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Behavioral finance consists of three themes: (1) heuristic‐driven bias; (2) frame dependence; and (3) inefficient markets. These themes are ubiquitous and germane, touching every corner of the financial landscape: portfolio selection, corporate finance, asset pricing, and options. Notably all the preceding areas have been recognized through the awarding of Nobel prizes in Economics. Indeed, behavioral finance was explicitly recognized with the 2002 award to Daniel Kahneman, one of the psychologists upon whose work behavioral finance is built. A key lesson for financial practitioners is to appreciate that successful investing requires taking the psychological propensities of others into account. Historically, behavioral psychologists first laid the groundwork for behavioral finance by developing the underlying psychological framework. In the 1980s a few financial economists began to apply this framework to finance. Debates with proponents of the traditional approach soon followed.

This chapter examines the imperfect knowledge imperative in modern macroeconomics and finance theory. It argues that the Rational Expectations Hypothesis (REH) has nothing to do with how even minimally reasonable profit-seeking individuals forecast the future in real-world markets. It attributes REH's insurmountable epistemological difficulties and widespread empirical problems to a single, overarching premise that underpins contemporary macroeconomics and finance theory: nonroutine change is unimportant for understanding outcomes. It also suggests that contemporary behavioral finance models rest on the same core premise as their REH-based counterparts. Finally, it introduces an alternative approach to modeling individual behavior and aggregate outcomes: Imperfect Knowledge Economics, which opens macroeconomics and finance models to nonroutine change and the imperfect knowledge that it engenders.

Summarises some of the successes of behavioural finance and shows how this field can inform the analysis of broader questions in economics. It begins with some of the open issues in security valuation. It then moves to the study of real consequences of financial markets on corporate finance and real investment, and evaluates the role of public policies. It concludes by enumerating 20 broad problems in behavioural finance.

Assesses the idea of efficient financial markets. It evaluates the theoretical and empirical foundations of the efficient markets hypothesis, emphasising the cracks that have emerged in them. Special attention is given to the rationality of investors, the randomness of the trades, and the role of arbitrageurs. Then the author suggests that an alternative theory—behavioural finance—could be more successful in explaining the evidence. The chapter concludes with a brief outline of the structure of the book.

Pension fund decision makers must make complex decisions — decisions that are made in a such way that maximizes a sound objective function (such as maximizing the probability that promised benefits will materialize), and which should be based on information that is as complete as possible and processed correctly. This chapter discusses what the field of behavioral finance says about the decision-making process, the potential pitfalls in that process, and the potential systematic mistakes and methods for avoiding them. Decision makers who are aware of the psychology of investing should be able to improve performance by avoiding mistakes and exploiting the mistakes of others.

The future of behavioral finance necessitates that the research areas of behavioral corporate finance and investor psychology develop richer models of financial decision-making behavior. Behavioral corporate finance requires expanding the focus from chief executive officer characteristics to those of the entire top management team, and also involves greater understanding of organizational theory. A greater focus is needed on cross-cultural factors and how they interact with behavioral influences. Investor psychology needs a more comprehensive theory of the drivers of investor behavior and better data. This need is strong for investor sentiment research, which might offer the most potential to advance understanding of psychological influences on asset pricing. The chapter expands on these ideas and discusses an overall context of the future philosophical development of behavioral finance and the inevitable push for greater openness, replicability, and reliability in research.

The mean‐variance paradigm has the strong implication that all investors should hold risky assets in the same proportion. Financial planners typically advise conservative investors to tilt their risky portfolios towards bonds and away from stocks; this has been called the “asset allocation puzzle” since it contradicts standard mean‐variance analysis. Financial planners also argue that long‐term investors can afford greater exposure to stock market risk. This book will show how financial planners’ advice can be justified by an inter‐temporal model of a rational investor. The model ignores some important real‐world issues, including diversification of individual stocks, transactions costs, taxation, and the biases identified by research in behavioural finance.

Behavioral finance is useful only if it can be applied to help people make better decisions. This chapter offers reflections on the good, bad, and ugly of practical applications of behavioral finance in a commercial banking setting. It explores the difficulties of nonexperts experimenting with behavioral finance, and how effective applications require a unique mix of expert knowledge and the ability to effect change through a business. Principles of good applications of behavioral finance are also presented, with information on how to start using behavioral finance within an organization. The importance of senior management’s acknowledging that behavioral finance practitioners do not necessarily know the correct answer and that they will need to use randomized control trials to learn is also discussed.

Begins by describing the closed end fund puzzle and enumerating some of the standard accounts that have been used to explain it. Then, applying the model developed in the previous chapter, the author comes to the conclusion that the apparent puzzle could be interpreted in terms of the influence of (individual) investors sentiments on securities prices. This interpretation, in turn, provides some useful hypotheses that are tested with evidence from the US, proving that behavioural finance theory can provide testable predictions.

