Behavioral finance focuses on systematic irrationalities that characterize investor decision
making. These "behavioral shortcomings" may be consistent with several efficient market
anomalies.
Among the information processing errors uncovered in the psychology literature are
memory bias, overconfidence, conservatism, and representativeness. Behavioral tendencies
include framing, mental accounting, regret avoidance, and loss aversion.
Limits to arbitrage activity impede the ability of rational investors to exploit pricing errors
induced by behavioral investors. For example, fundamental risk means that even if a security
is mispriced, it still can be risky to attempt to exploit the mispricing. This limits the
actions of arbitrageurs who take positions in mispriced securities. Other limits to arbitrage
are implementation costs, model risk, and costs to short-selling. Occasional failures of the
Law of One Price suggest that limits to arbitrage are sometimes severe.
The various limits to arbitrage mean that even if prices do not equal intrinsic value, it still
may be difficult to exploit the mispricing. As a result, the failure of traders to beat the market
may not be proof that markets are in fact efficient, with prices equal to intrinsic value.
Technical analysis is the search for recurring and predictable patterns in stock prices. It is
based on the premise that prices only gradually close in on intrinsic value. As fundamentals
shift, astute traders can exploit the adjustment to a new equilibrium.
Technical analysis also uses volume data and sentiment indicators. These are broadly
consistent with several behavioral models of investor activity.
The Dow theory attempts to identify underlying trends in stock indexes. Moving averages,
relative strength, and breadth are used in other trend-based strategies.
Some sentiment indicators are the trin statistic, the confidence index, and the put/call ratio.
