The New Commonsense Guide to Your 401(k): Rebuilding Your Portfolio From The Bottom up

Chapter 40. Behavioral Finance

WHY HAS INVESTING grown so complicated? The world is more complicated, of course, but another problem is that economic and investment theories that were viewed as forever workable twenty years ago have been turned on their heads by new experiments.

Consider the efficient market theory. Efficient market theory holds that all information about securities is known and is reflected in the stock prices, and so every security is rationally and appropriately priced. There is so much knowledge available, this theory holds, and so many knowledgeable players in the market that any changes in stock prices are due to random forces, almost mechanical forces, and market prices will quickly reset to again reflect, appropriately, the value of the security. Of course, anyone who has ever invested in a stock knows that this theory is pure folly. If it were true, little money would ever be made in the stock market.

In the 1980s, a group of economists began talking about what they called "behavioral economics" or "behavioral finance." They argued that people do not always choose an investment rationally. Imagine that! Indeed, these economists said, they detected all kinds of situations in which psychology had more influence on a decision than did economic reality. For example, investors hate to lose much more than they enjoy winning. They feel much more upset by a near miss than by an event they missed by a mile. Behavioral Economists like Meir Statman at Santa Clara University ...