Psychology-based Models of Asset Prices and Trading Volume

Abstract

Behavioral finance tries to make sense of financial data using models that are based on psychologically accurate assumptions about people's beliefs, preferences, and cognitive limits. I review behavioral finance approaches to understanding asset prices and trading volume, with particular emphasis on three types of models: extrapolation-based models, models of overconfident beliefs, and models of gain-loss utility inspired by prospect theory. The research to date shows that a few simple assumptions about investor psychology capture a wide range of facts about prices and volume and lead to concrete new predictions. I end by speculating about the form that a unified psychology-based model of investor behavior might take.

Keywords: extrapolation, overconfidence, prospect theory, mispricing, bubbles, volume

JEL Classification: G11, G12, G40