Behavioral Finance By Hersh Shefrin


Behavioral finance is an essential aspect in the modern business world. It involves the study of how psychology applies to making critical decisions involving investment and financial markets. Besides the neoclassical assumptions, it is prudent to understand how human behavior influence major financial decisions. ‘’ Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing’’ by Harsh Shefrin gives an excellent account on how human behavior relates to financial and investment decisions. The book enables learners and practitioners understand the human behavior that guides stock selection, financial services, and corporate financial strategy. It is essential to note that the book provides insights on the major pitfalls in financial decision making that are brought about by the financial behavior of human beings.

The author of the book points out major costly mistakes that corporate managers, financial planners, individuals, investment bankers and security analysts make in their daily activities. In essence, the book is very insightful for individual and corporate financial decision making. The book defines the basic concepts of behavioral finance and also gives a brief account of the practitioners and players in financial markets that can benefit from the insights provided in his work.  The author goes a step further and explains the purpose of which the concepts he presents in the book can be effectively utilized to have improved financial markets.  This paper will have an in-depth analysis of the major insights that comes along in the book.

The reliance on rules of thumb to make decisions without complete analysis of the situation (heuristic-driven bias)

This is one of the major themes that the author of the book puts a lot of emphases. Shefrin points out the major mistakes by financial players in making major financial decisions. Heuristic refers to a process by which people learn, discover or solve their problems. It is in most cases done through trial and error and usually leads to the rule of thumb or assumption of things that are poorly understood. The work of Shefrin dissects this concept in behavioral finance to bring out the common mistakes in financial decision making. The author outlines several heuristic-driven biases that seem too compelling but in most cases they do not lead to optimal solutions. This implies that the rules of thumb will always lead to a form of false security.  From the author’s perspective, the investors will make mistakes of using the available information to base their investment decisions. Such investors assume that all the information is available and in adequate amount. However, this is not always the case, and events or issues that get most attention will seem like the ones occurring more frequently. Shefrin outlines the dangers of stereotyping where investors will rely on past performances of stocks and securities to make investment decisions.  He warns that sometimes, the past performances may not always have an impact on future performances. He points out that at times people will always overestimate the effect and consequently end up making wrong investment decisions.

According to the Shefrin analysis, decisions clouded by unsuspected biases and misinterpretations of information are responsible for catastrophic and trifling mistakes in the finance world. He goes further and gives several examples of how heuristic biases have resulted in bankruptcy and collapse of major corporate organizations. The book has also outlined the adverse effect of human behavior on personal financial positions especially about retirement and other private investment schemes.  The author points out that such projection will always lead to biases since an independent event will have independent results since the odds are not destined to follow a particular pattern. Shefrin points out that investors will also be likely to suffer from being overconfident. Most people are always more sure of themselves, their opinions and knowledge than it is statistically the case. The book outlines how investors and financial managers use probabilities to calculate the expected gains and losses associated with given stocks or securities. In instances where probabilities are quite high, then the expected gain is also estimated quite high thus resulting in biased expected return. The author warns that overconfidence makes investors trade inappropriately with the stocks that are underperforming.

Another human behavior that affects investment decision as outlined in the book is anchoring. This refers to a situation whereby investors are preoccupied with a particular opinion regarding a certain financial aspect. The player holds that opinion and is reluctant to adjust from this opinion even if there is the emergence of new information. The author points out that most players in the financial market will have little weight with new information as compared to their first opinion. It is prudent pointing out that the author of this book is determined to sensitize investors on the importance of adjusting to new information. New information is likely to have either positive or negative influence in the finance market. Failure to adjust accordingly to new information could adversely affect the financial decision.

Gamblers’ Fallacy bias is another major concept that has been discussed at length in the book and also forms an integral part of behavioral finance. In the book, the author gives an explanation of how investors will tend to assume that the markets cannot go down for four years in a row. This is a misconception that is associated with gambling and is dependent on chances. Shefrin points out that most investors will tend to make investment decisions by taking chances and have eventually ended up making mistakes. He points out that there are high chances that investors suffering from this bias will be biased towards predicting a reversal in stock prices. Shefrin points out that gamblers’ fallacy will tend to occur when investors inappropriately predict that trend will reverse and are drawn into contrarian thinking. It is prudent to note that the author sensitizes investors on working on the perception that errors in random events are self-correcting.  He gives an example of tossing a coin and describes an investor who assumes that a coin cannot land on the tail for ten times and still land on the same side for the eleventh time to be suffering from gamblers’ fallacy.  He points out that most investors have fallen victim of this bias and consequently made mistakes that have as result suffered immense financial losses.

