Introduction

Formulate a Financial Plan

Know Your Net Worth

Manage & Minimize Debt

Accumulate Assets

Budget to Live Within Your Means

Understand Investing Basics

Plan for Retirement

Insure People & Property

Deal with Financial Advisors

Review Your Employment Contract

Make Plans for Your Estate

Make Good Decisions

Conclusion

In his book Behavioral Finance: The Second Generation, author Meir Statman contrasts early behavioral finance research with more recent efforts. The early work, or version 1.0, consisted of finding specific examples of biases or departures from classiscal economic's definition of rationality. This body of knowledge was often criticized because it didn't have a broad, comprehensive theoretical underpinning: it was simply a disparate set of individual observations or vignettes showing humans making decisions that appear illogical. 

Behavioral finance version 2.0 does provide a broad theoretical explanation for these observations. It begins with insisting that the old labels of rational vs. irrational humans should be discarded and instead we should simply view all people as normal, acknowledging that normal people have never been properly portrayed by classical economic's rational decision maker. As an aside: In my classes I often make the case that the only person who lives up to the definition of the truly rational decision maker is Star Trek's Mr. Spock -- and he's not even human (and he's not even real!).

Statman suggests that the normal investor's decision making is influenced by a combination of three considerations:

  • Utilitarian – What will this investment do for me in practical terms, i.e., expected return and risk?
  • Expressive – What will others think of me for making this decision?
  • Emotional – How will I feel about this decision? 

The utilitarian dimension is most simlar to the rational dimension of decision making. It ignores emotional matters and focuses on the pragmatic. The expressive dimension takes into account the impact we expect to have on others. Will they be pleased with me? Will they be impressed? Will I gain social status and respect? Will I be considered part of the group? The emotional dimension refers to how we feel about our values being expressed. For example, do we feel pride in the action we've taken?  

Allowing for these three dimensions helps to explain human "irrationality" and sets the stage for more sophisticated understanding of how we decide and how we can avoid less than optimal decisions.

 


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