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Cognitive Biases at Play? Insights from a Bayesian Game Framework

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  • Samiha Tariq

Abstract

This paper examines the impact of cognitive biases on financial decision-making through a static Bayesian game framework. While traditional economic theory assumes fully rational investors, real-world choices are often shaped by loss aversion, overconfidence, and herd behavior. Integrating psychological insights with economic game theory, the model studies strategic interactions among investors who allocate wealth between risky and risk-free assets. Solving for the Bayesian Nash Equilibrium reveals that each bias distorts optimal portfolios and alters aggregate market dynamics. The results echo Herbert Simon's notion of bounded rationality, showing how biases can generate market inefficiencies, price bubbles, and crashes. The findings highlight the importance of incorporating psychological factors into economic models to guide policies that foster market stability and more informed financial decision-making.

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  • Samiha Tariq, 2025. "Cognitive Biases at Play? Insights from a Bayesian Game Framework," Papers 2505.18835, arXiv.org.
    • Handle: RePEc:arx:papers:2505.18835
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    References listed on IDEAS

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    1. Ady, Sri Utami, 2018. "Cognitive And Psychological Bias In Investment Decision-Making Behavior (Evidence From Indonesian Investor’s Behavior)," INA-Rxiv uyfxj, Center for Open Science.
    2. Sri Utami Ady, 2018. "The Cognitive and Psychological Bias in Investment Decision-Making Behavior: (Evidence From Indonesian Investor's Behavior)," Journal of Economics and Behavioral Studies, AMH International, vol. 10(1), pages 86-100.
    3. Jiang, Rui & Wen, Conghua & Zhang, Ruonan & Cui, Yu, 2022. "Investor's herding behavior in Asian equity markets during COVID-19 period," Pacific-Basin Finance Journal, Elsevier, vol. 73(C).
    4. Brad M. Barber & Terrance Odean, 2001. "Boys will be Boys: Gender, Overconfidence, and Common Stock Investment," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 116(1), pages 261-292.
    5. repec:osf:inarxi:uyfxj_v1 is not listed on IDEAS
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