The author of the book is also determined to help us understand the distinction between emotional and cognitive errors prone to investors in financial decision making.  From the authors’ perspective, cognitive errors are as a result of the way people think. Nevertheless, he acknowledges that emotion plays a paramount role in the way players in a financial market remember events. To combine the two aspects, Shefrin brings about the issue of aversion to the ambiguity that is said to reflect both cognitive and emotional errors. His argument is based on the premise that the people are always comfortable with what they know and constantly live in fear of the unknown.  The fear of the unknown will lead to emotional fear and consequently will have major effects on the investor’s decisions. For instance, most of the U.S investors prefer stocks from their country thus suffering from home country bias. There is also a tendency of professional such as doctors having overweight healthcare stocks as a result of familiarity bias. Shefrin sites this as a bias that can have adverse effects especially if the company goes bankrupt thus rendering them jobless and also losing a significant portion of their wealth.



Frame dependence

Frame dependence is another theme that is very clear in the book by Shefrin on behavioral finance. According to the author, frame dependence means that the form in which a problem is described has an impact on human behavior. The book helps readers and practitioners to have a clear distinction between form and substance. In his perspective, Shefrin defines the frame as the form used in describing the decision problem. This is unlike in traditional finance where there is no relation between form and behavior and the framing was presupposed transparent. It is, however, imperative to point out that behavioral finance presumes that frames are opaque, and decisions on investment are dependent on the frame used by the investor. In essence, the investors’ behavior reflects the frame dependence and hence any difference in form will consequently lead to frame dependence.

Shefrin successfully uses the concept of frame dependence to bring forth essential issues and phenomenon that relates to frame dependence. Loss aversion is one of the leading concepts that Shefrin describes in the behavioral finance. In this book, the author emphasis that people have the tendency to prefer avoiding losses rather than acquiring gains of similar value. The tendency by investors and other players in the financial market to avoid losses have consequently lead to biases in making investment decisions. The work of Shefrin looks like a continuation of the work of K&T that demonstrated that investors have much pain in financial loss as compared to pleasure felt from financial gains of the same magnitude. This consequently led to risk aversion behavior amongst investors where investors will avoid risks at all costs. The aversion loss strategies amongst investors can have adverse effects on investors’ decision-making. For instance, investors may shun investment strategies that have demonstrable long-term success because they are not profitable in the short term. This will consequently deny the investors an opportunity to enjoy the long term benefits associated with such investment plans.

On this note, Hersh Shefrin gives an example of how investors attempt to secure gains through the sale of winning investments and avoid permanent losses by holding losing investments. Such investors will make such decisions on premises of risk avoidance and in negligence of the fact that security prices often fall and rise for good reasons. Investors will not even bother to understand the change in security prices due to their risk avoidance nature. Shefrin argues that when investors fail to appropriately adjust to the estimated value of their investments as a result of new information causing them to sell their winning investment too early and the losing investment too late. This consequently leads to investors changing their risk-reward profile of their portfolios for the worse.  Shefrin points out that investors will be reluctant to sell their securities for the loss because by so doing, they give up the hope of rejuvenation. The wait for the prices to shoot may not be in the near future and persistence may lead to riding the stocks all the way to the bottom. In essence, the author points out the importance of gathering essential market information that will enable investors determine the winning and losing stocks and consequently making informed choices on what stock to hold and which to dispose of.

