Are typical investors persistently irrational in pursuit of wealth, or pursuing more than wealth? In his December 2019 book entitled Behavioral Finance: The Second Generation, Meir Statman describes and discusses second-generation behavioral finance, which replaces (1) pursuit of wealth persistently retarded by cognitive shortcuts and emotional biases with (2) pursuit of normal wants including financial security, success for children and families, adherence to values, high social status, inclusion, respect and fairness (with some shortcuts and errors). These normal wants, even more than cognitive shortcuts and emotional biases, explain saving and spending, portfolio construction, asset pricing and market efficiency. Based on the body of research and his long experience in behavioral finance, he concludes that:
- Knowledgeable investors learn to pause and reflect when “blink” intuition tends to mislead.
- Normal people commingle wants as investors and consumers, introducing conflicts and trade-offs among utilitarian, expressive and emotional benefits. Non-utilitarian wants are not errors, though normal people commit cognitive and emotional errors in pursuing these wants.
- Sophisticated investors combine knowledge of wants, cognitive/emotional shortcuts and cognitive/emotional errors with financial knowledge to satisfy wants efficiently.
- Behavioral portfolio theory prescribes an investment frontier that combines utilitarian, expressive and emotional benefits while avoiding temptations of illusory portfolios built on cognitive/emotional errors.
- Behavioral life-cycle investment management seeks to reconcile conflicts among wants by: (1) identifying utilitarian, expressive and emotional benefits in both saving and spending; and, (2) introducing rules (framing, mental accounting and self-control) to help avoid raiding of key mental accounts.
- Behavioral asset pricing models encompass utilitarian, expressive and emotional wants and acknowledge presence of cognitive/emotional errors, whereas standard asset pricing models attend strictly to utilitarian wants (return and risk) and ignore cognitive/emotional errors.
- Behavioral finance distinguishes between value-efficient and hard-to-beat market hypotheses and explains why so many investors wrongly believe that markets are easy to beat.
In summary, second-generation behavioral finance: (1) addresses everyday trade-offs among utilitarian, expressive and emotional wants, with frequent sacrifice of wealth to exercise social responsibility or achieve high social status; and, (2) distinguishes between non-utilitarian wants and investment errors, while still aware of cognitive/emotional errors committed in achieving wants.
Cautions regarding conclusions include:
- Quantifying expressive and emotional wants is problematic.
- Expressive and emotional wants may be transitory compared to wealth objectives, inducing highly tactical portfolios.
