How can behavioural finance help us in better understanding the recent global financial crisis?

Abstract

The recent global financial crisis calls for a need to adopt a more interdisciplinary approach to the study of economics and finance by focussing also on the individual and social psychology that drives the actions of market participants. Behavioural finance offers such a perspective by drawing on the fields of psychology and the other social sciences to explain how investors are led to make less than rational investment decisions and how these could aggregate to less than rational market outcomes, like periods of excessive investor euphoria preceding a financial crisis. This paper draws on the existing literature in behavioural finance and particularly on the two models of information cascade by Bikchandani et al. (1992) and limits to arbitrage by De Long et al. (1990) to provide a better understanding of the underlying reasons behind the recent global financial crisis. The paper concludes with a view to inform policy of the ways it can curb speculative excesses and prevent events like the recent global financial crisis.

Keywords: Investor psychology, information cascade, social contagion, limits to arbitrage, noise trader risk.