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Behavioral Finance and Investor Types: Managing Behavior to Make Better Investment Decisions by Michael M. Pompian

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Chapter 2

Overview of Behavioral Finance

People in standard finance are rational. People in behavioral finance are normal.

—Meir Statman, PhD, Santa Clara University

At its core, behavioral finance attempts to understand and explain actual investor and market behaviors versus theories of investor behavior. This idea differs from traditional (or standard) finance, which is based on assumptions of how investors and markets should behave. As Professor Statman's quote puts it, standard finance people are modeled as “rational,” whereas behavioral finance people are modeled as “normal.” This may be interpreted to mean that “normal” people may behave irrationally—but the reality is that almost no one (actually I will go so far as to say absolutely no one) behaves perfectly rationally. Fundamentally, behavioral finance is about understanding how people make decisions, both individually and collectively. By understanding how investors and markets behave, it may be possible to modify or adapt to these behaviors in order to improve economic outcomes. In many instances, knowledge of and integration of behavioral finance may lead to superior results for both advisors and their clients.

In the context of this book, we will be focusing on the development of individual investor biases or irrational behaviors. These biases will help to define the behavioral investor types reviewed later in the book. This chapter will focus on key developments that have occurred over the years that have led to ...

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