RAE-Revista de Administração de Empresas | FGV-EAESP 95 ESSAY Invited article DOI: http://dx.doi.org/10.1590/S0034-759020150109 THE BEHAVIORAL PARADIGM SHIFT In the last half decade, academic finance has experienced two revolutions, one neoclassical and one behavioral, which were jointly recognized in the awarding of the 2013 Nobel Prize in economics. Before 1960, academic finance was organized around a loose collection of anecdotes, puzzles, and investment philosophies. The neoclassical revolution changed all of this by importing the structure and rigor of rationality-based principles of microeconomics into finance. Three No- bel Prizes recognized its main contributors. The first, in 1990, was jointly awarded to Harry Mar- kowitz for mean-variance portfolio theory, to Merton Miller for corporate finance, and to William Sharpe for the capital asset pricing model (CAPM). The second prize, in 1997, was shared by My- ron-Scholes and Robert Merton for developing the Black-Scholes-Merton option pricing formu- la. Unfortunately, Fischer Black who co-developed the formula, died in 1995. The third prize, in 2013, was awarded to three economists, two of whom contributed to the neoclassical revolution - Eugene Fama, for his seminal work on market efficiency, and Lars Peter Hansen for his seminal work on asset pricing theory. The behavioral revolution imported ideas from behavioral psychology into finance, and replaced the rationality postulate with a more realistic alternative. Two of its main contributors were recognized with Nobel prizes. The first, in 2002, was awarded to Daniel Kahneman who shared the award with experimental economist Vernon Smith. The Nobel selection committee recognized Kahneman for his work with fellow psychologist Amos Tversky who died in 1996. The second prize, in 2013, was awarded to Robert Shiller for his work on asset pricing. Of course, this prize was shared by Shiller, Fama, and Hansen. Both of these revolutions created great intellectual value. The neoclassical revolution HERSH SHEFRIN provided a first pass at introducing structure and rigor into the way academics think about fi- [email protected] nancial issues. The behavioral revolution has provided a second pass at modifying this struc- Professor at Santa Clara University, ture to reflect the fact that human beings are not perfectly rational, but are instead imperfectly Leavey School of Business – Santa Clara – California, United States of rational. Behavioral finance focuses on the structure and implications of people’s imperfect at- America tempts to match means and ends when making financial decisions. ISSN 0034-7590 © RAE | São Paulo | V. 55 | n. 1 | jan-fev 2015 | 95-98 96 ESSAY | The behavioral paradigm shift In this second, behavioral, pass at they optimally balance expected return of extreme events are small, the aver- finance, behaviorists are modifying ev- against risk. Amazingly, in 1952 when age person is risk seeking in the domain ery nook and cranny of the discipline. Markowitz was developing mean-vari- of gains and risk averse in the domain of Mean-variance portfolio theory has its ance portfolio theory, he was also laying losses. counterpart in behavioral portfolio theo- the groundwork for behavioral portfolio The insights offered by prospect ry. Corporate finance has its counterpart in theory. In consecutive months he pub- theory motivated Meir Statman and me behavioral corporate finance. The CAPM, lished two seminal papers, one neoclas- to introduce “the disposition effect” into which neoclassical asset pricing theorists sical and the other behavioral. Kahneman finance literature. The disposition effect such as Hansen generalized to pricing ker- and Tversky built prospect theory with holds that investors are predisposed to nel theory, has its counterpart in behavior- Markowitz’s behavioral piece constitut- sell winners too quickly and hold losers al pricing kernel theory; a special case is ing one of its core elements. Psychologist too long, except in the month of December the behavioral Black-Scholes option pric- Lola Lopes also built SP/A theory with when the disposition will either weaken ing formula. Finally, the concept of effi- Markowitz’s behavioral insights as a core or reverse. Prospect theory was our start- cient markets based upon the idea of ar- element. ing point; however we pointed out that ex- bitrage has its counterpart in inefficient Prospect theory, applied to port- plaining the disposition effect required markets based upon the idea that there folio selection, tells us that investors other psychological elements such as re- are limits to arbitrage. will think about their portfolios as a col- gret and self-control. The behavioral revolution in finance lection of separate components (called Statman and