Behavioural Finance as an explanation of the subprime Crisis of world

Abstract

Behavioral finance has gathered a lot of attention during the last few years as a subject challenging the economic paradigms of rationality of investors and efficiency of markets. lessons from behavioral finance about the origins of the subprime crisis and the likelihood of averting the next ones , though belatedly, is now being talked about quite vigorously . we argue in this paper  that the crisis highlights the need to incorporate behavioral finance into our economic and financial theories as  explanatory variables  in understanding  subprime crisis in a holistic way.

Psychology, including aspirations, cognition, emotions, and culture, is at the heart of behavioral finance. This psychology and its reflection in the behavior of investors and the institutions, including corporations, governments, bankers,mortgage lenders and markets is what we have explored in our discussion.

Our discussion includes Keynes’ view that psychology drives economic booms and busts. It also encompasses efficient markets and free markets, bubbles, links between financial markets and the real economy, debt financing and financial innovation, and a culture where homeownership is prized beyond its rational economic benefits. Our discussion revolves around the ideas from psychology which may be helpful for thinking about the subprime crisis of 2007-2008. We focus on the surge in house prices in the years leading up to 2006; the large positions in subprime-linked securities (CDO) that many banks had accumulated by 2007; and the dramatic decline in value of many of the risky assets during the period followed by the subprime crisis. A number of psychology-based anomalies including over-extrapolation of past price changes; and belief manipulation, overconfidence, representative heuristics, cognitive dissonance are being explored as the explanatory factors of the subprime crisis.