Behavioral finance presented in this book is the second generation of behavioral finance. The first generation, starting in the early 1980s, largely accepted standard finance’s notion of people’s wants as “rational” wants—restricted to the utilitarian benefits of high returns and low risk. That first generation commonly described people as “irrational”—succumbing to cognitive and emotional errors and misled on their way to their rational wants. The second generation describes people as normal. It begins by acknowledging the full range of people’s normal wants and their benefits— utilitarian, expressive, and emotional—distinguishes normal wants from errors, and offers guidance on using shortcuts and avoiding errors on the way to satisfying normal wants. People’s normal wants include financial security, nurturing children and families, gaining high social status, and staying true to values. People’s normal wants, even more than their cognitive and emotional shortcuts and errors, underlie answers to important questions of finance, including saving and spending, portfolio construction, asset pricing, and market efficiency.

Second-generation behavioral finance offers an alternative foundation block for each of the five foundation blocks of standard finance, incorporating knowledge about people’s wants and their cognitive and emotional shortcuts and errors. According to second-generation behavioral finance,

1. People are normal.
2. People construct portfolios as described by behavioral portfolio theory, where people’s portfolio wants extend beyond high expected returns and low risk, such as wants for social responsibility and social status.
3. People save and spend as described by behavioral life-cycle theory, where impediments, such as weak self-control, make it difficult to save and spend in the right way.
4. Expected returns of investments are accounted for by behavioral asset pricing theory, where differences in expected returns are determined by more than just differences in risk—for example, by levels of social responsibility and social status.
5. Markets are not efficient in the sense that price always equals value in them, but they are efficient in the sense that they are hard to beat.

People want three types of benefits—utilitarian, expressive, and emotional— from every activity, product, and service, including financial ones. Utilitarian benefits answer the question, What does something do for me and my wallet? Expressive benefits answer the question, What does something say about me to others and to myself? Emotional benefits answer the question, How does something make me feel?

The book distinguishes cognitive and emotional shortcuts from cognitive and emotional errors. Framing is one cognitive shortcut, such as framing money into two checking accounts, one for the wife and another for the husband, or into a single joint account. Each shortcut involves considerations of utilitarian, expressive, and emotional benefits and costs.

We see framing shortcuts and errors in many financial settings. Official US statistical agencies report monthly or quarterly numbers for GDP, industrial production, inflation, and more. In many other countries, however, statistical agencies report annual numbers.

Reporting data as monthly, quarterly, or annual makes no difference to rational investors because these data are different only in frame, not in substance. Yet financial market prices react more strongly to the most recent number placed in the headline of the press release—the monthly or quarterly number in countries that place that number in the headline and the annual number in countries that place that number in the headline.

Advice to set emotions aside when considering investments and use reason alone is common but wrong for three reasons: First, we cannot set emotions aside even if we want to. Second, emotions are not necessarily emotional errors. Third, emotional shortcuts help more than emotional errors harm. Emotional shortcuts complement reason, and the interaction between emotions and reason is beneficial, often critically so.

A study of financial advertisements showed that compared with neutral imagery, emotionally laden imagery increases investor knowledge about important investment characteristics, such as costs, time to maturity, and dividend frequency. Emotionally laden disclosure of risk factors increases knowledge of risk factors but does not increase knowledge of other investment characteristics. Emotionally laden imagery increases average amounts invested, whereas emotionally laden disclosure of risk decreases the willingness to consider other information.

The efficient market hypothesis is at the center of standard finance, and many believe that behavioral finance refutes it. Indeed, many believe that refutation of the efficient market hypothesis is the most important contribution of behavioral finance. This issue becomes confused, however, when discussants fail to distinguish between two versions of efficient markets and their corresponding efficient market hypotheses—the price-equals-value efficient market hypothesis and the hard-to-beat efficient market hypothesis. And it remains a mystery why so many investors believe that markets are easy to beat.

Both standard finance and behavioral finance provide evidence refuting the value-efficient market hypothesis, but their evidence generally supports the hard-to-beat efficient market hypothesis. Behavioral finance also explains why so many investors believe that markets are easy to beat when, in fact, they are hard to beat.

Value-efficient markets are markets where investment prices always equal their intrinsic values, and the value-efficient market hypothesis is the claim that investment prices always equal their intrinsic values. Hard-to-beat efficient markets are markets wherein some investors are able to beat the market consistently, earning abnormal returns over time, but most are unable to do so. Abnormal returns are returns exceeding the returns one would expect according to a correct asset pricing model.

Value-efficient markets are impossible to beat because abnormal returns come from exploiting discrepancies between prices and values. Such discrepancies are absent in value-efficient markets. But hard-to-beat efficient markets are not necessarily value-efficient markets. It might be that substantial discrepancies between prices and values are common, implying markets far from value efficiency, but discrepancies are hard to identify in time or difficult to exploit for abnormal returns. As I often say, markets are crazy, but this does not make you a psychiatrist.