Equity Markets, Valuation, and Analysis

CHAPTER 5Investor Psychology and Equity Market Anomalies

Hunter M. Holzhauer

Robert L. Maclellan and UC Foundation Associate Professor of Finance, University of Tennessee Chattanooga

INTRODUCTION

Richard Thaler, a founding father of behavioral finance, notes: “You assume that the agents in the economy are as smart as you are, and I assume that they are as dumb as me” (Harford 2019, p. 1). Thaler directed his comment to traditionalist Robert Barro during a National Bureau of Economic Research (NBER) conference. The quote perfectly contrasts the irrationality of investor decision-making explored in behavioral finance with the more rational framework of traditional finance models. However, behavioral finance is often and wrongly viewed as a direct competitor to traditional established theories like expected utility theory (EUT) (Bernoulli 1738; Neumann and Morgenstern 1944), modern portfolio theory (MPT) (Markowitz 1952), and the efficient market hypothesis (EMH) (Fama 1970, 1991). The most logical but false reason that many view behavioral finance as the polar opposite of traditional finance is that these well-established traditional theories assume that investors are always rational. Thus, many books erroneously claim that behavioral finance assumes that investors are always irrational. This assumption is simply not valid. Instead, behavioral finance assumes that investors are human but not always rational. This clarification is important because behavioral finance is not necessarily ...