Biases and Portfolio Selection

This module introduces the third course in the Investment and Portfolio Management Specialization. In this module, we first present the efficient market hypothesis (EMH) – another pillar idea of modern finance. You will learn about its rationale as well as the empirical evidence that supports and challenges the predictions of the EMH such as anomalies. Finally, we will consider why smart money may sometimes fail to exploit away anomalies in financial markets.

In this module, we review the behavioral critique of market rationality. In contrast to the presumption that investors are rational, behavioral finance starts with the assumption that they are not. We will examine some of the information-processing and behavioral biases uncovered by psychologists in several contexts. In addition, we will consider alternative, more realistic ways of describing investor preferences.

In this module, we review a number of puzzles related to the aggregate stock market and the cross-section of average stock returns that have been documented in the literature. We examine how the behavioral biases and tendencies discussed in the previous module might result in some of these puzzles observed in financial markets.