Behavioral Finance: The Second Generation

Abstract

Finance Behavioral finance presented in this book is the second-generation of behavioral finance. The first generation, starting in the early 1980s, largely accepted standard finance’s notion of people’s wants as “rational” wants—restricted to the utilitarian benefits of high returns and low risk. That first generation commonly described people as “irrational”—succumbing to cognitive and emotional errors and misled on their way to their rational wants. The second generation describes people as normal. It begins by acknowledging the full range of people’s normal wants and their benefits—utilitarian, expressive, and emotional—distinguishes normal wants from errors, and offers guidance on using shortcuts and avoiding errors on the way to satisfying normal wants. People’s normal wants include financial security, nurturing children and families, gaining high social status, and staying true to values. People’s normal wants, even more than their cognitive and emotional shortcuts and errors, underlie answers to important questions of finance, including saving and spending, portfolio construction, asset pricing, and market efficiency. Second-generation behavioral finance offers an alternative foundation block for each of the five foundation blocks of standard finance, incorporating knowledge about people’s wants and their cognitive and emotional shortcuts and errors. According to second-generation behavioral finance: 1. People are normal. 2. People construct portfolios as described by behavioral portfolio theory, where people’s portfolio wants extend beyond high expected returns and low risk, such as wants for social responsibility and social status. 3. People save and spend as described by behavioral life-cycle theory, where impediments, such as weak self-control, make it difficult to save and spend in the right way. 4. Expected returns of investments are accounted for by behavioral asset pricing theory, where differences in expected returns are determined by more than just differences in risk—for example, by levels of social responsibility and social status. 5. Markets are not efficient in the sense that price always equals value in them, but they are efficient in the sense that they are hard to beat.