Shefrin also points out on the concept of myopic loss aversion. This concept refers to a situation whereby investors are reluctant to hold stocks simply because they are evaluating their decisions over extremely short periods. In essence, Shefrin points out the tendency of investors to narrowly frame the outcomes of their investment decisions in days and weeks rather than framing it on long-term basis mainly tears and decades.  According to him, this behavioral trait is dangerous from investors since it can make them lose focus on their long-term financial goals. The dangers of myopic loss aversion are more rampant especially in cases where there is heightened market volatility, and investors are tempted to postpone their investment decisions as they wait for calmness to resume. Shefrin points out that investors who stay away from turbulent financial markets miss out on opportunities. He, however, points out that it is difficult enduring the downside market as it is also difficult in predicting the financial market downturns. He points out that as it is difficult in establishing the market turmoil, the same difficulties exists in determining the passage of such rough patches in the market. This implies that risk-averse investors are likely to be out of financial markets for longer periods even after the crisis are over.

Another aspect of frame dependence that is brought about by Shefrin in the book is the concept of concurrent decision making. This is a form of frame dependence where people mentally separate two problems while in a real sense the problems together form a ‘’package’’. Under such circumstances, people do not see the package and consequently miss on potential gains. In the book, the author puts emphasis on the tendency of the investors to concentrate more on losses rather than gains resulting from investment decisions.

Mental accounting is another form of frame dependence that is widely discussed in the book. This refers to an approach whereby investors attempt to code, categorize or evaluate potential economic outcomes about their investment choices. To explain the concept, the author gives an example of an investor who opts to spend only the income generated from investment and will always avoid using the ‘’capital‘’. In such circumstances, investors are mentally accounting for different forms of return, current income and capital appreciation, instead of considering the total return. The author points out that this may not be a problem as long as investors’ needs can be met with a well-diversified portfolio and asset mix that meets long-term objective and also risk tolerance. Nevertheless, he cautions investors that this is not always the case, and there are high chances that investors can fall prey of the mental accounting rule and restructure their portfolio to generate more current income instead of taking total return approach.  Under such instances, investors may be tempted to sell their stocks to increase their allocation of bonds thus adding a small amount of yield but reducing the potential growth in portfolio substantially and therefore increasing the risk of outliving one’s assets. It is essential to point out that there is high tendency for investors to invest in junk bonds, high-divided paying stocks, and preferred stocks. When such decisions happen, then there are high chances investors will be exposed to downside risk. Investors will always be reluctant to sell their investments at a loss. They always make such decisions on the justification of mental accounting where they refer to such losses as ‘’paper losses’’ and hence not real. From the book, it is clear that there is nothing like paper losses, but instead, it is a form of mental accounting where investors can’t cope with the fact that they have lost money. The more the investors use these mental accounting excuses, the more they cling on losing portfolios and consequently end up suffering more losses.

Hedonic Editing is another instrumental aspect in the frame dependence theme as explained by Hersh Shefrin in his book. He cites these as an approach whereby investors have a preference for some frames instead of others.  It is the tendency by investors to prefer frames that obscurely loses. Investors will prefer situations whereby there is a slim possibility of loss rather than taking a sure portfolio but with a small loss. Such decisions will always have an long-term adverse effect on the portfolio balance of the investor as well as achievement of long-term success. Also, the book discusses at length the cognitive and emotional aspects of frame dependence just like they are in heuristic bias. The cognitive and emotional aspect gives a detailed explanation as to why people exhibits frame dependence in their investment decisions. The cognitive concept is concerned with the way people organize information while emotional aspect is primarily concerned with how people feel as they register this information.  The two concepts play an integral role in making essential investment decisions amongst financial practitioners.

On the same note, the author also tries to give an account on the role of framing effects in dealing with self-control and regret. Shefrin asserts that lack of self-control can be as a result of the inability to control emotions. Consequently, framing effects are often used to deal with self-control. Besides, the concept of regret and its role in making financial decisions is also discussed at length. According to Shefrin, investors will always focus too much on what might have been if not for their past mistakes. Regret is an emotion and is often associated with one feeling responsible for incurred losses. This should be combined with the ability to have self-control and consequently will make informed investment choices. The chapter also has an emphasis on the concept of money illusion and its effect on investment decision making. This refers to a situation whereby the investors are concerned with the value of their investment regarding money with little or no consideration of inflation effect. Shefrin points out that most are the times when investors are more concerned with the nominal value of money rather than the real monetary value. Under such circumstance, investors and financial practitioners may be deceived and make unwise investment decisions.

