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PART Ⅰ CONVENTIONAL FINANCE，PROSPECT THEORY，AND MARKET EFFICIENCY1

CHAPTER 1 Foundations of Finance Ⅰ：Expected Utility Theory3

Introduction3

Neoclassical Economics4

Rational Preferences4

Utility Maximization4

Relevant Information6

Expected Utility Theory6

Risk Attitude8

Allais Paradox11

Framing14

Looking Forward14

Chapter Highlights14

Discussion Questions and Problems15

Appendix：More on Expected Utility Theory16

Definitions16

Axioms Required to Derive Expected Utility17

Sketch o f a Proof17

Characteristics of Utility Functions18

Endnotes18

CHAPTER 2 Foundations of Finance Ⅱ：Asset Pricing，Market Efficiency，and Agency Relationships19

Introduction19

The Pricing of Risk20

Risk and Return for Individual Assets20

Risk and Return for Portfolios o f Assets21

The Optimal Portfolio22

Capital Asset Pricing Model26

Operationalizing the CAPM27

Market Efficiency28

Efficiency and Information28

What Does Market Efficiency Imply？29

Misconceptions about Market Efficiency30

Joint Hypothesis Problem30

Agency Theory31

From Rationality to Psychology33

Chapter Highlights33

Discussion Questions and Problems34

Endnotes35

CHAPTER 3 Prospect Theory，Framing，and Mental Accounting37

Introduction37

Prospect Theory38

Key Aspects o f Observed Behavior38

Value Function40

Lottery Tickets and Insurance41

Weighting Function42

Hypothetical Value and Weighting Functions44

Some Examples45

Other Issues45

Riskless Loss Aversion45

Origins of Prospect Theory46

Prospect Theory and Psychology47

Competing Alternative Theories47

Framing47

Does Prospect Theory Work with Nonmonetary Outcomes？48

Integration vs.Segregation48

Mental Accounting50

Opening and Closing Accounts50

Evaluating Accounts and Choosing When to Close Them51

Closure，Integration，and Segregation52

From Theory to Practice52

Chapter Highlights53

Discussion Questions and Problems53

Appendix：Conditions Required for the Prospect Theory Weighting Function55

Conditions55

Endnotes56

CHAPTER 4 Challenges to Market Efficiency60

Introduction60

Some Key Anomalies61

Lagged Reactions to Earnings Announcements61

Small-Firm Effect62

Value vs.Growth63

Momentum and Reversal65

Noise-Trading and Limits to Arbitrage67

Theoretical Requirements for Market Efficiency67

Support 1：All Investors Are Always Rational67

Support 2：Investor Errors Are Uncorrelated68

Shiller’s Model68

Support 3：There are no Limits to Arbitrage71

What Limits Arbitrage？72

Fundamental Risk72

Noise-Trader Risk72

Implementation Costs73

Looking Forward75

Chapter Highlights75

Discussion Questions and Problems76

Appendix：Proofs for Shiller Model77

Endnotes78

PART Ⅱ BEHAVIORAL SCIENCE FOUNDATIONS81

CHAPTER 5 Heuristics and Biases83

Introduction83

Perception，Memory，and Heuristics84

Perception84

Memory84

Framing Effects85

Ease of Processing and Information Overload86

Heuristics86

Examples of Heuristics87

Familiarity and Related Heuristics87

Familiarity87

Ambiguity Aversion88

Diversification Heuristic89

Status Quo Bias and Endowment Effect89

Heuristics and Biases，Prospect Theory，and Emotion90

Representativeness and Related Biases90

Conjunction Fallacy91

Base Rate Neglect91

Bayesian updating92

Hot Hand Phenomenon93

Gambler’s Fallacy vs.Hot Hand95

Overestimating Predictability95

Availability，Recency，and Salience96

Anchoring97

What Explains Anchoring？98

Anchoring vs.Representativeness99

Irrationality and Adaptation99

Fast and Frugal Heuristics99

Response to Critique100

Looking Ahead100

Heuristics and Biases and Financial Decision-Making100

Do Heuristic-Induced Errors Cancel Out？101

Chapter Highlights101

Discussion Questions and Problems102

Endnotes103

CHAPTER 6 Overconfidence106

Introduction106

Miscalibration106

What Is It？106

Example of a Calibration Test107

Other Strains of Overconfidence110

Better-Than-Average Effect110

Illusion o f Control111

Excessive Optimism111

Being Overconfident in More than One Sense112

Are People Equally Overconfident？112

Are People Consistently Overconfident？113

Factors Impeding Correction114

