Studies on Korean Capital Markets from the Perspective of Behavioral Finance

Behavioral finance encompasses research that gives up the traditional assumptions of expected utility maximization with rational investors in an efficient market. It is defined as the application of psychology to financial decision making and financial markets. Based on this definition, our review essay summarizes recent work of behavioral studies in Korean capital markets along with some pioneering papers in the behavioral finance literature. In Korea, behavioral studies are in their early stages of development. First, we start with discussion of the limits of arbitrage as a foundation of behavioral finance. We discuss the limits of arbitrage to explain why Friedman’s (1953) paradigm of arbitrage may not eliminate pricing errors in capital markets. Second, the prospect theory of Kahneman and Tversky (1979) and its related empirical results are reviewed. Third, empirical results related to overreaction and underreaction are addressed. Fourth, investors’ trading behaviors and return patterns as influenced by psychological biases are discussed. In conclusion, we address several areas to explore as promising research fields. First, experimental investigation with psychologists is warranted. Second, regional anomalies need be explored from behavioral perspectives. Investors’ behavior across cultures is also an interesting topic in behavioral finance. Third, collaborative work with other business areas is needed. Finally, corporate behavioral finance has much room for further investigation.