Finance and the Behavioral Prospect Risk, Exuberance, and Abnormal Markets

This book explains how investor behavior, from mental accounting to the combustible interplay of hope and fear, affects financial economics. The transformation of portfolio theory begins with the identification of anomalies. Gaps in perception and behavioral departures from rationality spur momentum, irrational exuberance, and speculative bubbles. Behavioral accounting undermines the rational premises of mathematical finance. Assets and portfolios are imbued with “affect.” Positive and negative emotions warp investment decisions. Whether hedging against intertemporal changes in their ability to bear risk or climbing a psychological hierarchy of needs, investors arrange their portfolios and financial affairs according to emotions and perceptions. Risk aversion and life-cycle theories of consumption provide possible solutions to the equity premium puzzle, an iconic financial mystery. Prospect theory has questioned the cogency of the efficient capital markets hypothesis. Behavioral portfolio theory arises from a psychological account of security, potential, and aspiration.

1 The Structure of a Behavioral Revolution.- 2 Mental Accounting, Emotional Hierarchies, and Behavioral Heuristics.- 3 Higher-Moment Capital Asset Pricing and Its Behavioral Implications.- 4 Tracking the Low-Volatility Anomaly Across Behavioral Space.- 5 The Intertemporal Capital Asset Pricing Model: Hedging Investment Risk Across Time.- 6 Risk Aversion.- 7 The Equity Risk Premium and the Equity Premium Puzzle.- 8 Prospect Theory.- 9 Specific Applications of Prospect Theory to Behavioral Finance.- 10 Beyond Hope and Fear: Behavioral Portfolio Theory.- 11 Behavioral Gaps Between Hypothetical Investment Returns and Actual Investor Returns.- 12 Irrational Exuberance: Momentum Crashes and Speculative Bubbles.- Conclusion: The Monster and the Sleeping Queen.

James Ming Chen holds the Justin Smith Morrill Chair in Law at Michigan State University, USA. He teaches, lectures, and writes widely on law, economics, and regulation. His books, Disaster Law and Policy and Postmodern Portfolio Theory, cover a broad range of issues concerning extreme events and risk management, from natural to financial disasters. He is of counsel to the Technology Law Group of Washington, D.C.; a public member of the Administrative Conference of the United States; and an elected member of the American Law Institute. A magna cum laude graduate of Harvard Law School and a former editor of the Harvard Law Review, Chen also served as a clerk to Justice Clarence Thomas of the Supreme Court of the United States.