Behavioral Finance in "Finance for Normal People

 
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Finance For Normal People:
How Investors and Markets Behave
 
 
Introduction: What is Behavioral Finance?
Part 1: Behavioral People are Normal People
Chapter 1: Normal people
Chapter 2: Our wants for utilitarian, expressive, and
emotional benefits
Chapter 3: Cognitive shortcuts and errors
Chapter 4: Emotional shortcuts and errors
Chapter 5: Correcting cognitive and emotional errors
 
Finance For Normal People:
How Investors and Markets Behave
 
 
Chapter 6: Experienced happiness, life-evaluation, and
choices: Expected Utility Theory and Prospect Theory
 
 
Chapter 7: Behavioral Finance Puzzles: The dividend puzzle,
the disposition puzzle, and the puzzles of dollar-cost-
averaging and time-diversification
 
Finance For Normal People:
How Investors and Markets Behave
 
 
Part 2: Behavioral Finance in Portfolios, Life-Cycles, Asset
Prices, and Market Efficiency
 
Chapter 8: Behavioral portfolios
Chapter 9: Behavioral life-cycle of saving and spending
Chapter 10: Behavioral asset pricing
Chapter 11: Behavioral market efficiency
Chapter 12: Lessons of behavioral finance
 
Foundation blocks of
standard and behavioral finance
 
Standard finance
 
 
 
1. People are rational
 
Behavioral finance
 
 
 
1. People are normal
 
Foundation blocks of
standard and behavioral finance
 
Standard finance
 
 
 
2. People construct portfolios
as described by mean-
variance portfolio theory,
where people’s portfolio
wants include only high
expected returns and low risk
 
Behavioral finance
 
 
 
2. People construct portfolios
as described by behavioral
portfolio theory, where
people’s portfolio wants
extend beyond high expected
returns and low risk, such as
for social responsibility and
social status
 
Foundation blocks of
standard and behavioral finance
 
Standard finance
 
 
 
3. People save and spend as
described by standard life-
cycle theory, where people
find it easy to find and follow
the right way to save and
spend
 
Behavioral finance
 
 
 
3. People save and spend as
described by behavioral life-
cycle theory, where
impediments, such as weak
self-control, make it difficult
to find and follow the right
way to save and spend
 
Foundation blocks of
standard and behavioral finance
 
Standard finance
 
 
4. Expected returns of
investments are accounted
for by standard asset pricing
theory, where differences in
expected returns are
determined only by
differences in risk
 
Behavioral finance
 
 
4. Expected returns of
investments are accounted
for by behavioral asset pricing
theory, where differences in
expected returns are
determined by more than
differences in risk, such as by
levels of social responsibility
and social status
 
Foundation blocks of
standard and behavioral finance
 
Standard finance
 
 
 
 
5. Markets are efficient, in the
sense that prices equal values
in them and in the sense that
they are hard to beat
 
Behavioral finance
 
 
 
 
5. Markets are not efficient in
the sense that prices equal
values in them, but they are
efficient in the sense that
they hard to beat
 
Why do we behave as we do?
Rational, Irrational, and Normal Behavior
 
 
 
 
1
st
 generation
behavioral finance
 
 
 
Because we are 
irrational
 
 
We fall victim to cognitive and
emotional errors
 
2
nd
 generation
behavioral finance
 
 
Because we are 
normal,
pursuing what normal
people want
 
We fall victim to cognitive and
emotional errors 
on our
way to what we want
 
Why do we behave as we do?
Rational, Irrational, and Normal Behavior
 
 
 
Standard Finance says:
 
Rational 
people do not buy lottery tickets
 
 
 
 
Why do we behave as we do?
Rational, Irrational, and Normal Behavior
 
 
 
1
st
 generation Behavioral Finance says:
 
Irrational
 people buy lottery tickets because they are
fooled by cognitive errors – exaggerating the odds of
winning
 
 
 
 
Why do we behave as we do?
Rational, Irrational, and Normal Behavior
 
 
 
2nd generation Behavioral Finance says:
 
Normal people buy lottery tickets for the emotional
benefits of hope of winning and the utilitarian benefits of
the miniscule odds of winning
 