I developed the psy- and economics came fast on the heels of a mental accounts), rather than as a single chological underpinnings for the dispo- similar behavioral revolution in psycholo- integrated entity. Kahneman and Tversky sition effect against the results of a ma- gy which gave us coherent frameworks to told us that this lack of integration will jor study of individual investors by Lease, study how people make choices among make people vulnerable to making choic- Lewellen, and Schlarbaurm who found ev- risky prospects, how they rely on heuris- es that violate first order stochastic dom- idence of disposition effect behavior, but tics to form judgments, and how their im- inance, meaning they will act as if they argued that it did not stem from psycho- perfections leave them vulnerable to par- throw away money. logical sources. Several years later, Ter- ticular biases. The set of psychological A key aspect of the explanation ry Odean built a rich database of U.S. in- frameworks and concepts from which be- for why investors behave in this fashion dividual investors and tested the main havioral economists draw includes pros- is that they evaluate these components hypotheses Meir and I had developed. pect theory, SP/A theory, regret theory, in terms of gains and losses, rather than Subsequently, the disposition effect has change of process theory, excessive opti- net asset position. Moreover, they exhib- become one of the most studied features mism, overconfidence, confirmation bias, it loss aversion in the sense of experienc- of investor behavior. Researchers have in- anchoring-and-adjustment bias, illusion ing losses more acutely than gains. Loss vestigated the disposition effect in differ- of control, representativeness, and the aversion will induce people to be risk ent countries, different time periods, and affect heuristic. Behavioral economists averse when facing situations in which different markets. They have also extend- have been applying these frameworks and they might experience gains if fortunate, ed the analysis to professional investors, concepts to investigate issues across the but might also experience losses if unfor- and studied its impact on asset prices. entire landscape of finance. tunate. However, at the same time, peo- The work of Lease, Lewellen, and In the remainder of these intro- ple will be averse to sure losses, and Schlarbaum told us that investors trade ductory remarks, I will offer a short per- prone to exhibiting risk-seeking behavior too much, and that the portfolios of those sonal perspective on how these develop- when dealing with the prospect of a re- who trade the most, the so-called “high ments from psychology impact aspects alized loss. Among Kahneman and Tver- rollers”, experience the worst perfor- of finance, effectively my impressions of sky’s key lessons is the fourfold pattern mance. Using transaction data that was how the behavioral approach adds in- in which people’s risk appetite is circum- more recent and more extensive, Brad sights and value to the major subfields stance dependent. When outcome prob- Barber and Terry Odean documented the of finance: portfolio theory, asset pricing, abilities are in the midrange, the aver- degree to which turnover hurts perfor- and corporate finance. age person is risk averse in the domain mance, and attributed excessive trading Mean-variance theory tells us how of gains and risk seeking in the domain to overconfidence. Lease, Lewellen, and investors can choose portfolios in which of losses. When outcome probabilities Schlarbaum also reported that high roll- © RAE | São Paulo | V. 55 | n. 1 | jan-fev 2015 |95-98 ISSN 0034-7590 AUTHOR | Hersh Shefrin 97 ers are overly prone to focus on short-term having data on investors’ expectations of acquisition activity, and corporate gov- capital gains and use technical analysis, returns, meaning ex ante judgments, as ernance. Although some of these issues and in recent work with Arvid Hoffmann, opposed to relying on ex post realized re- pertain to the impact of psychological im- which uses data from Dutch investors, we turns, can serve to distinguish whether or perfections on corporate managers, oth- find that this continues to be so. not prices are fully rational. This statement ers involve how corporate managers react In the last decade, research has applies both to the cross-section of secu- to market inefficiencies. shown that entertainment, gambling, and rity returns and to the time series. In re- I am going to close these remarks thrill seeking are important aspects in spect to the cross-section, Statman points by going back in time, first a few decades, portfolio decisions, not just risk and ex- out that investors’ need for value expres- and then a few centuries. My first work pected