The Entropy Theory of Mind and Behavioral Finance
29 Pages Posted: 5 Jan 2011 Last revised: 14 Mar 2011
Date Written: January 3, 2011
Rapid accumulation of empirical studies in behavioral finance calls for a unified and consistent theoretical synthesis. Instead of building up a behavioral theory of economics directly, we present the entropy theory of mind, which is an economic theory of mind. Then we integrate the value and cost of information processing into the overall picture in economic decision making. The entropy theory of mind includes a theory of judgment, which provides a common framework to integrate behavioral and informational theories of investment. The theory of judgment provides a quantitative link between investors’ judgment and their trading activities. It offers a simple and unified understanding of major patterns in market activities and investor behaviors. As an application, a simple mathematical model based on the entropy theory of mind is constructed to understand many empirical patterns related to the cycles of momentum and reversals in asset markets. During various phases of the cycles, trading volumes and trading behaviors of investors of different sizes often show distinct characteristics. It has been a long standing challenge to describe the multiple patterns simultaneously from a quantitative theory. In this paper, we show that the predictions derived from the model are consistent with the multiple empirical patterns of trading volumes and investor activities at the different phases of the cycle of momentum and reversal.
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