Abstract

Investors are rational, in the sense that they make decisions according to axioms of expected utility theory, they have stable preferences, and their forecasts about the future are unbiased. Financial markets are effective given that nobody is able to systematically beat the market, and security prices reflect only utilitarian characteristics (see Statman 1999a). These two assumptions of investors’ rationality and market efficiency have dominated, like a charm, the standard theory of finance. Economic models of human behavior based on the two assumptions are simple and elegant, but more and more data show that they are incomplete or unrealistic. Results from the growing field of behavioral finance, which applies psychology to economic models, seem to indicate neither that investors are rational nor that markets are effective (at least in the sense of prices’ rationality). The importance of psychosocial factors in economic interactions is also revealed in the experimental economists’ work on financial markets. Smith showed, using experimental methods, that the behavior of individuals participating in trust games is sensitive to reciprocity (see Smith 2000 for a review). This means that traders tend to accept a reciprocal exchange even if this is not rational from an economic point of view.