Behavioral Heuristics and Financial Modelling

Copyright: © 2012 Semenov A. This is an open-access article distributed under the terms of the Creative Commons Attribution License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original author and source are credited. All financial models are based on some simplifying assumptions about the behavior of market participants. One of such underlying behavioral assumptions is that the investors make decisions about buying or selling securities on the basis of their expectations about the future. An important element of forming these expectations is the agents’ beliefs about the likelihood of particular events or, stated formally, the subjective probabilities that the investors assign to different possible states of the world. It is observed that, when determining the subjective probabilities, people often make systematic mental mistakes by adopting some intuitive simplifying rules of thumb, or heuristics, for information processing rather than strict logic. As a result, the subjective probabilities may deviate substantially from the objective probabilities that are based on formal rules or analysis. This deviation in probabilities can lead to biased expectations that, in turn, can cause irrational investment decisions. Gilovich et al. [1] provide an excellent overview of the behavioral heuristics.