Chapter 3: Behavioral Economics, Thinking Processes, Decision-Making, and Investment Behavior

Abstract

This chapter provides a critical review of behavioral economic approaches to decision-making with a focus on the thinking processes of investors. It discusses the bounded rationality approach to decision-making as compared to the errors and biases approach for better understanding decision-making processes and outcomes. The latter focuses on the importance of cognitive illusions and biases whereas the former pays more attention to the optimality of institutional design and the limited information processing capacity of the human brain. Both approaches attempt to make sense of and explain why decision-making outcomes tend to be inconsistent with the predictions of the conventional economics wisdom, especially regarding the efficient market hypothesis. The chapter also extends the analyses of the behavioral understanding of decision-making, especially from the bounded rationality modeling perspective.

Keywords: Behavioral economics, traditional economics, thinking processes, heuristics, trust, investment behavior, behavioral finance, behavioural finance, behavioural economics

JEL Classification: A12, D81, G00, G30, G10, M00, M10, M41