On this note, the author has also taken the time to expound on the concept of regret aversion. As aforementioned, most are the times that investors fear in making investment decisions for fear of unwanted outcomes. The indecisive nature and failure of an investor to take action as a result of fear of negative outcome are what is referred to as regret aversion. Investors will always avoid instances whereby they feel responsible for underperforming stocks or losses incurred as a result of investment decision. From the author’s point of view, regret version can either be as a result of omission or commission or as a result of misgivings about things they wish they had done. Shefrin points out that the concept can be much more prevalent in instances where investors had suffered losses in recent years. Such investors will become too conservative about reasonable outcome expectations and prevailing risk levels.

Risk and regret evasiveness can unnecessarily prevent investors from deviating from the habitual course when favorable opportunities come their way. For instance, in the case where an investor has short-term bonds in fear of stock volatility, and then stock prices rise to a point where high quality businesses could be bought cheaply, the concept of regret aversion could prevent them from breaking their bond-buying behavior and capitalizing on the high potential stocks. Regret averse investors are afraid of taking risks and just like the loss averse, they better not make gains of any measure in instances where there are chances of making losses.  Such decisions do not only influence the bonds and stocks but have also been influential to people making major investment schemes such retirement schemes. The author sensitizes investors on the importance of avoiding such behavior through maintaining a balance between loss aversion and potential gains from an investment decision. E emphasizes that investors must embrace making choices since failure to make a decision or take action is a choice in itself. It is prudent noting that investors are advised to assess regularly estimated values and allocate capital accordingly maximizing the best alternatives for a given time, risk and budget situation. Failure to take such actions would also be a cause of regret in itself, and hence, it is of paramount importance ensuring investors are always up to date and make informed investment decisions.

In efficient markets

The concept of market inefficiency is also discussed at length in this book and is the third theme that is clear in the book and an integral aspect of behavioral finance. The concept of representativeness and its effect on mispricing the value of equity, especially on those equities of past winners and past losers is widely discussed in the chapter. Shefrin gives an example of how people would imagine that after a company reaches a record high stock price, that the stock price would continue going up or the worst scenario stay neutral. Nevertheless, the overconfidence and optimistic nature of the shareholders and the fact that stocks operate in an efficient market, the stock prices goes down until it levels its fundamental price.  This is an expansion of the heuristic bias and is also the case in stock losers that appreciate in future despite being losers initially.

On the concept of the inefficient market, the author revisits the concept of anchoring and overconfidence on the part of the investor. As aforementioned, investors are always obsessed and confident that the information they have and their future predictions are true and correct. This makes the investors quite rigid and fails to adjust in response to the new market information. In this case, Shefrin cites an example of how an investor will fail to adjust his earnings predictions sufficiently despite the availability of new information thus leading to mispricing of the equity. In this book, Shefrin warns that there is the possibility of either positive or adverse effect depending on the price of the stock fluctuates the way the practitioner predicted.

The concept of loss aversion is also related to market inefficiency. Shefrin insists on the investors’ tendency to prefer avoiding losses over acquiring equivalent gains. This in behavioral fiancé translates to risk and tries to assess to what extent an investor is willing to take a risk to win.  The author notes that some investors say that investments are less risky when they are smaller a concept that Shefrin relates to myopic loss aversion. Nevertheless, the author warns that this is not always the case since there are studies that have proved that when stakes are smaller, people will be more tolerant to risks.

Shefrin warns that the concept of market inefficiency makes it difficult for financial practitioners to time the market. He gives the example of the financial crisis that met investors off guard despite the presence of the market efficient theory.  In the book, the author gives an example of various wrong market predictions in relation to the leading stocks of leading global companies. Shefrin argues that if the concept of market efficient were realm, then it would be easy for financial practitioners and players in the financial market to predict and forecast times of financial crisis. On the same note, the author argues that it would be easy for investors to predict market bubbles and take advantage of these bubbles. According to Shefrin, hindsight bias and confirmation errors are responsible for the many errors that happen in market forecasts. He uses the concept of market inefficiency to explain why markets are not beatable and that financial practitioners should always be flexible too and adjust as new information emerges in the markets. Nevertheless, most investors think that high P/E ratios and low dividend yields might indicate the presence of bubbles and thus making the market beatable. Nevertheless, Shefrin points out that use of P/E ratios and dividend yields by investors may not always be in their favor.  It is argued that relatively high P/E ratios and relatively low dividends yields predict relatively low subsequent long returns. This emphasis the concept of market inefficiency and enhances the chances of beating the market.

