The field of behavioral finance uses a broad social science perspective to study the behavior of financial markets. Methods that originate in psychology are used as research tools, along with traditional finance research methods.

Research in behavioral finance is relatively new: it took place mostly since 1985. The workshop in behavioral finance has continued under the direction of Robert J. Shiller and Richard H. Thaler at the NBER since 1991. Over these years, we have seen the blossoming of behavioral finance into a significant body of knowledge.

The research methods in finance most in use before the advent of behavioral finance did not then seem to lend themselves to the application of psychology. Models of individual optimization were almost exclusively based on the assumption of perfectly rational individual behavior. Many of the predictions of these models were described as representing the notion that financial markets were “efficient,” that is, that prices in financial markets accurately incorporate all publicly available information. Studies of the efficiency of financial markets often reported apparent contradictions of efficient markets in the literature, but, before the development of the theory of behavioral finance, their results were hard to interpret, there being at that time no well-delineated alternative hypothesis to compare with the efficient markets hypothesis.

A substantial share of the research that has been presented at the behavioral finance workshop since its beginnings has been at work in developing alternative theoretical approaches to the study of financial markets. Such theoretical research has taken great impetus from the prospect theory of Daniel Kahneman and Amos Tversky, which was first published in 1979.

Prospect theory offered the first significant alternative to the expected utility paradigm that dominated research in finance until then. Prospect theory was based on experimental evidence about human behavior under uncertainty, and was built up to fit the evidence rather than embody an abstract sense of rationality. Prospect theory relies on evidence that when making economic decisions people are easily influenced by framing, that is by the context and ambience that accompany the decision problem. Part of this context is generated by the people themselves, as when they adopt arbitrary mental accounting of their financial circumstances.

Many papers presented at the Workshop in Behavioral Finance are in the realm of clarifying the relevance of prospect theory and its associated issue of framing to financial market phenomena. For example, we have seen studies that use prospect theory to help us to understand the reasons for the apparent excess volatility of certain speculative asset prices, for the momentum that is often seen in these prices, as well as for the mean reversion that is often seen in these prices. Applying the psychological theory to such phenomena gives us a sense when to expect excess volatility, momentum or mean reversion, and when not.

Source: Robert Shiller's Workshop in Behavioral Finance (for more information, click the link)