Advances in Behavioural Economics and Finance

René Doff

Chapter 3 introduced the concept of homo economicus: a fully rational actor in the financial markets able to reach their investment objectives in an optimal way. We will show in this chapter that humans are not so fully rational, but rather suffer from all kinds of human biases and heuristics. A bias is a consistent and systematic behaviour (ie, not random) that deviates from rational behaviour as defined in traditional economic theory. Heuristics are problem-solving approaches such as rules of thumb or irrational shortcuts that result in biases. This chapter will assess the key insights of a large body of behavioural economic sciences. Since this body of science encompasses entire libraries of books and journals, it is impossible to do justice to it all, so we will focus on the most crucial areas and try to link our insights to the extent they are relevant for the risk manager. Interested readers should consult the bibliography at the end of this book.

This chapter, and the following, will investigate the theoretical foundations that we will use later in the book. Some of these theories might seem quite complex, which is why examples will help illustrate the essence of each