Leading expert in behavioural finance pushes for new three-lens framework on investment decisions
As useful as it’s been in accounting for investors’ tendency to make choices that seemingly run counter to their best interests, the rational/irrational method of categorizing investors still grossly oversimplifies the real world.
That’s according to a recent Forbes article explaining why Dr. Meir Statman, the Glenn Klimek Professor of Finance at Santa Clara University, is proposing a second-generation view of behavioural finance.
While behavioural finance correctly questions the classical economic view of human beings as perfectly rational decision-makers, Statman maintained that it still falls short by attributing “faulty” financial decision-making to a host of cognitive biases and failures. A better interpretation, which he lays out in a free-to-download book called Behavioral Finance: The Second Generation, would describe investors and humanity as just “normal.”
“[W]e want freedom from poverty through steady income, prospects for riches in houses of our own, nurturing our children, helping family and friends, and being helped by them,” Statman said in the book. “[We] use shortcuts and sometimes commit errors on our way to satisfying our wants. And we…are usually normal-knowledgeable and normal-smart but sometimes normal-ignorant or normal-foolish.”
To better capture the reasoning behind a financial decision, he argued, requires going beyond the dogmatic embrace of utilitarianism. As explained in the Forbes article, decisions should also be viewed from an expressive and emotional standpoint.
Taking one example, the article noted that purchasing a luxury vehicle is almost invariably an “irrational” decision from a utility perspective. But it could make sense when viewed from an expressive perspective; the buyer may wish to signal something about themselves through their purchase.
From an emotional perspective, they may also enjoy a real benefit from having a car that can go from zero to sixty miles an hour in just a few seconds, even if there’s no functional reason for them to go that fast.
That’s not to say people should get a free pass for their financial decisions. As the Forbes article noted:
“[B]ehavioral finance 2.0 doesn’t offer a license to err—instead it frees us to look at financial decisions from a different perspective (or perspectives), breathing new life into the first generation that, while more self-aware than the staid traditional approach, was unnecessarily judgmental.”
