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

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Classical finance assumes that investors are rational optimizers and that competition drives prices to fundamental values. Decades of evidence, from the excess volatility of stock prices and the size of the equity premium to long-horizon overreaction, strain that assumption. Behavioral finance responds by grounding asset pricing in two ideas with empirical support. Real investors are subject to systematic psychological biases, and the arbitrage that is supposed to correct the resulting mispricings is itself limited. This survey, written for a numerate reader with no specialist training, develops both ideas from first principles and shows how they combine into testable theories of market behavior. It reviews the core biases, namely heuristics, loss aversion in the sense of prospect theory, mental accounting, overconfidence and the disposition effect, and traces how each maps to a market phenomenon. It then presents the three canonical behavioral models that reconcile short-run momentum with long-run reversal, and the sentiment-based view of the cross-section of returns. The efficient-markets rebuttal is given its full weight. Anomalies split roughly evenly between over- and underreaction and are fragile to methodology, a caution reinforced by the multiple-testing and replication evidence of the past decade. The paper closes with the adaptive-markets synthesis and an agenda for research, including the practical question of how a disciplined quantitative process can help ordinary investors act against their own biases.

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Shehadi Candela, A. (2026). The Behavioral Foundations of Asset Prices: Investor Psychology, Limits to Arbitrage and Market Anomalies. QUAFI Working Paper No. 2026-02. QUAFI Research.

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

Historial de versiones

1. v1.113 sep 2026exposition revised throughout; structure and register brought in line with journal practice; no change to results or references
2. v1.01 abr 2026first working-paper draft