Chapter 1 - What Is Behavioral Finance?
Key Figures in Behavioral Finance
1. Robert Shiller (Yale University)
o Wrote "Irrational Exuberance"
o Warned of overvalued stock prices before the 2000 market peak
o Predicted potential market disappointment
2. Richard Thaler (University of Chicago)
o Co-authored "Can the Market Add and Subtract?"
o Demonstrated irrational pricing in 3Com's Palm spin-off
o Editor of "Advances in Behavioral Finance"
3. Hersh Shefrin (Santa Clara University)
o Authored "Beyond Greed and Fear"
o Argued investors weigh positive past events too heavily
o Predicted the 2000 market meltdown
4. Andrei Shleifer (Harvard University)
o Published "Inefficient Markets: An Introduction to Behavioral Finance"
o Focused on the efficient market debate
5. Meir Statman (Santa Clara University)
o Wrote "Behavioral Finance: Past Battles and Future Engagements"
o Researched cognitive errors, emotions, and investor aspirations
o Won multiple awards for his work in behavioral finance
6. Daniel Kahneman & Vernon Smith
o Shared the 2002 Nobel Prize in Economic Sciences
o Kahneman: Integrated psychological insights into economic science
o Smith: Established laboratory experiments in empirical economic analysis
Behavioral Finance Micro (BFMI) vs Macro (BFMA)
1. Behavioral Finance Micro (BFMI)
o Examines behaviors or biases of individual investors
o Focuses on how individuals deviate from rational economic actors
o Aims to identify psychological biases influencing investment decisions
2. Behavioral Finance Macro (BFMA)
o Detects and describes anomalies in the efficient market hypothesis
o Studies market-level outcomes that contradict standard finance theory
o Examines how behavioral effects impact overall market efficiency
Standard Finance vs Behavioral Finance Debates
1. Efficient Markets vs Irrational Markets
Efficient Market Hypothesis (EMH):
Weak form: Past market prices and data fully reflected in securities prices
Semi-strong form: All publicly available information fully reflected in prices
Strong form: All information (including insider information) fully reflected in prices
Market Anomalies: a. Fundamental Anomalies
Value investing (low P/B, P/E, P/S ratios outperforming)
High dividend yield stocks outperforming
b. Technical Anomalies
Challenges to the idea that past prices can't predict future prices
Debates around the effectiveness of technical analysis strategies
c. Calendar Anomalies
January Effect: Abnormally high returns, especially for small stocks
Turn-of-the-Month Effect: Higher returns at month-end and start
December Effect: Related to mutual fund reporting and anticipation of January increases
2. Rational Economic Man vs Behaviorally Biased Man
Homo Economicus (Rational Economic Man) Assumptions:
1. Perfect Rationality
o Challenged by the role of emotions in decision-making
o Psychologists argue intellect may be subservient to emotion
2. Perfect Self-Interest
o Contradicted by examples of altruism, philanthropy, and self-destructive behaviors
o Religious and social values often prioritize selflessness
3. Perfect Information
o Impossible for individuals to have perfect knowledge in all domains
o Many economic decisions made with incomplete information
Role of Behavioral Finance with Private Clients
1. Enhancing understanding of client's financial goals
2. Maintaining a systematic and consistent approach to advising
3. Delivering on client expectations more effectively
4. Ensuring mutual benefits for both client and advisor
Benefits of Applying Behavioral Finance
1. Formulating Financial Goals
o Understand the psychology and emotions behind goal-setting
o Deepen the bond between advisor and client
2. Maintaining Consistent Approach
o Incorporate behavioral finance into existing advisory disciplines
o Add professionalism and structure to the client relationship
3. Delivering Client Expectations
o Better understand client motivations and needs
o Address the root of client expectations more effectively
4. Ensuring Mutual Benefits
o Improve client satisfaction and retention
o Enhance the advisor's practice and work life
Finally:
Behavioral finance provides a framework for advisors to deeply understand clients' motivations, fears, and
objectives. This understanding leads to more appropriate portfolio design, stronger client-advisor bonds, and
ultimately more successful advisory relationships. By incorporating behavioral finance insights, advisors can
address the primary reason clients leave – feeling misunderstood – and create more satisfying, long-lasting
partnerships.
