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Chapter 2. Behavioral Finance

Psychologists have known for a long time that people often act in a seemingly irrational manner and make predictable errors when forecasting. This behavior is harmless when it causes a zest for the home sports team. Being overly optimistic when rooting for your team is fun. However, when this behavior affects your investing decisions, it can cause you to make small mistakes that lower your return or make big blunders that devastate your wealth.

All people are affected by psychological biases. However, traditional finance considers this irrelevant. Traditional finance assumes that people are “rational.” Financial theory has developed with the proposition, called market efficiency, that stock prices are reasonably accurate and reflect the true value of firms. If stock prices are efficient, then investors won't do serious harm to their wealth if they trade frequently or follow specific investing strategies. Therefore, financial economics has developed in a proscriptive manner. That is, it has developed ideas and useful financial tools for how investors should behave. As a consequence, little research has been conducted on actual investor behavior.


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