Cognitive Biases at Play? Insights from a Bayesian Game Framework

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.