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Finance forNormal People:How Investors and Markets BehaveIntroduction and Chapter 1
FinanceFor Normal People:How Investors and Markets Behave
Introduction: What is Behavioral Finance?Part 1: Behavioral People are Normal PeopleChapter1: Normal peopleChapter 2: Our wants for utilitarian, expressive, and emotional benefitsChapter 3: Cognitive shortcuts and errorsChapter4: Emotional shortcuts and errorsChapter5: Correcting cognitive and emotional errors
FinanceFor Normal People:How Investors and Markets Behave
Chapter6: Experienced happiness, life-evaluation, and choices: Expected Utility Theory and Prospect TheoryChapter7: Behavioral Finance Puzzles: The dividend puzzle, the disposition puzzle, and the puzzles of dollar-cost-averaging and time-diversification
FinanceFor Normal People:How Investors and Markets Behave
Part2: Behavioral Finance in Portfolios, Life-Cycles, Asset Prices, and Market EfficiencyChapter8: Behavioral portfoliosChapter 9: Behavioral life-cycle of saving and spendingChapter 10: Behavioral asset pricingChapter 11:Behavioral market efficiencyChapter 12: Lessons of behavioral finance
Foundation blocks ofstandard and behavioral finance
Standard finance
1. Peopleare rational
Behavioral finance
1. People are normal
Foundation blocks ofstandard and behavioral finance
Standard finance
2. Peopleconstruct portfolios as described by mean-variance portfolio theory, where people’s portfolio wants include only high expected returns and low risk
Behavioral finance
2. Peopleconstruct portfolios as described by behavioral portfolio theory, where people’s portfolio wants extend beyond high expected returns and low risk, such as for social responsibility and social status
Foundation blocks ofstandard and behavioral finance
Standard finance
3. People save and spend as described by standard life-cycle theory, where people find it easy to find and follow the right way to save and spend
Behavioral finance
3. People save and spend as described by behavioral life-cycle theory, where impediments, such as weak self-control, make it difficult to find and follow the right way to save and spend
Foundation blocks ofstandard and behavioral finance
Standard finance
4. Expected returns of investments are accounted for by standard asset pricing theory, where differences in expected returns are determined only by differences in risk
Behavioral finance
4. Expected returns of investments are accounted for by behavioral asset pricing theory, where differences in expected returns are determined by more than differences in risk, such as by levels of social responsibility and social status
Foundation blocks ofstandard and behavioral finance
Standard finance
5. Markets are efficient, in the sense that prices equal values in them and in the sense that they are hard to beat
Behavioral finance
5. Markets are not efficient in the sense that prices equal values in them, but they are efficient in the sense that they hard to beat
Whydo we behave as we do?Rational, Irrational, and Normal Behavior
1stgenerationbehavioral finance
Becausewe areirrationalWe fall victim to cognitive and emotional errors
2ndgenerationbehavioral finance
Becausewe arenormal,pursuing what normal people wantWefall victim to cognitive and emotional errorson our way to what we want
Why do we behave as we do?Rational, Irrational, and Normal Behavior
Standard Finance says:Rationalpeople do not buy lottery tickets
Why do we behave as we do?Rational, Irrational, and Normal Behavior
1stgeneration Behavioral Finance says:Irrationalpeople buy lottery tickets because they are fooled by cognitive errors – exaggerating the odds of winning
Why do we behave as we do?Rational, Irrational, and Normal Behavior
2ndgeneration Behavioral Finance says:Normal people buy lottery tickets for the emotional benefits of hope of winning and the utilitarian benefits of the miniscule odds of winning
Rational andNormal
Standard finance – People are rationalMerton Miller and Franco Modigliani in their 1961 article on dividends:a. Rational people always prefer more wealth to lessb. Rational people are never confused by the form of wealthRational people are indifferent between company-paid dividends and “homemade” dividends created by selling sharesNormal people are notindifferent between company-paid dividends and “homemade” dividends
Rational and Normal
Behavioral finance - People are normalNormal people have normal wants, such as social responsibility, social status, and caring for familyNormal peopleusecognitive and emotionalshortcutson the way to their wantAt times, cognitive and emotional shortcutsbecome cognitive and emotional errorsFraming errors are one example:Normal people are often confused by the form of wealth
Rational and NormalCompany-paid dividends versus “homemade” dividends(in the absence of transaction costs or taxes)
$1,500 Dividend
Cognitiveand Emotional Shortcuts and Errors
Whichrestaurant should we choose for dinner tonight?Goodshortcuts take us close to the best choices, solutions, andanswersCognitiveand emotional shortcuts turn into errors when they take us far from our bestchoices
System 1 and System 2
Intuition, reflected in cognitive and emotional shortcuts, leads us right in most of life. But reflection leads us better when intuitionmisleadsSystem1 is the intuitive “blink” system in our minds - automatic, fast, and effortlessSystem2 is the reflective “think” system in our minds - controlled, slow, andeffortful
Three kinds of knowledge
Financial-facts knowledge - Factsabout finance and financialmarketshuman-behavior knowledge - Knowledgeis about our wants, the cognitive and emotional shortcuts we take, and the errors wemakeInformation knowledge– Exclusively-available, narrowly available, and widely-availableinformation
Transformation fromignorant to knowledgeable
Teachers guidein the search and application of financial-facts, human-behavior, and informationknowledgeExperiencecan also be a goodteacherWepay in money, time, and exertion, both physical and mental, when we transform ourselves from ignorant intoknowledgeableWepay in money, time, and exertion when we substitute the reflective System 2 for the intuitive System1Transformationis worthwhile when benefits exceedcosts

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