often show distinct characteristics. It has been a long standing challenge to describe the multiple patterns simultaneously from a quantitative theory. In this paper, we present the theory of judgment, which provides a common framework to integrate behavioral and informational theories of investment. The theory of judgment provides a quantitative link between investors’ judgment and their trading activities. As an application, a simple mathematical model based on the theory of judgment is constructed. The predictions derived from the model are consistent with the multiple empirical patterns of trading volumes and investor activities at the different phases of the cycle of momentum and reversal.