The Conceptual Foundations of Investing

8CAN BEHAVIORAL ANOMALIES BE EXPLOITED?

Let's start by reviewing what the standard “rational” finance model is before diving into what behavioral finance says is wrong with it. Recall that investors are assumed to maximize the utility associated with consumable wealth. That utility always increases as wealth rises, but at a decreasing rate. The fact that each added dollar provides a little less utility than the last is the basis for risk aversion. It is this risk aversion that drives rational asset pricing models. Furthermore, investors are assumed to be rational in their efforts to maximize utility. They do not succumb to fear and greed.

Taken at face value, the traditional model appears to most people to be clearly false. Can you think of anyone who is not affected by fear when the stock market is crashing? The field of behavioral finance, which has grown dramatically in the past two decades, has taken up the task of attempting to develop models of behavior that are, in their view, more realistic than the assumption of rational utility maximization. This effort has not gone unnoticed. Nobel prizes in economics have been awarded to Herbert Simon, Daniel Kahneman, and Richard Thaler, leaders in the growing area of behavioral finance, for providing evidence contrary to the assumption of rationality. But the fact that individuals evidence departures from rationality does not mean that those departures can serve as a basis for beating the market. After all, Richard Thaler is ...