 
 
Rational and Normal
 
Standard finance – People are rational
 
Merton Miller and Franco Modigliani in their 1961 article on dividends:
a.  Rational people always prefer more wealth to less
b.  Rational people are never confused by the form of wealth
Rational people are indifferent between company-paid dividends and
“homemade” dividends created by selling shares
 
Normal people are not indifferent between company-paid dividends and
“homemade” dividends
 
Rational and Normal
 
 
Behavioral finance - People are normal
Normal people have normal wants, such as social responsibility, social status,
and caring for family
 
Normal people use cognitive and emotional shortcuts on the way to their want
 
At times, cognitive and emotional shortcuts become cognitive and emotional
errors
 
Framing errors are one example:
 
Normal people are often confused by the form of wealth
 
 
Rational and Normal
Company-paid dividends versus “homemade” dividends
(in the absence of transaction costs or taxes)
 
$1,500
Dividend
 
Cognitive and Emotional Shortcuts and Errors
 
Which restaurant should we choose for dinner tonight?
 
 
Good shortcuts take us close to the best choices, solutions, and
answers
 
 
Cognitive and emotional shortcuts turn into errors when they take us
far from our best choices
 
System 1 and System 2
 
Intuition, reflected in cognitive and emotional shortcuts, leads us right
in most of life. But reflection leads us better when intuition misleads
 
 
System 1 is the intuitive “blink” system in our minds - automatic, fast,
and effortless
 
 
System 2 is the reflective “think” system in our minds - controlled, slow,
and effortful
 
Three kinds of knowledge
 
 
1.
Financial-facts knowledge - Facts about finance and financial
markets
 
2.
human-behavior knowledge - Knowledge is about our wants, the
cognitive and emotional shortcuts we take, and the errors we make
 
3.
Information knowledge – Exclusively-available, narrowly available,
and widely-available information
 
Transformation from ignorant to knowledgeable
 
Teachers guide in the search and application of financial-facts, human-
behavior, and information knowledge
 
Experience can also be a good teacher
 
We pay in money, time, and exertion, both physical and mental, when
we transform ourselves from ignorant into knowledgeable
We pay in money, time, and exertion when we substitute the reflective
System 2 for the intuitive System 1
 
Transformation is worthwhile when benefits exceed costs
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Delve into the world of behavioral finance as presented in "Finance for Normal People," exploring how investors and markets behave based on cognitive and emotional factors. The book covers topics such as cognitive shortcuts and errors, emotional biases, and correcting investment mistakes. It also discusses experienced happiness, life-evaluation, and various behavioral finance puzzles. Additionally, learn about behavioral finance in portfolios, life cycles, asset pricing, and market efficiency through a comprehensive overview of standard and behavioral finance concepts.


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  1. Finance for Normal People: How Investors and Markets Behave Introduction and Chapter 1

  2. Finance For Normal People: How Investors and Markets Behave Introduction: What is Behavioral Finance? Part 1: Behavioral People are Normal People Chapter 1: Normal people Chapter 2: Our wants for utilitarian, expressive, and emotional benefits Chapter 3: Cognitive shortcuts and errors Chapter 4: Emotional shortcuts and errors Chapter 5: Correcting cognitive and emotional errors

  3. Finance For Normal People: How Investors and Markets Behave Chapter 6: Experienced happiness, life-evaluation, and choices: Expected Utility Theory and Prospect Theory Chapter 7: Behavioral Finance Puzzles: The dividend puzzle, the disposition puzzle, and the puzzles of dollar-cost- averaging and time-diversification

  4. Finance For Normal People: How Investors and Markets Behave Part 2: Behavioral Finance in Portfolios, Life-Cycles, Asset Prices, and Market Efficiency Chapter 8: Behavioral portfolios Chapter 9: Behavioral life-cycle of saving and spending Chapter 10: Behavioral asset pricing Chapter 11: Behavioral market efficiency Chapter 12: Lessons of behavioral finance

  5. Foundation blocks of standard and behavioral finance Standard finance Behavioral finance 1. People are rational 1. People are normal

