thought you were going to monitor our investments closely. Our portfo-
lio shows nothing but huge losses.
Dave:I know; I feel terrible. All the experts said these stocks would re-
bound, but they kept going down.
Jen:This has happened before. I don’t understand why you do so badly.
For years you watch the market closely, study all these financial reports,
and seem to be very well informed, yet you seem to always make the
wrong decisions. You buy near the highs and sell near the lows. You hold
on to losers while selling your winners. You...
Dave:I know, I know. My stock investments always go wrong. I think
I’m giving up on stocks and sticking with bonds.
Jen:Listen, Dave. I have talked to a few other people about your invest-
ing troubles, and I want you to go see an investment counselor. They use
behavioral psychology to help investors understand why they do
poorly. The investment counselor will help you correct this behavior.
Dave, I made you an appointment already. Please go see him.
BEHAVIORAL FINANCE
TIME:NEXT WEEK
Dave was skeptical. He thought that understanding stocks required
knowledge of economics, accounting, and mathematics. Dave never
heard the word psychologyused in any of those subjects. Yet he knew he
needed help, and it couldn’t hurt to check it out.
Investment Counselor (IC):I have read your profile and talked to your
wife extensively. You are very typical of the investor that we counsel
here. I adhere to a new branch of economics called behavioral finance.
Many of the ideas my profession explores are based on psychological
concepts that have rarely before been applied to the stock market and
portfolio management.
Let me give you some background. Until recently, finance was
dominated by theories that assumed investors maximized their ex-
pectedutility, or well-being, and always acted rationally. This was an ex-
tension of the rational theory of consumer choiceunder certainty applied to
uncertain outcomes.
In the 1970s two psychologists, Amos Tversky and Daniel Kahne-
man, noted that many individuals did not behave as this theory predicted.
They developed a new model—called prospect theory—of how individuals
actually behave and make decisions when faced with uncertainty.^3 Their
322 PART 4 Stock Fluctuations in the Short Run