Behavioral Finance: Investor Psychology, Cognitive Biases, and Market Mispricing

Abstract

Behavioral finance integrates insights from psychology into finance, relaxing the assumption of full rationality to explain asset pricing patterns that are inconsistent with efficient market predictions. Two foundational pillars support behavioral finance: (1) investor psychology—systematic cognitive biases and heuristics that cause investors to make predictably irrational decisions; and (2) limits to arbitrage—structural and institutional barriers that prevent rational arbitrageurs from fully exploiting and eliminating mispricing. Kahneman and Tversky’s (1979) Prospect Theory, published in Econometrica (47(2): 263–292), provided the psychological foundation by demonstrating that decisions under uncertainty systematically deviate from expected utility maximization, with loss aversion, probability weighting, and reference dependence all implying behavior inconsistent with rational investor models. This paper reviews the behavioral finance literature, examining key psychological biases and their financial market implications, limits to arbitrage that allow mispricing to persist, and the integration of behavioral insights into asset pricing models.