According to Shefrin, large deviations of prices from intrinsic values will to a great extent reduce the ability of the P/E in predicting the future returns. He cites overconfidence and the anchoring on the side of the investors as the reasons behind the unpredictable nature of the inefficient market. It has been suggested that the relationship between the P/E ratios and dividend yields is not tight and hence these cannot be trusted in forecasting and predicting future returns on stocks and other financial assets.

Analysis and application

It is clear that the work of Shefrin is concerned with the behavioral aspect of investors and other players in the financial market. From the author’s point of view, the mental and emotional quirks that influence investment decisions are not confined to ‘’naïve’’ individual investors, but instead also affects professionals on whom such individuals rely for advice and guidance in investment decisions. The author gives examples of professionals and practitioners such as Wall Street strategists, portfolio managers, investment bankers, financial planners and security analysts to drive home the point of the mistakes and biases present in making essential investment decisions. It is also prudent to note that the book also points out that these biases are somehow caused by a combination of cognition and emotion. The availability bias or the representativeness bias is an example of how some events may be too emotional as compared to others. The more emotional the event is, the higher the chances that the event sticks for a longer period in the memory of the people. Also, emotions can also be a source of gambler’s fallacy since a streak of bad luck may be a source of distress and hence people make emotions guide them in decision making rather than basing their decisions on statistics and data. Most of the heuristics biases outlined in the book can be combined such as anchoring and also stem from overconfidence in the side of the investor. It is prudent to note that people always trust their feelings and knowledge to an extent that they tend to think that they know more than what they know.

From Shefrin’s analysis, it is clear that investment decisions clouded by unsuspected biases and misinterpretations of data are to blame for the trifling and catastrophic mistakes made in the financial market. In essence, the book tries to uncover human factors that to a great extent affect the effectiveness of major financial decisions made by players in the financial market. There are various examples from the book where major corporate bodies suffered as a result of these biases as well as individual victims of financial decision mistakes. The depth analysis acknowledges that people will make several decisions in a day, and not all of these decisions go through a rational thinking process and hence mistakes are inevitable.  In essence, the book outlines the major pitfalls that investment practitioners and other players in the sector must understand and follow to guide their investment decisions.  It provides guidelines on what to be done to avoid major mistakes that happen in investment decisions. The author is also concerned with the issue of market inefficiency and points out that investors can profit through understanding the forces that create such inefficiencies. Nevertheless, Shefrin warns investors against taking a contrarian approach too far as it may have adverse effects. He has also embraced input from other scholars to emphasize on the biases and make the claim that these biases are not anomalies but in fact they are part of investors’ daily activities.


Shefrin’s book Beyond Greed and Fear is a comprehensive book that discusses at length the concept of behavioral finance. The book starts by defining what this concept means and the primary underlying issues. There is a great explanation of the psychological relation in making major investment decisions and defines behavioral finance as the application of psychology in finance behavior.  it is also essential to note that the author has also outlined the major players and practitioners to benefit from his work.

The book has three distinct themes that have been discussed at length and include; heuristic-driven bias, frame dependence and the inefficient market. All these themes have been explained at length where concepts such as regression, representativeness, gambler’s fallacy and overconfidence have been exhaustively discussed in the book. On the theme of frame dependence, Shefrin has given an account on various frames such as mental accounting, self-control, and money illusion and regret aversion just to mention a few frames upon which investors base their decision making. The book finally speaks of the market inefficiencies that play an important role of summarizing the other major themes. The author gives a detailed account of the causes of market inefficiencies and major shortcomings associated with these inefficiencies.

Work cited

Shefrin, Hersh. Beyond Greed And Fear. Boston, Mass.: Harvard Business School Press, 2000. Print.


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