Department of Computer Science
University College London
February 2007 (revised August 2008)
An introduction to behavioural finance, including a review of the major
works and a summary of important heuristics.
Behavioural finance is the study of the influence of psychology on the behaviour
of financial practitioners and the subsequent effect on markets. Behavioural
finance is of interest because it helps explain why and how markets might be
inefficient. For more information on behavioural finance, see Sewell (2001).
Back in 1896, Gustave le Bon wrote The Crowd: A Study of the Popular Mind,
one of the greatest and most influential books of social psychology ever written
(le Bon 1896).
Selden (1912) wrote Psychology of the Stock Market. He based the book
‘upon the belief that the movements of prices on the exchanges are dependent
to a very considerable degree on the mental attitude of the investing and trading
In 1956 the US psychologist Leon Festinger introduced a new concept in
social psychology: the theory of cognitive dissonance (Festinger, Riecken and
Schachter 1956). When two simultaneously held cognitions are inconsistent,
this will produce a state of cognitive dissonance. Because the experience of
dissonance is unpleasant, the person will strive to reduce it by changing their
Pratt (1964) considers utility functions, risk aversion and also risks consid-
ered as a proportion of total assets.
Tversky and Kahneman (1973) introduced the availability heuristic: ‘a judg-
mental heuristic in which a person evaluates the frequency of classes or the prob-
ability of events by availability, i.e. by the ease with which relevant instances
come to mind.’ The reliance on the availability heuristic leads to systematic
In 1974, two brilliant psychologists, Amos Tversky and Daniel Kahneman,
described three heuristics that are employed when making judgments under
uncertainty (Tversky and Kahneman 1974):
representativeness When peo