The Mind of the Investor

Chapter 10 discusses the rational investor, behavioral finance, neurofinance, consensus opinions, and their impacts on stock and other markets. The chapter begins with a discussion of rational investor paradigms, describing the St. Petersburg Paradox and von Neuman-Morgenstern axioms of choice. Essential findings of Prospect Theory are described, including the framing and anchoring problems, myopia, overreaction, overconfidence, and other fundamental problems in pursuing sound rational solutions to investing, and trading problems. Connections between all of these barriers to rational decision-making to finance are explored. Psychological and physiological underpinnings to such problems are offered. Relationships between irrational investors and markets, either efficient or inefficient are discussed. In this discussion, game shows, betting markets, analyst estimates, and consensus forecasts are offered as evidence that cognitively impaired investors can comprise rational markets, while information cascades and herding can lead to irrational markets.