A Literature Review of Behavioural Finance

The efficient market hypothesis and behavioural finance theory have been the cornerstone of modern asset pricing for the past 50 odd years. Although both theories are fundamental in explaining modern asset pricing, they are opposing views. The efficient market hypothesis dictates that the price of any asset depends on the information, while the behavioural finance theory dictates that the price depends on the reaction of the market participants to the information. Therein lays the key to the argument influencing modern asset pricing, does price immediately reflect the information or market participants’ perception of the information. In this paper, we will critical evaluate the theories influencing the behavioural finance theory. We will review the overreaction/underreaction hypothesis and rational bubbles arguments influencing the behavioural finance theory. In concluding, we find that although the behavioural finance theory has difficulties in testing and the empirical evidence is mixed. Yet it does explain a number of anomalies in the financial world and is a more accurate view of the real world. It is also possible to explain market efficiency using the underreaction/overreaction hypothesis. However, a key advantage of using the efficient market hypothesis is that it is a useful benchmark for regulators and central bankers alike. The lack of a uniformed testable model means that the behavioural finance theory as it stands cannot be used as a benchmark. Conversely, the key to the behavioural finance theory is in its ability to explain the movement from the benchmark. So in essence, both models are required to explain asset pricing.