Why Using Behavioral Approaches to Understand Stock Price Behaviour Makes Sense

In much of the financial literature the price of a security is determined by calculating the net discounted present value of the future stream of cash flows, where the discount rate is the expected rate of return on the security estimated using pricing models like Capital Asset Pricing Model (CAPM) or its variants. Investors in the CAPM framework are assumed to be rational and risk-averse. In reality, investors are not always rational. Biases in investor’s behaviour leading to inertia,overconfidence, herd behavior, and loss aversion can cause investors to make irrational decisions.By explicitly taking into account the psychological underpinnings of investor’s behaviour, a more realistic approach to study stock price behaviour can be established.