Scientific analysis and assumptions of rational behaviour can help to generate new insights, but this approach also has its limitations. Before the credit crisis, a crucial question in mainstream economics was whether markets immediately factor all information into the prices of equities and other securities, in other words whether markets are efficient. Eminent economists based their research on market efficiency. To an increasing extent, particularly after the credit crisis, this theory has appeared to be too limited to generate sufficiently reliable and useful knowledge of the real behaviour of markets. It has become increasingly clear that behavioural finance can add practical knowledge to this. Behavioural finance, which makes use of the insights of social psychology, biology and the cognitive sciences, analyses the behaviour of groups of investors and speculates what this knowledge means to markets and their dynamics.
The 2008 credit crisis has once again made it clear that markets are not always efficient. They are heavily influenced by the mood swings and the erratic behaviour of human beings. The influence of what Keynes termed “animal spirits” on markets has never been greater than in today’s rapidly changing world where opinions, emotions and information are increasingly shared instantaneously through digital networks that stretch across the globe. This rapid transmission of information adds to the ways in which investor emotion can exert influence on markets. If the resulting market swings create feedback loops strong enough to impact the “real” economy, than self-fulfilling prophecies are created.
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