Monday, February 6, 2012

Quantitative Behavioral Finance

Though Fama's Efficient Market Hypothesis (EMH) and variants thereof reigned unchallenged for several decades, during the 1980s and 1990s, behavioral finance gained significant credibility. Behavioral finance has since evolved and given rise to subfields such as Quantitative Behavioral Finance. The hypothesis remains the same: markets are not completely efficient because the human participants are not completely rational. Cognitive biases are the main culprit. Quantitative Behavioral Finance takes this idea a little further by rigorously modeling market prices given such biases (which manifest themselves in terms of underreaction and overreaction) exist by combining differential equations and statistical time series analysis.

Richard Thaler's article, "The End of Behavioral Finance", is an excellent survey of the first decade.

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