model established them as the pioneers of behavioral finance, and their re-
search has been making much headway in the finance profession.Fads, Social Dynamics, and Stock BubblesIC:Let us first discuss your decision to get into the Internet stocks. Think
back to October 1999. Do you remember why you decided to buy those
stocks?
Dave:Yes. My stocks were simply not going anywhere. My friends at
work were investing in the Internet and making a lot of money. There
was so much excitement about these stocks; everyone claimed that the
Internet was a communications revolution that would change business
forever.
IC:When everyone is excited about the market, you should be extremely
cautious. Stock prices are not based just on economic values but on psy-
chological factors that influence the market. Yale economist Robert
Shiller, one of the leaders of the behavioral finance movement, has em-
phasized that fads and social dynamics play a large role in the determi-
nation of asset prices.^4 Shiller showed that stock prices have been far too
volatile to be explained by fluctuations in economic factors, such as div-
idends or earnings.^5 He has hypothesized that much of the extra volatil-
ity can be explained by fads and fashions that have a large impact on
investor decisions.
Dave:I did have my doubts about these Internet stocks, but everyone
else seemed so sure they were winners.
IC:Note how others influenced your decision against your better judg-
ment. Psychologists have long known how hard it is to remain separate
from a crowd. This was confirmed by a social psychologist named
Solomon Asch. He conducted a famous experiment where subjects were
presented with four lines and asked to pick the two that were the same
length. The right answer was obvious, but when confederates of Dr. Asch
presented conflicting views, the subjects often gave the incorrect answer.^6CHAPTER 19 Behavioral Finance and the Psychology of Investing 323
(^3) Daniel Kahneman and Amos Tversky, “Prospect Theory: An Analysis of Decision under Risk,”
Econometrica, vol. 47, no. 2 (March 1979).
(^4) Robert Shiller, “Stock Prices and Social Dynamics,” Brookings Papers on Economic Activity, Wash-
ington, D.C.: Brookings Institution, 1984.
(^5) Robert Shiller, “Do Stock Prices Move Too Much to Be Justified by Subsequent Movements in Div-
idends?”American Economic Review, vol. 71, no. 3 (1981), pp. 421–436. See Chapter 16 for further dis-
cussion.
(^6) Solomon Asch, Social Psychology, Englewood Cliffs, N.J.: Prentice Hall, 1952.