Santa Clara’s Leavey School of Business recently looked into excerpts from professor Meir Statman’s new book Finance for Normal People: How Investors and Markets Behave, which investigates the rationale (or lack thereof) underlying our financial behavior and that of the market.
In the early 1980s, the first generation of behavioral finance analysts characterized people as “irrational.” In other words, we “succumbed to cognitive and emotional errors.” The idea was that “cognitive errors such as hindsight and overconfidence, and emotional errors such as exaggerated fear and unrealistic hope” frequently misled us en route to our rational wants—“utilitarian benefits of high return and low risk.”
Statman’s counterpoint, in line with what he describes as behavioral finance’s second generation, is when we fail to consider financial products and services in terms of their expressive and emotional benefits and only within their rational value, we “miss many insights into our financial behavior and the behavior of financial markets.”
The second generation believes the spectrum of human desire as well as the spectrum of value—“utilitarian, expressive and emotional”—is quite normal. By acknowledging this full range, Statman says economists will find that “people’s normal wants, even more than their cognitive and emotional shortcuts and errors, underlie answers to important questions of finance, including saving and spending, portfolio construction, asset pricing and market efficiency.”
These questions in turn help us “transform ourselves from normal-ignorant and normal-foolish into normal-knowledgeable and normal-smart, learning the lessons of behavioral finance and applying them to reduce ignorance, gain knowledge and increase the ratio of smart to foolish behavior on our way to what we want.”