Financial Decision-Making in Markets and Firms: A Behavioral Perspective

35 Pages Posted: 1 Jul 2003  

Werner F.M. DeBondt

DePaul University - Driehaus Center for Behavioral Finance

Richard H. Thaler

University of Chicago - Booth School of Business; National Bureau of Economic Research (NBER)

Date Written: June 1994

Abstract

In its attempt to model financial markets and the behavior of firms, modern finance theory starts from a set of normatively appealing axioms about individual behavior. Specifically, people are said to be risk-averse expected utility maximizers and unbiased Bayesian forecasters, i.e., agents make rational choices based on rational expectations. The rational paradigm may be criticized, however, because (1) the assumptions are descriptively false and incomplete, and (2) the theory often lacks predictive power. One way to make progress is to characterize actual decision- making behavior. Efforts along these lines are made by behavioral economists and psychologists. This paper provides a selective review of recent work in behavioral finance. First, we ask why economists should be concerned with the psychology of decision-making. Next, we discuss a series of key behavioral concepts, e.g., people's well-known tendencies to give too much weight to vivid information and to show excessive self-confidence. The body of the paper illustrates the relevance of these concepts to important topics in investment theory and corporate finance. In each case, behavioral finance offers a new perspective on results that are anomalous within the standard approach.

Suggested Citation

DeBondt, Werner F.M. and Thaler, Richard H., Financial Decision-Making in Markets and Firms: A Behavioral Perspective (June 1994). NBER Working Paper No. w4777. Available at SSRN: https://ssrn.com/abstract=420312

Werner F.M. DeBondt

DePaul University - Driehaus Center for Behavioral Finance ( email )

1 East Jackson Boulevard
Suite 6123/6124
Chicago, IL 60604-2287
United States
312-362-8394 (Phone)

Richard H. Thaler (Contact Author)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

University of Chicago - Booth School of Business ( email )

5807 S. Woodlawn Avenue
Chicago, IL 60637
United States
773-702-5208 (Phone)
773-702-0458 (Fax)

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