PREFACE
It has been a decade since the first volume in this series was published. That
volume documented the birth of a new approach to studying financial mar-
kets. This volume illustrates some of what has been going on during the
second decade of behavioral finance research. It has been an exciting time
both for financial markets and for financial market research. I think that
many economists began to take behavioral approaches to finance more seri-
ously on October 19, 1987, when stock prices fell over 20 percent on a day
without any important news (other than the crash itself). If that is the case,
then the rise and fall of the Internet bubble has surely solidified the view
that rational models have trouble explaining all that we see in financial
markets. It is quite hard to claim that NASDAQ was rationally priced at
both 5000 and 1300 within a couple years. Indeed, I think it is now gener-
ally accepted that it is essential to understand how investors behave if we
are to truly understand how prices behave.
Since the first chapter of the book presents an extensive review of behav-
ioral finance research to date, in this preface I will just provide a brief out-
line of what is to come. In selecting the papers to include, I have drawn
on what I consider to be the five major themes of research over the past
decade.^1
I.Limits to ArbitrageIt has long been known by researchers in behavioral economics that the
importance of less than fully rational behavior depends on the extent to
which rational actors can profit from the suboptimal choices of others, es-
pecially if in the act of profiting, rational individuals push the quasi-rational
(^1) Of course, in choosing these papers I have had to make many hard choices in order to
keep the volume to a manageable size. My apologies to the authors of the excellent ones that
have been left out. Serious scholars should use this book as an entry point to the field; the
book is not meant to be complete. One explicit choice I made was not to include articles from
critics of behavioral finance. This is not meant to suggest that behavioral finance is without
critics (though, in fact, there are not many examples of comprehensive critiques of the whole
field). Readers interested in a critical appraisal of some of the empirical papers in this book
could start with Eugene Fama’s (1998). And, to be explicit about something that should be
obvious, the field of behavioral finance could not exist without the building blocks of tradi-
tional (rational) financial theorizing, including the efficient market hypothesis, the capital asset
pricing model, the Modigliani-Miller theorem, and so forth. Behavioral economics (of which
behavioral finance is a subset) builds upon (does not replace) standard economics analyses.