ABSTRACT
In this chapter, the authors examine how markets work and explore anomalies in the way that they do so. They investigate how markets can be used to aggregate and process information and to provide forecasts, and examine how modern theories of human perception and behaviour, notably prospect theory, can be used to explain some financial puzzles and other puzzles of behaviour and decision-making. The authors present a special focus on the so-called "wisdom of crowds" and expert forecasting, and they find an anomaly at the interface between probability, gambling, and taxation. Coates and Herbert argue that since testosterone and cortisol have cognitive and behavioural effects, it is possible that high market volatility may shift risk preferences and even affect a trader's ability to engage in rational choice. An explanation may lie in the risk profile of small-firm stocks compared to large-firm stocks.
