How can behavioral 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 ofeconomics and finance by focussing also on the individual and social psychology that drives the actions ofmarket participants. Behavioural finance offers such a perspective by drawing on the fields of psychologyand the other social sciences to explain how investors are led to make less than rational investmentdecisions and how these could aggregate to less than rational market outcomes, like periods of excessiveinvestor euphoria preceding a financial crisis. This paper draws on the existing literature in behaviouralfinance 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 reasonsbehind the recent global financial crisis. The paper concludes with a view to inform policy of the ways itcan 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.