BEHAVIORAL FINANCE Behavioral finance is not a branch of standard finance: it is its replacement with a better model of humanity. Meir Statman THUS FAR I have described stock-market theories and techniques based on the premise that investors are completely rational. They make decisions with the objective of maximizing their wealth and are constrained only by their tolerance for bearing risk. Not so, declares a new school of financial economists who came to prominence in the early part of the twenty-first century. Behavioralists believe that many (perhaps even most) stock-market investors are far from fully rational. After all, think of the behavior of your friends and acquaintances, your fellow workers and your supervisors, your parents and (dare I say) spouse (children, of course, are another matter). Do any of these people act rationally? If your answer is no or even sometimes no, you will enjoy this journey down the less than rational byways of behavioral finance.

Efficient-market theory, modern portfolio theory, and various asset-pricing relationships between risk and return all are built on the premise that stockmarket investors are rational. As a whole, they make reasonable estimates of the present value of stocks, and their buying and selling ensures that the prices of stocks fairly represent their future prospects. By now, it should be obvious that the phrase as a whole represents the economists escape hatch. That means they can admit that some individual market participants may be less than rational. But they quickly wriggle out by declaring that the trades of irrational investors will be random and therefore cancel each other out without affecting prices. And even if investors are irrational in a similar way, efficient-market theory believers assert that smart rational traders will correct any mispricings that might arise from the presence of irrational traders.

Psychologists will have none of this economic claptrap. Two in particular Daniel Kahneman and Amos Tverskyblasted economists views about how investors behave and in the process are credited with fathering a whole new economic discipline, called behavioral finance. The two argued quite simply that people are not as rational as economic models assume. Although this argument is obvious to the general public and non-economists, it took over twenty years for it to become widely accepted in academia. Tversky died in 1996, just as it was gaining increased credibility. Six years later, Kahneman won the Nobel Memorial Prize in Economic Sciences for the work. The award was particularly notable in that it was not given to an economist. Upon hearing the news, Kahneman commented, The prize . . . is quite explicitly for joint work, but unfortunately there is no posthumous prize. Though the insights expounded by Kahneman and Tversky affected all social

Imaginea whole new field in which to publish papers, give lectures for hefty fees, and write graduate theses. While that may be all well and good for the professors and the students, what about all the other people who want to invest in stocks. How can behavioral finance help them? More to the point, whats in it for you? Actually, quite a bit. Behavioralists believe that market prices are highly imprecise. Moreover, people deviate in systematic ways from rationality, and the irrational trades of investors tend to be correlated. Behavioral finance then takes that statement further by asserting that it is possible to quantify or classify such irrational behavior. Basically, there are four factors that create irrational market behavior: overconfidence, biased judgments, herd mentality, and loss aversion.