Investor sentiment and psychological biases are significant factors in asset pricing, offering a nuanced perspective often overlooked in traditional financial models. Behavioral finance emphasizes the role of sentiment and external psychological influences, demonstrating that these factors shape market outcomes and individual decision-making in measurable ways.

Investor sentiment is a crucial determinant of asset prices, particularly for small-cap stocks that are newly listed or difficult to value. Research indicates that elevated sentiment levels often lead to the overvaluation of such stocks, resulting in lower future returns. Beyond direct market dynamics, environmental factors like weather and daylight hours also shape sentiment. Studies reveal that longer daylight can elevate sentiment, increasing stock returns. However, high trading costs often diminish the benefits, illustrating the interplay between psychological and transactional market factors.

Behavioral biases, such as underreaction and overreaction, introduce inefficiencies in market pricing. Stocks with unexpected positive earnings announcements often exhibit an initial underreaction, followed by an overreaction, contributing to short-term momentum and eventual long-term reversals. Heuristics like representativeness bias also influence investment decisions. For instance, investors may disproportionately favor stocks of reputable companies, leading to overvaluation and subsequent underperformance.

Loss aversion, a cornerstone of behavioral economics, provides insights into the equity risk premium. Investors' tendency to strongly prefer avoiding losses over acquiring equivalent gains leads to a demand for higher returns on equities. This preference is compounded by generational volatility experiences, influencing long-term investment behavior.

Understanding these behavioral dimensions enhances predictive accuracy in asset pricing and equips investors with strategies to navigate psychological pitfalls, improving decision-making and long-term performance outcomes.