Investor Behavior: The Psychology of Financial Planning and Investing

CHAPTER 2

Traditional and Behavioral Finance

Lucy F. Ackert

Professor of Finance, Coles College of Business, Kennesaw State University

INTRODUCTION

Psychologists and other social scientists have made great strides in understanding how individual and group behavior, as well as brain function, shape the decisions people make. Throughout history, financial commentators and scholars recognized the impact of human psychology on financial decision-making and market outcomes. For example, the prominent economist John Maynard Keynes (1964) notes that people's decisions about the future could not depend only on mathematical expectations because the world is fraught with uncertainty. Instead, Keynes contends that human decisions are often based on whim, sentiment, or simple chance. Despite the recognition that human psychology has an important role in determining economic and financial decisions, traditional finance theory reflects the abrupt and overwhelming movement of economists toward the mathematical modeling tools used in the hard sciences. In hindsight, finance theorists apparently fell prey to “physics envy,” the desire to mathematize the study of financial behavior.

Certainly, mathematical paradigms are useful in numerous applications, but empirical evidence contradicting traditional finance models mounted over recent years. Even very simple choices in controlled environments were inconsistent with the theories that dominated just a few decades ago. Thus, behavioral finance theorists ...