Asset price formation and behavioral biases

Abstract

Purpose The purpose of this paper is to examine the debate on whether psychology affects asset prices using agent-based modeling. Design/methodology/approach The authors set up three simulation regimes where the first regime contains fundamental investors who invest based on the mean-variance framework. The second regime includes purely irrational investors who invest based on behavioral biases. The third regime combines the two types of investors. The authors test whether the return properties from regime 3 converge to that of regime 1 or 2. Findings Results suggest that the type of irrationality affects return properties in different ways. Irrational investors who are introspective in their irrationality, only examining their performance and deficiencies, do not have much of a systematic effect on stock returns when combined with rational investors. However, irrational investors that aggregate information in an irrational manner have a systematic effect when combined with rational investors. Research limitations/implications Research implication of using simulation analysis is that the results need to be verified via other methods such as empirical and/or experimental analysis. Practical implications Practical implications of the research is that policy makers can look for factors that investors use to aggregate to better understand the movement of financial prices and ignore other factors. Social implications Social implication is that mass psychology impacts financial prices. Originality/value No other paper has used agent-based/behavioral analysis to better understand how different types of behavior may impact financial prices in different ways.