A Second Generation Behavioral Finance

The first generation of behavioral finance, starting in the early 1980s, largely accepted standard finance’s notion of people’s wants as “rational” wants—mainly high expected returns and low risk. That first generation commonly described people as “irrational” — misled by cognitive and emotional errors on their way to their rational wants.The second generation of behavioral finance describes people as “normal,” neither “rational” nor “irrational.” Normal people are people like you and me. Each of us has wants, although our wants vary — hope for riches, freedom from poverty, nurturing children and families, being true to values, gaining high social status, playing games and winning, and more. We apply knowledge and cognitive and emotional shortcuts as we pursue our wants. Sometimes, however, we are diverted from our wants by ignorance and cognitive and emotional errors. Our wants, even more than our knowledge, ignorance, and cognitive and emotional shortcuts and errors, underlie answers to important questions of finance, including portfolio construction, saving and spending, asset pricing, and market efficiency (Statman, 2017).