Investor Behavior: The Psychology of Financial Planning and Investing

CHAPTER 3

Behavioral Economics, Thinking Processes, Decision Making, and Investment Behavior

Morris Altman

Professor of Behavioral and Institutional Economics, School of Economics and Finance, Victoria University of Wellington, New Zealand and Professor of Economics, University of Saskatchewan, Canada

INTRODUCTION

According to traditional economic theory embodied in the efficient market hypothesis (EMH), investor behavior should be rational in terms of incorporating all relevant information into the decision-making process, as well as being calculating, forward looking, and not subject to regret. Such behavior also is ideally bereft of emotions because emotions are assumed to bias decisions away from calculating, forward-looking, and maximizing outcomes. In other words, traditional economics assumes decisions result in optimal financial outcomes. What it assumes to be rational behavior should generate the highest possible returns compared to less rational or irrational behavior. Moreover, rational investor outcomes should be efficient such that, on average, market prices reflect the fundamentals of investment choices and therefore incorporate all relevant information about investment prospects.

This chapter addresses the empirical reality that investor behavior often does not generate outcomes that are efficient, yielding suboptimal financial returns, and market prices often deviate from their fundamental values (e.g., resulting in bubbles and busts) (Shiller 2000). Moreover, ...