Behavioral Finance and Your Portfolio. Michael M. Pompian

Behavioral Finance and Your Portfolio - Michael M. Pompian


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a hard choice, the deck is stacked in our favor.

      Another prolific contributor to behavioral finance is Meir Statman, PhD, of the Leavey School of Business, Santa Clara University (Figure 1.5).

Photograph of Meir Statman, PhD, Glenn Klimek Professor of Finance at the Leavey School of Business, Santa Clara University.

       Figure 1.5 Meir Statman, PhD, Glenn Klimek Professor of Finance at the Leavey School of Business, Santa Clara University

      Source: www.scu.edu

Photograph of Daniel Kahneman, 2002 Nobel Prize winner in Economic Sciences.

       Figure 1.6 Daniel Kahneman, 2002 Nobel Prize Winner in Economic Sciences

      Source: The White House

      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.

      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 and discusses some evidence that has emerged in favor of the behavioral approach.

      Overview


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