Statman, PhD, of the Leavey School of Business, Santa Clara University (Figure 1.5).
Statman is the author of many significant works in the field of behavioral finance, including an early paper entitled “Behavioral Finance: Past Battles and Future Engagements,”5 which is regarded as another classic in behavioral finance research. His research posed decisive questions: What are the cognitive errors and emotions that influence investors? What are investor aspirations? How can financial advisors and plan sponsors help investors? What is the nature of risk and regret? How do investors form portfolios? How important are tactical asset allocation and strategic asset allocation? What determines stock returns? What are the effects of sentiment? Statman produces insightful answers to all of these points. Professor Statman has won the William F. Sharpe Best Paper Award, a Bernstein Fabozzi/Jacobs Levy Outstanding Article Award, and two Graham and Dodd Awards of Excellence.
Figure 1.5 Meir Statman, PhD, Glenn Klimek Professor of Finance at the Leavey School of Business, Santa Clara University
Source: www.scu.edu
More recently, Professor Statman has written a book entitled What Investors Really Want.6 According to Statman, what investors really want is three kinds of benefits from our investments: utilitarian, expressive, and emotional. Utilitarian benefits are those investment benefits that drop to the bottom line: what money can buy. Expressive benefits convey to us and to others an investor's values, tastes, and status. For example, Statman contends that hedge funds express status, and socially responsible funds express virtue. Emotional benefits of investments express how people feel. His examples are: insurance policies make people feel safe, lottery tickets and speculative stocks give hope, and stock trading gives people excitement.
Perhaps the greatest realization of behavioral finance as a unique academic and professional discipline is found in the work of Daniel Kahneman and Vernon Smith, who shared the very first behavioral finance–related Nobel Prize in Economic Sciences in 2002. The Nobel Prize organization honored Kahneman for “having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty.” Smith similarly “established laboratory experiments as a tool in empirical economic analysis, especially in the study of alternative market mechanisms,” garnering the recognition of the committee.7
Figure 1.6 Daniel Kahneman, 2002 Nobel Prize Winner in Economic Sciences
Source: The White House
Professor Kahneman (Figure 1.6) found that under conditions of uncertainty, human decisions systematically depart from those predicted by standard economic theory. Kahneman, together with Amos Tversky (deceased in 1996), formulated prospect theory. An alternative to standard models, prospect theory provides a better account for observed behavior and is discussed at length in later chapters. Kahneman also discovered that human judgment may take heuristic shortcuts that systematically diverge from basic principles of probability. His work has inspired a new generation of research employing insights from cognitive psychology to enrich financial and economic models.
Another notable figure is Professor Dan Ariely (Figure 1.7). Professor Ariely is the James B. Duke Professor of Psychology and Behavioral Economics at Duke University and a founding member of the Center for Advanced Hindsight. He does research in behavioral economics on the irrational ways people behave. His immersive introduction to irrationality took place as he overcame injuries sustained in an explosion. He began researching ways to better deliver painful and unavoidable treatments to patients. Ariely became engrossed with the idea that we repeatedly and predictably make the wrong decisions in many aspects of our lives, and that research could help change some of these patterns.
Figure 1.7 Professor Dan Ariely, James B. Duke Professor of Marketing
Source: Yael Zur, for Tel Aviv University Alumni Organization, https://commons.wikimedia.org/wiki/File:Dan_Ariely_January_2019.jpg. CC BY-SA 4.0.
His works include Irrationally Yours, Predictably Irrational, The Upside of Irrationality, The (Honest) Truth About Dishonesty, the movie Dishonesty and the card game Irrational Game. These works describe his research findings in non-academic terms, so that more people will discover the excitement of behavioral economics and use some of the insights to enrich their own lives.
Behavioral Finance Micro versus Behavioral Finance Macro
As we have observed, behavioral finance models and interprets phenomena ranging from individual investor conduct to market-level outcomes. Therefore, it is a difficult subject to define. For practitioners and investors reading this book, this is a major problem, because our goal is to develop a common vocabulary so that we can apply behavioral finance. For purposes of this book, we adopt an approach favored by traditional economics textbooks; we break our topic down into two subtopics: behavioral finance micro and behavioral finance macro.
1 Behavioral finance micro (BFMI) examines behaviors or biases of individual investors that distinguish them from the rational actors envisioned in classical economic theory.
2 Behavioral finance macro (BFMA) detects and describe anomalies in the efficient market hypothesis that behavioral models may explain.
Each of the two subtopics of behavioral finance corresponds to a distinct set of issues within the standard finance versus behavioral finance discussion. With regard to BFMA, the debate asks: Are markets “efficient,” or are they subject to behavioral effects? With regard to BFMI, the debate asks: Are individual investors perfectly rational, or can cognitive and emotional errors impact their financial decisions? These questions are examined in the next section of this chapter; but to set the stage for the discussion, it is critical to understand that much of economic and financial theory is based on the notion that individuals act rationally and consider all available information in the decision-making process. In academic studies, researchers have documented abundant evidence of irrational behavior and repeated errors in judgment by adult human subjects.
Finally, one last thought before moving on. It should be noted that there is an entire body of information available on what the popular press has termed the psychology of money. This subject involves individuals' relationship with money—how they spend it, how they feel about it, and how they use it. There are many useful books in this area; however, this book will not focus on these topics, it will focus on building better portfolios.
Standard Finance versus Behavioral Finance
This section reviews two basic concepts in standard finance that behavioral finance disputes: rational markets and the rational economic man. It also covers the basis on which behavioral finance proponents challenge each tenet
