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Behavioral Finance: Quo Vadis?
Werner De Bondt, Gulnur Muradoglu, Hersh Shefrin, and Sotiris K. Staikouras

Richard Thaler. Soon, this small group of financial economists was meeting regularly with psychologists —— including Paul
Andreassen, Daniel Kahneman, and Amos Tversky —— at the
Russell Sage Foundation in New York. Five or six years later, the National Bureau of Economic Research began organizing semi-annual meetings. From its beginnings as a fringe movement, behavioral finance moved to a middle-ofthe-road movement, with spillover effects on marketing, management, experimental economics, game theory, political science and law. Now behavioral finance is poised to replace neoclassical finance as the dominant paradigm of the discipline. Traditionally, economists model behavior in terms of rational individual decision-makers who make optimal use of all available information. There is ample evidence that the rationality assumption is unrealistic. The path-breaking work of Herbert Simon, Tversky and Kahneman, Lola Lopes, and others on bounded rationality, judgmental heuristics, biases, mental frames, prospect theory, and SP/A theory has provided new foundations for financial economics. Behavioral finance studies the nature and quality of financial judgments and choices made by individual economic agents, and examines what the consequences are for financial markets and institutions. Investment portfolios are frequently distorted, with consequent excess volatility in stock and bond prices.
Examples include the stock market crash of 1987, the bubble in Japan during the 1980s, the demise of Long-Term Capital
Management, the Asian crisis of 1997, the dot-com bubble, and the financial crisis of 2008. Most everyone agrees that it is problematical to discuss these dramatic episodes without reference to investor psychology.
The term ““behavioral finance”” has a variety of meanings.
Our paper aims to provide an over-arching view of the field.
It is a summary of a panel discussion. The paper is written for a wide spectrum of readers, including financial practitioners. It begins by examining the current state of finance, reviews some fundamental questions, and then

Behavioral finance endeavors to bridge the gap between finance and psychology. Now an established field, behavioral finance studies investor decision processes which in turn shed light on anomalies, i.e., departures from neoclassical finance theory. This paper is the summary of a panel discussion. It begins by reviewing the foundations of finance and it ends with a discussion of the future of behavioral finance and a self-critique.
We describe the move from the standard view that financial decision making is rational to a behavioral approach based on judgmental heuristics, biases, mental frames, and new theories of choice under risk. A new class of asset pricing models, which adds behavioral elements to the standard framework, is proposed.

„Proponents of behavioral finance argue that poorly informed and unsophisticated investors might lead financial markets to be inefficient. The debate between neoclassical and behavioral finance is wide ranging, and sometimes explains differences in policy recommendations on such issues as financial regulation, corporate governance, or the privatization of social security. It had immediate impact worldwide including emerging markets (Muradoglu, 1989).
Behavioral finance emerged as a field in the early 1980s with contributions by, among others, David Dreman, Robert
Shiller, Hersh Shefrin, Meir Statman, Werner De Bondt and

Werner De Bondt is a Professor of Finance at DePaul University in Chicago, IL. Gulnur Muradoglu is a Professor of Finance at Cass Business
School in London, UK. Hersh Shefrin is a Professor of Finance at Santa
Clara University in Santa Clara, CA. Sotiris K. Staikouras is a Senior Lecturer in Finance at Cass Business School in London, UK.

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JOURNAL OF APPLIED FINANCE —— FALL/WINTER 2008

introduces behavioral…