Practical Applications of A Unified Behavioral Finance

Abstract

We often hear that behavioral finance is just a collection of stories about irrational people who make cognitive and emotional errors-that the theory lacks the unified structure of standard finance. Yet today's standard finance is no longer unified, as wide cracks have opened between theory and evidence.

In A Unified Behavioral Finance, published in the Summer 2018 issue of the Journal of Portfolio Management, Meir Statman, the Glenn Klimek Professor of Finance at the Leavey School of Business at Santa Clara University in Santa Clara, California, describes a second generation of behavioral finance theory as a unified structure that bridges theory, evidence, and practice, in which parts of standard finance are incorporated and others are replaced.

In second-generation behavioral finance, investors are “normal,” neither rational nor irrational, each with the full range of normal human desires-for wealth, freedom from the fear of poverty, nurturing families, the capacity to honor values, social status, winning games, and more. The author offers guidance on using shortcuts and avoiding errors on the way to satisfying wants. People’s wants, even more than cognitive and emotional errors, address important questions of finance, including behavior, portfolio construction, life-cycle saving and spending, asset pricing, and market efficiency.

TOPICS: Wealth management, portfolio management/multi-asset allocation