Biases Interfering with Learning114

Is Overconfidence an Unmitigated Flaw？114

Looking Ahead to Financial Applications115

Chapter Highlights116

Discussion Questions and Problems116

Endnotes117

CHAPTER 7 Emotional Foundations120

Introduction120

The Substance of Emotion120

A Short History of Emotion Theory122

Evolutionary Theory124

The Brain126

Emotion and Reasoning128

Our Minds，Bodies，and Emotion130

Looking Ahead130

Chapter Highlights132

Discussion Questions and Problems132

Endnotes133

PART Ⅲ INVESTOR BEHAVIOR135

CHAPTER 8 Implications of Heuristics and Biases for Financial Decision-Making137

Introduction137

Financial Behaviors Stemming from Familiarity138

Home Bias138

Distance，Culture and Language139

Local Investing and Informational Advantages140

Investing in Your Employer or Brands that You Know141

Financial Behaviors Stemming from Representativeness141

Good Companies vs.Good Investments142

Chasing Winners143

Availability and Attention-Grabbing145

Anchoring to Available Economic Cues145

An Experimental Study of Real Estate Appraisals145

Anchoring vs.Herding and Analysts147

Chapter Highlights147

Discussion Questions and Problems148

Endnotes148

CHAPTER 9 Implications of Overconfidence for Financial Decision-Making151

Introduction151

Overconfidence and Excessive Trading151

Overconfident Traders：A Simple Model152

Evidence from the Field157

Evidence from Surveys and the Lab159

Demographics and Dynamics161

Gender and Overconfidence in the Financial Realm161

Dynamics of Overconfidence among Market Practitioners161

Underdiversification and Excessive Risk Taking162

Excessive Optimism and Analysts163

Chapter Highlights164

Discussion Questions and Problems164

Endnotes165

CHAPTER 10 Individual Investors and the Force of Emotion168

Introduction168

Is the Mood of the Investor the Mood of the Market？169

Pride and Regret170

The Disposition Effect171

Empirical Evidence171

Prospect Theory as an Explanation for the Disposition Effect172

Another Possible Explanation174

Experimental Evidence174

House Money175

Evidence o f a House Money Effect on a Large Scale175

Prospect Theory and Sequential Decisions176

Affect177

Chapter Highlights178

Discussion Questions and Problems179

Endnotes179

PART Ⅳ SOCIAL FORCES183

CHAPTER 11 Social Forces：Selfishness or Altruism？185

Introduction185

Homo Economicus186

Fairness，Reciprocity，and Trust186

Ultimatum and Dictator Games187

The Trust Game189

Who Is More Fair？191

Social Influences Matter192

Competition in Markets193

Incentives and Contract Design194

Conformity196

Testing Conformity196

Obedience to Authority197

Social Behavior and Emotion198

Social Behavior and Evolution198

Chapter Highlights199

Discussion Questions and Problems199

Endnotes200

CHAPTER 12 Social Forces at Work：The Collapse of an American Corporation202

Introduction202

Corporate Boards203

Benefits of a Corporate Board203

Outside Directors204

It’s a Small World205

Directors，Compensation，and Self-Interest205

Directors and Loyalty206

Analysts206

What Do Professional Security Analysts Do？207

The Performance of Security Analysts207

Do Analysts Herd？208

Enron209

The Performance and Business of Enron209

The Directors211

The Analysts212

Other Players in Enron’s Downfall213

Organizational Culture and Personal Identity213

Chapter Highlights214

Discussion Questions and Problems214

Endnotes215

PART Ⅴ MARKET OUTCOMES217

CHAPTER 13 Behavioral Explanations for Anomalies219

Introduction219

Earnings Announcements and Value vs.Growth219

What is Behind Lagged Reactions to Earnings Announcements？219

What Is Behind the Value Advantage？220

What is Behind Momentum and Reversal？221

Daniel-Hirshleifer-Subrahmanyam Model and Explaining Reversal222

Grinblatt-Han Model and Explaining Momentum224

Barberis-Shleifer-Vishny Model and Explaining Momentum and Reversal227

Rational Explanations230

Inappropriate Risk Adjustment230

Fama-French Three-Factor Model232

Explaining Momentum232

Temporary Deviations from Efficiency and the Adaptive Markets Hypothesis233

Chapter Highlights233

Discussion Questions and Problems234

