What is behavioral finance? Traditional (so-called “modern”) finance theory is the least behavioral of the various sub-disciplines of economics. In much of social science, what people actually do is, if not in the foreground, at least part of the picture. Yet, financial economics insists that whatever people do, they do it “right.” People “optimize” but their actual behavior is mostly a black box. An approach that ignores human irrationality (e.g., financial illiteracy) is not only unhelpful, it is wrong. In fact, to characterize optimal and actual choices with one-and-the-same stylized model is altogether impossible!
It has not always been this way. Earlier generations of economists, starting with Adam Smith —including Vilfredo Pareto, Thorstein Veblen, Wesley Mitchell, Irving Fisher, John Maynard Keynes, Friedrich von Hayek, George Katona, Hyman Minski, Benjamin Graham, and others— put great emphasis on the fallible nature of human decision-making.
Today, there is a pressing need to develop explicitly descriptive theories of financial decision-making behavior in households, organizations, and markets. This research program, called behavioral finance, has already produced a revolution in economic thought. Behavioralists are particularly interested in the nature, quality and effects of choices and beliefs. Typically, a careful investigation of decision processes tells us a great deal about decision outcomes.
We aim to build better models of how investors gather information, save for retirement, build portfolios, value securities, take on debt, and so on. Behavioral insights not only enrich our understanding of individual action and well-being, but also of asset management, corporate finance, banking, international finance, public finance, and regulation. Among a long list of ideas, mental frames, overconfidence, extrapolation bias, loss aversion, lack of willpower and fashion are key micro-concepts. At the macroeconomic or systemic level, we study bubbles, disequilibrium, market power, perceptions of fairness and unfairness, and the buildup and evaporation of trust.
Academic interest in the human factor waned during the 1960s and the 1970s. It rebounded during the 1980s —especially after Robert Shiller wrote about irrational exuberance and after Richard Thaler and I discovered predictable trends and reversals in stock prices related to fluctuations in investor sentiment, i.e., under- and overreaction. The internet bubble of the 1990s and the financial crisis of 2007-2008 have made it clear to everyone, but especially to finance practitioners, that it would be pure madness to ignore investor psychology and its consequences for risk and return. So, paradoxically, “it is rational to be behavioral.”