Methodology:

At the outset behavioral economics and finance theories were developed almost exclusively from experimental observations and survey responses, though in more recent times real world data has taken a more prominent position. fMRI has also been used to determine which areas of the brain are active during various steps of economic decision making. Experiments simulating market situations such as stock market trading and auctions are seen as particularly useful as they can be used to isolate the effect of a particular bias upon behavior; observed market behavior can typically be explained in a number of ways, carefully designed experiments can help narrow the range of plausible explanations. Experiments are designed to be incentive compatible, with binding transactions involving real money the norm.

Key observations:90

There are three main themes in behavioral finance and economics (Shefrin, 2002):

1. Heuristics: People often make decisions based on approximate rules of thumb, not strictly rational analyses. See also cognitive biases and bounded rationality.
2. Framing: The way a problem or decision is presented to the decision maker will affect their action.
3. Market inefficiencies: Attempts to explain observed market outcomes which are contrary to rational expectations and market efficiency. These include mispricings, non-rational decision making, and return anomalies. Richard Thaler, in particular, has written a long series of papers describing specific market anomalies from a behavioral perspective.

Market wide anomalies cannot generally be explained by individuals suffering from cognitive biases, as individual biases often do not have a large enough effect to change market prices and returns. In addition, individual biases could potentially cancel each other out. Cognitive biases have real anomalous effects only if there is a social contamination with a strong emotional content (collective greed or fear), leading to more widespread phenomena such as herding and groupthink. Behavioral finance and economics rests as much on social psychology as on individual psychology.

There are two exceptions to this general statement. First, it might be the case that enough individuals exhibit biased (ie. different from rational expectations) behavior that such behavior is the norm and this behavior would, then, have market wide effects. Further, some behavioral models explicitly demonstrate that a small but significant anomalous group can have market-wide effects (eg. Fehr and Schmidt, 1999).