Lecture 11: Behavioral Finance and the Role of Psychology

What this lecture covers

This lecture asks how well the assumption of rationality, which underlies much of financial theory, actually describes real investors and financial professionals. Robert Shiller argues that people are neither fully rational nor simply irrational: they are complex, prone to predictable psychological errors, but also constrained by character, reputation and a desire for moral approval that limits how much these errors get exploited.

The lecture surveys the core findings of behavioral finance, from Adam Smith's observations on praise-worthiness to Kahneman and Tversky's Prospect Theory, and shows how each bias shows up in real financial products and institutions, from funeral insurance to financial advising. After watching, you should be able to name the major behavioral biases covered in the course and explain, with an example, how each one can distort financial decisions or be exploited commercially.

Key ideas

• Praise-worthiness: Adam Smith argued in The Theory of Moral Sentiments that mature adults come to want to deserve praise, not just receive it, which restrains purely selfish behavior in professions like finance.
• Antisocial Personality Disorder (APD): a personality type, more common in men, marked by lack of remorse and empathy and a tendency to manipulate; Shiller ties it to the minority of people who do exploit others in finance.
• Prospect Theory: Kahneman and Tversky's model in which people value gains and losses relative to a reference point, with a value function that is concave for gains, convex for losses, and kinked at zero, making small losses feel disproportionately painful.
• Probability weighting: people round very low probabilities to zero and very high ones to one, and distort those in between, which explains products like flight insurance sold at the point of maximum anxiety.
• Overconfidence: people systematically give confidence intervals that are too narrow, illustrated in class with an experiment on world population, Earth's mass, and the number of languages.
• Cognitive dissonance: people avoid or reinterpret evidence that contradicts a decision they already made, shown in studies of investors who stay in badly performing funds and advisors who defer to clients' existing (risky) portfolios.
• Anchoring and the representativeness heuristic: irrelevant numbers (like a spun wheel) bias people's estimates, and rare chart patterns get overweighted as predictive signals.
• Social contagion: opinions spread through a shared "zeitgeist" or collective consciousness, driving herd behavior and large market swings.

Walkthrough

Human failings and the desire for praise-worthiness (0:00)

Shiller opens by positioning behavioral finance as a departure from the assumption of pure rationality. He argues that outright exploitation of human weakness is limited in practice because successful businesses protect their long-term reputation and because people have an innate moral sense. He then works through Adam Smith's Theory of Moral Sentiments, explaining the shift from wanting praise to wanting to deserve praise, and connects this to why the finance profession, despite opportunities to manipulate customers, is not uniformly predatory.

Personality psychology (11:37)

Using the DSM-IV, Shiller describes Antisocial Personality Disorder and its traits: lack of remorse, superficial charm, manipulativeness. He cites a figure of roughly 3% of men and 1% of women meeting the criteria, and a study finding 40% prevalence among prison inmates, and notes neuroscience research linking APD to differences in the prefrontal cortex. He also discusses everyday manipulation, such as $9.99 pricing, as a milder, more pervasive form of the same tendency.

Prospect Theory (20:14)

Shiller introduces Kahneman and Tversky's Prospect Theory, drawing the value function (concave for gains, convex for losses, kinked at a reference point) and the probability weighting function. He explains how the kink makes people overreact to small losses and how this is exploited by narrowly targeted insurance products such as funeral insurance, diamond ring insurance and flight insurance, even though these cover comparatively small financial risks. He notes that some researchers, such as Gerd Gigerenzer, argue people can be trained out of these errors, while experiments with students show the biases persist even among strong quantitative thinkers.

Regret Theory and gambling behavior (35:53)

Regret Theory holds that people structure decisions to avoid the pain of having made a mistake, which can itself lead to worse decisions. Shiller then turns to gambling as a human universal, citing survey data on participation and compulsive gambling rates, and connects gambling psychology to sensation-seeking behavior that can be channeled productively into stock market activity.

Overconfidence and its exploitation (40:40)

The class runs a live experiment: students give 90% confidence intervals for world population, Earth's mass and the number of languages worldwide, and most intervals turn out far too narrow. Shiller uses this to explain overconfidence as an illusion of understanding, extends it to overconfidence in "genius" friends and CEOs (citing Rakesh Khurana's work on the "charismatic CEO" and Nassim Taleb's Fooled by Randomness), and argues this bias helps explain why some CEO hires or investment picks are wrongly attributed to skill rather than luck.

Cognitive dissonance, anchoring, representativeness, and social contagion (57:16)

Shiller defines cognitive dissonance and gives two finance examples: mutual fund investors who underestimate how badly their fund has performed, and financial advisors (studied by Sendhil Mullainathan) who rarely challenge clients' risky existing portfolios, even concentrated positions in their own employer's stock. He then covers anchoring (irrelevant numbers biasing estimates, as in Kahneman and Tversky's wheel-of-fortune experiment), the representativeness heuristic (overweighting rare chart patterns like Head and Shoulders), and social contagion, tying the discussion to Durkheim's idea of collective consciousness and the "zeitgeist" as a driver of herd behavior in markets.

Moral judgment in business (1:12:38)

The lecture closes by returning to the balance between exploitation and integrity, citing Michael Porter's concept of "shared value" and Anna Bernasek's Economics of Integrity, using the example of milk safety to argue that everyday personal integrity, not just regulation, keeps markets functioning well.

Before you watch

• Familiarity with basic expected-utility ideas is useful context, since Prospect Theory is presented as a departure from standard utility theory.
• No specific earlier lecture in this course is required, but general awareness of insurance products and mutual funds helps the examples land.

Check your understanding

1. How does the kink in the Prospect Theory value function explain why people buy narrowly targeted insurance like flight or funeral insurance?
2. What does the class confidence-interval experiment reveal about overconfidence, and why does the effect vary across the three questions?
3. In Mullainathan's study, why did most financial advisors fail to challenge clients holding highly concentrated or risky portfolios?
4. According to Shiller, why doesn't behavioral finance imply that financial markets are dominated by exploitation and manipulation?