One of the most overused– and misunderstood — terms I’ve seen used by finance practitioners is “behavioral finance.” Many professionals consider themselves to be “behavioral finance experts” because they identify irrational investors.1

Newsflash: Identifying irrational investors is not behavioral finance.

But here is a great summary from a Baker, Bradley, and Wurgler paper we’ve covered in the past:

Behavioral models of security prices combine two ingredients. The first is that some market participants are irrational in some particular way…The second ingredient is limits on arbitrage, which explain why the “smart money” does not offset the price impact of any irrational demand.

Too many practitioners focus on irrational investors and too little attention on limits of arbitrage. We go in depth on the subject of behavioral finance here and explain why it is much more complicated to exploit irrational behavior than many want to believe.

 

1. It is a bit ironic that some research identifies that professionals ARE the irrational investors).

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