Traditional finance theory is based on actions of rational investors who can process information efficiently in a timely, unbiased manner and consistently make informed, value-maximizing decisions. However, as mentioned above traditional finance does not assume that all, or even most, investors are rational. But it does assume that irrational investors will be driven out of the market by smart, rational investors.

Behavioral finance theorists question the primary assumption of rational investor behavior. Based on concepts and models developed by cognitive psychologists, they claim that psychological forces prevent decision makers from acting in a rational manner. There are two basic themes of behavioral finance: heuristic-driven bias and frame dependence. Other characteristics of irrational behavior can usually be deduced from these themes.

The term heuristic refers to a rule of thumb that is developed by an individual based on trial and error. Note that the rule of thumb is developed not by scientific reasoning but simply on the basis of one’s own experience or knowledge. Living in Blacksburg (home to Virginia Tech), a resident might believe that Virginia Tech is the best university in the nation. A New Yorker might believe that Fordham University is third only to NYU and Columbia. Or a Philadelphia resident might believe that Temple is just behind the University of Pennsylvania. Not only do people believe in what they think, they believe it so strongly that they suffer from overconfidence. Moreover, overconfidence becomes worse with self-attribution. Assume an investor “knows” that after a long bull run, Cisco is bound to fall. He has seen it happen before. So he sells Cisco once it rises by 10 percent. If Cisco falls thereafter, he pats himself on the back for having predicted the fall correctly. If Cisco rises, he doesn’t blame himself for the error but just puts it down to bad luck. According to behavioral finance, investors take credit for occurrences that support their prior beliefs but dismiss any events that do not, making them more confident through self-attribution.

FundsReliance on rules of thumb also means that people are affected more by recent events even though those events may not represent the norm. Thus, their recent experiences will erroneously play a greater role in the formation of their expectations. Imagine a string of heads in a coin toss. According to behavioral finance, investors who are driven by heuristics will believe that either the probability of a head in a coin toss is greater than 0.5 or that the coin is biased.

The heuristic-driven bias has several implications for investor behavior. Investors will tend to change their beliefs slowly and only when presented with repetitive evidence. But then they swing to the other extreme that also causes swings in prices. Moreover, investors believe strongly in their ability where none exists, and they will continue to make wrong decisions due to their overconfidence. The overconfidence, like their other beliefs, is difficult to overcome.

The second theme of behavioral finance is frame (or form) dependence. Rational economic theory argues that a dollar in your right pocket is the same as a dollar in your left pocket, or that a dollar earned in capital appreciation is the same as a dollar paid in dividends, assuming no taxes and no market imperfections. In a portfolio setting, rational investors consider only the risk and return of the ‘I entire portfolio, not the risk or return of individual securities. These assumptions of rational thinking are called frame (or form) independence, meaning that the form does not matter, only content does.

Behavioral finance enthusiasts contend that individual behavior is not consistent with frame independence. The example above regarding a salary raise of 4 percent versus a raise of 2 percent is a case of narrow framing. Even though the real change in salary is —6 percent for the first worker and 2 percent for the second worker, the pay raises are framed and compared separately from inflation rates. Consequently, the first worker is likely to be happier than the second. In the same vein, investors look at each stock individually, not as part of a portfolio as traditional economists assume. As a result, investors engage in mental accounting. They tend to value stocks that pay dividends more than stocks that pay capital gains. They tend to be loss-averse rather than risk averse. Some experiments find that investor behavior is consistent with frame dependence. For example, investors are known to hold losers for too long because they are averse to realizing a loss. On the other hand, investors sell winners too quickly because they don’t want to see the winner become a loser.

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