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The Implications of Behavioural Finance for the Modelling of Securities Prices

Much of the traditional economic and financial modelling is based on the assumption that individuals act rationally, processing all available information in their decision-making process. However, research conducted on the ways that human beings arrive at decisions and choices when faced with uncertainty has uncovered that this is not precisely the case. People often make systematic errors, the so-called cognitive biases, which lead them to less rational behaviour than the classical economic paradigm assumes. These cognitive biases have been found to be responsible for various irregular phenomena often observed in financial markets (turbulence, predictable trends, seasonable cycles, “bubbles”, etc). Behavioural finance attempts to merge concepts from financial economics and cognitive psychology in an attempt to better understand how the systematic biases in the decision-making process of financial agents influence prices and other dimensions of financial markets. This paper reviews some results from the behavioural finance or related literature. We argue that the findings of behavioural finance often suggest a new approach to the modelling of securities prices and other financial phenomena.