A frequent criticism in investment management circles has been the lack of a unified theory of behavioral finance. Unlike the mathematically elegant efficient market theory, which provides a comprehensive structure for the actions of rational markets, behavioral finance encompasses an assortment of empirical studies at the intersection of psychology and finance. Without a unified framework, investment professionals have remained uncertain about how they can use behavioral finance effectively as part of their professional discipline.
Meir Statman, professor of finance at Santa Clara University, takes this topic head-on in his new book, developing a unified framework for behavioral finance as an alternative to standard finance. A pioneer in the field, Statman has the credentials and experience to pull together the various strands of behavioral finance. He is a prolific author and lectures extensively, both on the investment circuit and in academic circles. His detailed knowledge of the subject is corroborated by the fact that more than a quarter of the book’s pages are given over to notes, references, and an index.
Finance for Normal People: How Investors and Markets Behave aims to satisfy various audiences. For Statman’s students and academic colleagues, it is a textbook for college courses. For the general reader, it is filled with behavioral anecdotes and examples that make it an entertaining and informative read. For the investment professional, the real meat of this book is in Part 2, where the author develops a unified structure of behavioral finance and provides guidance on how it can be used in practice.
Part 1 of Finance for Normal People takes the reader through an introductory course on behavioral finance, replete with examples and illustrations. Although investment professionals may see Part 1 as a mere “refresher,” an essential concept introduced in Part 1 is that people’s behavior is “normal” as opposed to “rational” (as assumed in standard finance). Investors are (mostly) normal people who have emotions, wants, and needs outside the standard finance definition of rationality. This framing also highlights the goal of Statman’s work: to move his readers from “normal-ignorant” to “normal-knowledgeable”—that is, still susceptible to behavioral errors but more aware of how to correct them.
Readers should not skip the author’s introduction, in which he concisely outlines the five foundational blocks of standard finance and contrasts them with the corresponding five foundational blocks of behavioral finance. This summary provides a useful shortcut for readers wanting to move directly to Part 2.
In the five chapters of Part 2, Statman explains how a behavioral finance framework can reorient an investor’s perspective on portfolio management and asset pricing. He also covers life-cycle investing and the behavioral analogue of efficient market theory.
For investment professionals and their clients, an important difference between standard finance and behavioral finance becomes clear in Part 2: Standard finance places considerable emphasis on portfolio construction and characteristics, whereas behavioral finance focuses more on how a portfolio is used to meet investor needs. In this context, Finance for Normal People can be very helpful to financial advisers as well as client-facing portfolio managers and analysts.
The objective of creating a practical, unified framework for behavioral finance is admirable. Has Meir Statman succeeded? In this reviewer’s opinion, the answer is yes—so long as the reader’s focus is on practical aspects of investing. Although the framework of standard finance theory is more mathematically elegant, it depends on assumptions that increasingly seem out of step with the “normal” world. It may be a result of living in New York City, but this reviewer has yet to meet a purely rational person. In reality, the world seems to be populated with individuals along the spectrum of normal-ignorant to normal-knowledgeable, to use Statman’s parlance. For investment professionals and their clients, this book can provide a significant boost to their understanding and decision making in managing real-world portfolios.