Most industrialized countries suffered a major breakdown of financial markets and systems during the period 2007 to 2009. This chapter reviews the causes and consequences of this financial market failure and its relationship with market inefficiencies to develop a framework for possible corrective regulations. The analysis combines insights from multiple fields such as finance, economics, and politics to understand the many reasons for market failure. This analysis is the basis for developing five practical principles to guide regulations required to mitigate the effects of market failures. The results should be of interest to individuals, money managers, business executives, and policymakers.

Financial behavior is a complex subject because how people should behave according to traditional finance often differs from how they actually behave. Although traditional and behavioral finance play important roles in understanding investor and market behavior, this book focuses on behavioral finance. Behavioral finance uses insights largely from finance, psychology, and other disciplines to explain how people act and how their behavior affects markets and other financial applications. This chapter provides an overview of behavioral finance, followed by a brief explanation of the book’s purpose, distinguishing features, and intended audience. The chapter outlines the book’s structure of: (1) financial behavior and psychology, (2) financial behavior of major players, (3) financial and investor psychology of specific players, (4) psychology of financial services, (5) behavioral aspects of investment products and markets, (6) market efficiency issues, and (7) application and future of behavioral finance.

This chapter provides an overview of portfolio theory and management. It discusses the three major steps in the portfolio management process—planning, execution, and feedback—and the key tasks involved in each step. Next the chapter examines modern portfolio theory including such topics as asset pricing models, traditional finance models, behavioral finance, alternative investments, performance evaluation and presentation, and the recent financial crisis. Next the chapter describes the purpose of the book, its distinguishing features, and intended audience. The chapter then discusses the structure of the remaining 29 chapters and provides an abstract of each chapter. The final section offers a summary and conclusions. While the theory and practice of portfolio management have been moving ahead at a dizzying pace, this book enables readers to gain a better understanding of the existing state of knowledge and the challenges remaining in this area.

This chapter discusses the role of speculation in the financial markets that influences individual and group behavior in the form of bubbles and crashes. The chapter highlights behavioral finance issues associated with bubbles, such as overconfidence, herding, group polarization, groupthink effect, representativeness bias, familiarity issues, grandiosity, excitement, and the overreaction and underreaction to prices. These issues are important for understanding past financial mistakes because history often repeat itself. The chapter also examines the aftermath of the financial crisis of 2007–2008 on investor psychology, including the impact of a severe financial downturn, anchoring effect, recency bias, worry, loss averse behavior, status quo bias, and trust. The aftermath of the financial crisis might have negative long-term effects on investor psychology in which some investors remain overly risk averse, resulting in under-investment in stocks and over-investment in cash and bonds.

This chapter provides an overview of the emerging cognitive and emotional themes of behavioral finance that influence individual behavior. The behavioral finance perspective of risk incorporates both qualitative (subjective) and quantitative (objective) aspects of the decision-making process. An emerging subject of research interest and investigation in behavioral finance is the inverse (negative) relation between perceived risk and expected return (perceived return). The chapter highlights important topics such as representativeness, framing, anchoring, mental accounting, control issues, familiarity bias, trust, worry, and regret theory. It also examines the role of negative affective reactions on financial decisions. A host of biases that depend on specific aspects of the financial product or investment service influence the judgment and decision-making process of most financial players.

This chapter examines how behavioral factors influence financial decision processes. It takes a behavioral perspective to explain phenomena in financial markets that the neoclassical view of rationally acting agents has trouble explaining. Among these puzzles are the equity premium puzzle and excess volatility. Starting from theoretical challenges to the neoclassical view of thinking including prospect theory, the chapter discusses the most important heuristics and biases in decision making that help to explain empirically observed asset prices including the role of overconfidence and noise traders on financial markets. The chapter also discusses collective behavior such as herding.

Investors are inextricably linked to financial institutions, money managers, and the products they market. Mutual funds, exchange-traded funds (ETFs), hedge funds, and pension funds manage or hold roughly $55 trillion in combined wealth. This chapter examines these topics with a behavioral finance approach, focusing on two main ideas: the performance and rationality of each group, and the behavioral biases that relate to individuals’ selection of particular investments within each group. Research indicates that actively managed mutual funds and hedge funds underperform passive investments. Pension funds generate alpha of roughly zero on a risk-adjusted basis. The fees involved in investing in such funds exacerbate the observed underperformance in mutual funds and hedge funds. Behavioral biases provide one perspective on sources of underperformance. Further, individuals exhibit a wide range of behavioral biases that may lead to suboptimal asset allocation, including the selection of mutual funds, ETFs, and hedge funds.

This chapter reviews various behavioral concepts and strategies to help clients avoid behavioral errors, with the result of increasing the probability of a successful plan design and implementation. The chapter discusses how the concepts introduced by research in behavioral finance have become integrated throughout Evensky & Katz/Foldes Financial’s practice. The chapter begins with framing for new clients, which is part of the firm’s approach to retirement planning called “anchoring on the efficient frontier.” Anchoring refers to the intersection of the client’s return requirement as determined by a capital needs analysis and the client’s risk tolerance. Framing is introduced as a powerful behavioral management tool for the practitioner. Behavioral finance lessons are integrated in the risk tolerance and return discussions, as well as the reporting process.