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Abstract:
In its attempt to model financial markets and the behavior of firms, modern finance theory starts from a set of normatively appealing axioms about individual behavior. Specifically, people are said to be risk-averse expected utility maximizers and unbiased Bayesian forecasters, i.e., agents make rational choices based on rational expectations. The rational paradigm may be criticized, however, because (1) the assumptions are descriptively false and incomplete, and (2) the theory often lacks predictive power. One way to make progress is to characterize actual decision-making behavior. Efforts along these lines are made by behavioral economists and psychologists. This paper provides a selective review of recent work in behavioral finance. First, we ask why economists should be concerned with the psychology of decision-making. Next, we discuss a series of key behavioral concepts, e.g., people's well-known tendencies to give too much weight to vivid information and to show excessive self-confidence. The body of the paper illustrates the relevance of these concepts to important topics in investment theory and corporate finance. In each case, behavioral finance offers a new perspective on results that are anomalous within the standard approach.

Abstract:
Behavioral finance endeavors to bridge the gap between neoclassical finance and cognitive psychology. Now an established field, behavioral finance looks at the investors' decision making formula as well as at their behavior, which in turn sheds light on the observed departures from the traditional finance theory. The paper provides an overarching view of the behavioral finance area. It begins by reviewing a few fundamental questions and lead slowly to the future of behavioral finance. The study unveils the move from the traditional approach that decision making is based on rational individuals using all available information, to including heuristics and biases as the background for framing choices under uncertainty. A new class of asset pricing models is put forward as a solution to overcome the obstacles of the neoclassical finance paradigm. The behavioral element is central to the new proposition without disputing the value of the traditional approach. It is suggested that with all its strengths and weaknesses the new paradigm will combine the best of neoclassical and behavioral elements.

Behavioral finance, Neoclassical finance, Asset valuation, Behavioral SDF-based pricing