Overview

Behavioral finance is the study of how psychological phenomena impact financial behavior. As its title suggests, the subject of this book is the implications of behavioral finance for asset pricing. The long-term objective of behavioral finance is to behavioralize finance. In this vein, the objective of the book is to behavioralize asset pricing theory. Behavioralizing asset pricing theory means tracing the implications of behavioral assumptions for equilibrium prices.

Financial economists are in the midst of a debate about a paradigm shift, from a neoclassical-based paradigm to one that is behaviorally based. The basis for the debate about a paradigm shift in finance involves the way that people make decisions. In the course of making decisions, people generally make observations, process data, and arrive at judgments. In finance, these judgments and decisions pertain to the composition of individual portfolios, the range of securities offered in the market, the character of earnings forecasts, and the manner in which securities are priced through time.

In building a framework for the study of financial markets, academics face a fundamental choice. They need to choose a set of assumptions about the judgments, preferences, and decisions of participants in financial markets. The paradigmatic debate centers on whether these assumptions should be neoclassical-based or behaviorally based.

Traditionally, finance has adopted the neoclassical framework of micro-economics. In the neoclassical framework, financial decision-makers possess von Neumann Morgenstern preferences over uncertain wealth distributions, and use Bayesian techniques to make appropriate statistical judgments from the data at their disposal.

Psychologists working...