Chapter 9. What Is Behavioral Finance?


Glenn Klimek Professor of Finance, Santa Clara University

Abstract: Behavioral finance is a framework that augments some parts of standard finance and replaces other parts. It describes the behavior of investors and managers; it describes the outcomes of interactions between investors and managers in financial and capital markets; and it prescribes more effective behavior for investors and managers.

Keywords: behavioral finance, standard finance, modern portfolio theory, meanvariance portfolio theory, behavioral portfolio theory, capital asset pricing model (CAPM), behavioral asset pricing theory, behavioral asset pricing model (BAPM), three-factor model, rational investors/people, normal investors/people, proto-behavioral finance

Standard finance, also known as modern portfolio theory, has four foundation blocks: (1) investors are rational; (2) markets are efficient; (3) investors should design their portfolios according to the rules of mean-variance portfolio theory and, in reality, do so; and (4) expected returns are a function of risk and risk alone. Modern portfolio theory is indeed modern, dating back to the late 1950s and early 1960s. Merton Miller and Franco Modigliani described investors as rational in 1961. Eugene Fama described markets as efficient in 1965. Harry Markowitz prescribed mean-variance portfolio theory in its early form in 1952 and in its full form in 1959. William Sharpe adopted mean-variance portfolio ...

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