Behavioral Finance and Factor Investing

Abstract

This paper explores the intersection of behavioral finance and factor investing, providing an overview of the foundational theories in behavioral finance and their implications for asset pricing. The study discusses how cognitive biases, such as overconfidence, anchoring, and prospect theory, influence investor behavior, leading to systematic mispricing in financial markets. These biases are linked to anomalies such as momentum, reversal, and post-earnings announcement drift, which have been observed across various asset markets. Furthermore, the paper highlights the role of limits to arbitrage, emphasizing that even sophisticated investors face challenges in correcting mispricing due to factors such as noise trader risk and fundamental risk. Drawing on these insights, the paper examines how behavioral factors can be integrated into asset pricing models, citing examples like the Stambaugh-Yuan four-factor model and the Daniel-Hirshleifer-Sun three-factor model. Finally, the application of these models to the Chinese stock market is discussed, where investor behavior, particularly overreaction, plays a significant role in explaining market anomalies. This study underscores the growing importance of behavioral finance in understanding and navigating the complexities of modern asset markets.

JEL Classification: G12, G41