Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing.

• Author: Greifer, Nicholas
• Position: Brief Article - Review

Shefrin, Hersh

Boston, MA: Harvard Business School Press, 2000. (368 pp)

This excerpt from Beyond Greed and Fear illustrates a central theme of the book--how professional and amateur investors continue to make fundamental mistakes over time, due to basic human psychology. In showing these mistakes, the author succeeds in writing a book that is both entertaining and informative. Public-sector investors who manage either equity or fixed income investments would do well to read this book and learn from the mistakes made by others.

"Some things never change[ldots][T]he evolution of the 1933 Securities Act and 1934 Securities Exchange Act [were][ldots] a response to the fate that befell optimistic, overconfident traders in the 1920s.[dots]On January 27, 1999, Securities and Exchange Commission chair Arthur Levitt warned that on-line trading was like a 'narcotic' to many on-line traders. The technology may have changed over the last seventy years, but human psychology has not.

Beyond Greed and Fear presents the latest wave in the application of the social sciences to finance. This relatively new field marries economics and psychology to understand how investors, advisors, and the markets behave, and along the way, it shows how they depart from the "rational" behavior postulated by economists from the efficient market school of thought.

The book is divided into six parts: a) an overview that defines the field of behavioral finance; b) applications of behavioral finance theory to investors who try to predict the market; c) mistakes made by individual/retail investors; d) mistakes made by institutional investors, including views on the Orange County failure; e) corporate finance; and f) derivatives. Part d) on institutional investors may be particularly useful to public investors as it sheds light on traps that they may fall into.

At the heart of behavioral finance are three concepts. First, people use heuristics or rules of thumb that help them make sense of investment data. A well-known example is that investors select either individual securities or mutual funds based on past performance. According to the author, traditional financial theory would argue that rational investors use statistical tools (and any other information sources) appropriately to process data as opposed to rules of thumb. A reliance on heuristics makes investors predisposed to errors when selecting investments.

What are some of the heuristics that people rely on? With the...