The Behavioral Foundations of Asset Prices: A Pedagogical Survey of Investor Psychology, Limits to Arbitrage, and Market Anomalies

Agustín Shehadi Candela · QUAFI Research · 2026-04-01 · v1.0

Abstract

Classical finance assumes investors are rational optimizers and that competition drives prices to their fundamental values. Decades of evidence — from excess volatility and the equity-premium puzzle to long-horizon overreaction — strain that assumption. Behavioral finance responds by grounding asset pricing in two empirically disciplined ideas: that real investors are subject to systematic psychological biases, and that the arbitrage which is supposed to correct the resulting mispricings is itself limited. This didactic survey develops both pillars from first principles, catalogs the core biases (heuristics, prospect-theoretic loss aversion, mental accounting, overconfidence, the disposition effect) and maps each to a market phenomenon, presents the three canonical behavioral models that reconcile short-run momentum with long-run reversal, and covers the sentiment-based view of the cross-section. It gives the efficient-markets rebuttal its full weight — anomalies split between over- and underreaction and are fragile to methodology, a caution reinforced by the multiple-testing and replication literature — and closes with the adaptive-markets synthesis and an agenda for further research, including how a disciplined quantitative process can help ordinary investors act against their own biases.

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Cite

@techreport{shehadi2026behavioral,
  author      = {Shehadi Candela, Agust\'in},
  title       = {The Behavioral Foundations of Asset Prices: A Pedagogical Survey of Investor Psychology, Limits to Arbitrage, and Market Anomalies},
  institution = {QUAFI Research},
  type        = {QUAFI Working Paper},
  number      = {2026-02},
  year        = {2026}
}

Preliminary working paper; circulated for discussion. The views are the author's own. Not investment advice.