Endnotes234

CHAPTER 14 Do Behavioral Factors Explain Stock Market Puzzles？237

Introduction237

The Equity Premium Puzzle238

The Equity Premium238

Why Is the Equity Premium a Puzzle？238

What Can Explain This Puzzle？240

Real-World Bubbles243

Tulip Mania244

The Tech/Internet Bubble245

Experimental Bubbles Markets247

Design o f Bubbles Markets248

What Can We Learn From These Experiments？249

Behavioral Finance and Market Valuations251

Excessive Volatility251

Do Prices Move Too Much？251

Demonstrating Excessive Volatility252

Explaining Excessive Volatility253

Volatility Forecasts and the Spike of 2008253

Markets in 2008254

Chapter Highlights258

Discussion Questions and Problems259

Endnotes259

PART Ⅵ CORPORATE FINANCE263

CHAPTER 15 Rational Managers and Irrational Investors265

Introduction265

Mispricing and the Goals of Managers266

A Simple Heuristic Model266

First Order Conditions267

Examples of Managerial Actions Taking Advantage of Mispricing268

Company Name Changes268

Explaining Dividend Patterns269

Share Issues and Repurchases272

Mergers and Acquisitions272

Irrational Managers or Irrational Investors？274

Chapter Highlights275

Discussion Questions and Problems275

Endnotes276

CHAPTER 16 Behavioral Corporate Finance and Managerial Decision-Making279

Introduction279

Capital Budgeting：Ease of Processing，Loss Aversion，and Affect279

Payback and Ease of Processing280

Allowing Sunk Costs to Influence the Abandonment Decision280

Allowing Affect to Influence Choices280

Managerial Overconfidence282

Investment and Overconfidence282

Overinvestment282

Investment Sensitivity to Cash Flows283

Mergers and Acquisitions284

Start-ups285

Can Managerial Overconfidence Have a Positive Side？288

Chapter Highlights288

Discussion Questions and Problems289

Endnotes289

PART Ⅶ RETIREMENT，PENSIONS，EDUCATION，DEBIASING，AND CLIENT MANAGEMENT293

CHAPTER 17 Understanding Retirement Saving Behavior and Improving DC Pensions295

Introduction295

The World-Wide Move to DC Pensions and its Consequences296

DBs vs.DCs296

Problems Faced by Employee-Investors298

Saving with Limited Self-Control and Procrastination298

How Much Needs to be Saved？298

Limited Self-Control300

Exponential and Hyperbolic Discount Functions301

Procrastination302

Evidence on Retirement Preparedness303

Asset Allocation Confusion303

Documenting the Problem303

Are There “Correct” Asset Allocations？305

Moving toward a Solution306

Is Education the Answer？307

Improvements in DC Pension Design307

Automatic Enrollment308

Scheduled Deferral Increase Programs310

Asset Allocation Funds311

Moving toward the Ideal 401（k）313

Chapter Highlights313

Discussion Questions and Problems314

Endnotes315

CHAPTER 18 Debiasing，Education，and Client Management319

Introduction319

Can Bias be Eliminated？319

Steps Required to Eliminate Bias319

Strategies for Helping Those Affected by Bias321

Debiasing Through Education322

Psychographic Profiling，Personality Types，and Money Attitudes323

Optimizing Education325

Client Management Using Behavioral Finance326

Traditional Process of Asset Allocation Determination326

Using Behavioral Finance to Refine Process328

Chapter Highlights330

Discussion Questions and Problems330

Endnotes331

PART Ⅷ MONEY MANAGEMENT333

CHAPTER 19 Behavioral Investing335

Introduction335

Anomaly Attenuation，Style Peer Groups，and Style Investing335

Refining Anomaly Capture337

Refining Value Investing Using Accounting Data337

Refining Momentum-Investing Using Volume337

Momentum and Reversal339

Momentum and Value341

Multivariate Approaches342

Style Rotation345

Is it Possible to Enhance Portfolio Performance Using Behavioral Finance？346

Early Evidence346

What is Behavioral Investing？347

Chapter Highlights348

Discussion Questions and Problems348

Endnotes348

CHAPTER 20 Neurofinance and the Trader’s Brain351

Introduction351

Expertise and Implicit Learning351

Neurofinance353

Insights from Neurofinance354

Expertise and Emotion355

Chapter Highlights356

Discussion Questions and Problems356

Endnotes357

GLOSSARY359

REFERENCES367

INDEX383