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"The economist may attempt to ignore psychology, but it is sheer impossibility for him to ignore human nature. … If the economist borrows his conception of man from the psychologist, his constructive work may have some chance of remaining purely economic in character. But if he does not, he will not thereby avoid psychology. Rather, he will force himself to make his own, and it will be bad psychology."
— John Maurice Clark
"Economics and Modern Psychology,"
Journal of Political Economy, 1918

What is Behavioral Finance?

Modern finance theory is probably the least behavioral of the various sub-disciplines of economics. In other areas of economics, what people actually do is, if not in the foreground, at least part of the picture. In finance, we simply insist that whatever people do, they do it right. People optimize but otherwise their behavior is like a black box. Much of mainstream finance reveals little interest in investor decision processes or in the quality of judgment.

It has not always been this way. Earlier generations of economists, starting with Adam Smith (and including Vilfredo Pareto, Wesley Mitchell, Irving Fisher, John Maynard Keynes, Friedrich von Hayek, Benjamin Graham and others), put great emphasis on the fallible nature of human decision-making. The interest of finance academics and practitioners in the human factor waned during the 1960s and the 1970s. It rebounded during the 1990s after it was shown that there are predictable trends and reversals in stock prices, likely related to shifts in investor sentiment.

The problems with modern finance theory are created by its dual purpose to characterize optimal choice and to describe actual choice. The validity of the theory for the first purpose is not in question. However, there is a pressing need to develop explicitly descriptive models of financial decision making behavior in households, organizations and markets. This research program is called behavioral finance.

To make progress, we need to better portray behavior in the usual domains of finance theory (e.g., portfolio selection and stock valuation) and to enrich the theory to incorporate new domains upon which finance has been silent. For instance, at this point, finance has little to say about the role of social norms. Efforts along these lines are made by behavioral economists, psychologists, sociologists and other social scientists.

We illustrate the new world of behavioral finance with brief descriptions of four concepts: overreaction, overconfidence, mental frames and fashion.

Overreaction

Are financial predictions made as if people have a working knowledge of Bayes' rule? Numerous studies conclude that the answer to this question is no. People appear to make probability judgments using similarity or what psychologists call the "representativeness heuristic." People evaluate the probability of an uncertain event by the degree to which it reflects the salient features of an underlying class of events, for instance, to the degree that it matches a well-known stereotype. Representativeness leads to systematic errors in judgment. It induces people to give too much weight to recent new evidence and too little weight to the base rate or prior odds. Representativeness may explain why financial markets overreact to economic news and why there appear to be predictable reversals in equity prices.

Overconfidence

A robust finding in the psychology of judgment is that people are overconfident. For instance, many people overestimate the reliability of their knowledge. When people say that they are 90 percent sure that event will happen or that a statement is true, they may only be correct 70 percent of the time. Widespread overconfidence may affect the structure of asset prices. It is an important reason why some investors trade as much as they do.

Mental Frames in the Psychology of Choice

A strong intuition about preferences is that people treat gains and losses differently and, in particular, that losses loom larger than gains. This intuition was formally incorporated into Kahneman and Tversky's prospect theory, a descriptive theory of decision making under uncertainty that is an alternative to expected utility theory. In prospect theory the carriers of value are changes in wealth rather than levels, and negative changes are weighted more heavily than gains.

Loss aversion implies that decision-making is sensitive to the way that the alternatives are described or "framed." Individuals often have opportunities to create their own frames, a process called mental accounting. Mental accounting can mitigate self-control problems, for example by setting up special accounts (e.g., the children's education account) that are considered off-limits to spending urges.

Fashion

Individual investors and money managers are influenced by their social environment, and they often feel pressure to conform. In many instances, conformist behavior is seen as prudent behavior. However, herding can lead people astray, e.g., when they follow a market guru. In general, it is found that fashions and fads are as likely to emerge in financial markets as anywhere else.