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COPYRIGHT NOTICE: Edited by Richard H. Thaler: Advances in Behavioral Finance, Volume II - page 13 / 23





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only would arbitrageurs face noise trader risk in trying to correct the mis- pricing, but fundamental risk as well, not to mention implementation costs.

3. Psychology

The theory of limited arbitrage shows that if irrational traders cause devia- tions from fundamental value, rational traders will often be powerless to do anything about it. In order to say more about the structure of these devi- ations, behavioral models often assume a specific form of irrationality. For guidance on this, economists turn to the extensive experimental evidence compiled by cognitive psychologists on the systematic biases that arise when people form beliefs, and on people’s preferences.9

In this section, we summarize the psychology that may be of particular interest to financial economists. Our discussion of each finding is necessar- ily brief. For a deeper understanding of the phenomena we touch on, we refer the reader to the surveys of Camerer (1995) and Rabin (1998) and to the edited volumes of Kahneman, Slovic, and Tversky (1982), Kahneman and Tversky (2000) and Gilovich, Griffin, and Kahneman (2002).

3.1. Beliefs

A crucial component of any model of financial markets is a specification of how agents form expectations. We now summarize what psychologists have learned about how people appear to form beliefs in practice.

Overconfidence. Extensive evidence shows that people are overconfident in their judgments. This appears in two guises. First, the confidence inter- vals people assign to their estimates of quantities—the level of the Dow in a year, say—are far too narrow. Their 98 percent confidence intervals, for ex- ample, include the true quantity only about 60 percent of the time (Alpert and Raiffa 1982). Second, people are poorly calibrated when estimating probabilities: events they think are certain to occur actually occur only

around 80 percent of the proximately 20 percent 1977).10

time, and events they deem impossible occur ap- of the time (Fischhoff, Slovic, and Lichtenstein

We emphasize, however, that behavioral models do not need to make extensive psycho- logical assumptions in order to generate testable predictions. In section 6, we discuss Lee, Shleifer, and Thaler’s (1991) theory of closed-end fund pricing. That theory makes numerous crisp predictions using only the assumptions that there are noise traders with correlated senti- ment in the economy, and that arbitrage is limited. 9

Overconfidence may in part stem from two other biases, self-attribution bias and hind- sight bias. Self-attribution bias refers to people’s tendency to ascribe any success they have in some activity to their own talents, while blaming failure on bad luck, rather than on their 10

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