  6. Foundation blocks of standard and behavioral finance Standard finance Behavioral finance 2. People construct portfolios as described by mean- variance portfolio theory, where people s portfolio wants include only high expected returns and low risk 2. People construct portfolios as described by behavioral portfolio theory, where people s portfolio wants extend beyond high expected returns and low risk, such as for social responsibility and social status

  7. Foundation blocks of standard and behavioral finance Standard finance Behavioral finance 3. People save and spend as described by standard life- cycle theory, where people find it easy to find and follow the right way to save and spend 3. People save and spend as described by behavioral life- cycle theory, where impediments, such as weak self-control, make it difficult to find and follow the right way to save and spend

  8. Foundation blocks of standard and behavioral finance Standard finance Behavioral finance 4. Expected returns of investments are accounted for by standard asset pricing theory, where differences in expected returns are determined only by differences in risk 4. Expected returns of investments are accounted for by behavioral asset pricing theory, where differences in expected returns are determined by more than differences in risk, such as by levels of social responsibility and social status

  9. Foundation blocks of standard and behavioral finance Standard finance Behavioral finance 5. Markets are not efficient in the sense that prices equal values in them, but they are efficient in the sense that they hard to beat 5. Markets are efficient, in the sense that prices equal values in them and in the sense that they are hard to beat

  10. Why do we behave as we do? Rational, Irrational, and Normal Behavior 2nd generation behavioral finance 1st generation behavioral finance Because we are normal, pursuing what normal people want Because we are irrational We fall victim to cognitive and emotional errors on our way to what we want We fall victim to cognitive and emotional errors

  11. Why do we behave as we do? Rational, Irrational, and Normal Behavior Standard Finance says: Rational people do not buy lottery tickets

  12. Why do we behave as we do? Rational, Irrational, and Normal Behavior 1st generation Behavioral Finance says: Irrational people buy lottery tickets because they are fooled by cognitive errors exaggerating the odds of winning

  13. Why do we behave as we do? Rational, Irrational, and Normal Behavior 2nd generation Behavioral Finance says: Normal people buy lottery tickets for the emotional benefits of hope of winning and the utilitarian benefits of the miniscule odds of winning

  14. Rational and Normal Standard finance People are rational Merton Miller and Franco Modigliani in their 1961 article on dividends: a. Rational people always prefer more wealth to less b. Rational people are never confused by the form of wealth Rational people are indifferent between company-paid dividends and homemade dividends created by selling shares Normal people are not indifferent between company-paid dividends and homemade dividends

  15. Rational and Normal Behavioral finance - People are normal Normal people have normal wants, such as social responsibility, social status, and caring for family Normal people use cognitive and emotional shortcuts on the way to their want At times, cognitive and emotional shortcuts become cognitive and emotional errors Framing errors are one example: Normal people are often confused by the form of wealth

  16. Rational and Normal Company-paid dividends versus homemade dividends (in the absence of transaction costs or taxes) $50,000 Capital $48,500 Capital $1,500 Dividend

  17. Cognitive and Emotional Shortcuts and Errors Which restaurant should we choose for dinner tonight? Good shortcuts take us close to the best choices, solutions, and answers Cognitive and emotional shortcuts turn into errors when they take us far from our best choices

  18. System 1 and System 2 Intuition, reflected in cognitive and emotional shortcuts, leads us right in most of life. But reflection leads us better when intuition misleads System 1 is the intuitive blink system in our minds - automatic, fast, and effortless System 2 is the reflective think system in our minds - controlled, slow, and effortful

  19. Three kinds of knowledge 1. Financial-facts knowledge - Facts about finance and financial markets 2. human-behavior knowledge - Knowledge is about our wants, the cognitive and emotional shortcuts we take, and the errors we make 3. Information knowledge Exclusively-available, narrowly available, and widely-available information

  20. Transformation from ignorant to knowledgeable Teachers guide in the search and application of financial-facts, human- behavior, and information knowledge Experience can also be a good teacher We pay in money, time, and exertion, both physical and mental, when we transform ourselves from ignorant into knowledgeable We pay in money, time, and exertion when we substitute the reflective System 2 for the intuitive System 1 Transformation is worthwhile when benefits exceed costs

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