So, I wanted to talk today about Behavioral Finance or

about Psychology and Finance.

This is a longstanding interest of mine.

I've been involved with it for over 20 years.

It's not really emphasized in your textbook, Fabozzi and his

co-authors talk about a lot of things in the financial world,

but not about the underlying human behavior.

Behavioral Finance, or Behavioral Economics more

broadly, is a kind of revolution that has occurred

in finance and economics over the last 20 or 30 years.

And it remains somewhat controversial.

I don't quite fully understand why it is that people polarize

as much as they do, but some people don't like this.

We're coming along to be the majority, I think.

People are now regarding Behavioral Finance as an

important element of finance.

But the real problem is that people are complex and our

financial institutions, as I've emphasized, are designed

for real people and their functioning depends on the

behavior of real people.

And it's not as simple.

You know, another revolution that's occurring parallel, of

bigger significance, is a revolution in neuroscience

about the human brain.

And the human brain is a very complicated organ.

Economists have liked to invoke the principle of

rationality as an underlying component of their theory, and

that has been useful, but it's of limited use, because people

aren't rational.

They are often rational, they're

not completely rational.

And very often, people behave stupidly.

I'll put it that way.

That includes everyone, including me, because we're

human and we have limits.

One thing about the human species is that we are aware

of other people's weaknesses and have an

impulse to exploit them.

So when you see other people behaving stupidly, sometimes

you think, maybe I can turn this to my advantage.

OK?

And that becomes a problem.

The history of humankind is a history of exploitation of one

person by another.

Not entirely, but I'm saying it has that as

an important element.

So, I'm going to talk about these human failings.

It's not to say that people are stupid, I'm just saying

they're people, and we're all imperfect.

We're smart in some dimensions and we can be very smart, but

we can also make important mistakes.

But before I start, I wanted to try to put this into a

perspective.

Maybe, I'll return to this at the end of the lecture, but I

wanted to start out on an upbeat note.

I'm going to talk about all kinds of human errors, but I

wanted to start on an upbeat note that the business world

generally doesn't exploit people terribly.

I believe that very characteristically successful

businesses in finance and elsewhere consider their

long-term advantage and the reputation they have. So,

doing something that is blatantly exploitative of

human weaknesses will work against

their long-term advantage.

You'll see a lot of human failings, but we don't see

people cashing in on them as often as you'd think.

And beyond that, I want to emphasize also that another

aspect of human behavior is morality.

Evolutionary biologists think that this evolved along with

our other traits, that we have an impulse to be moral.

And so, in the long run, you might not really gain so much

satisfaction from exploiting other people's mistakes.

And so, you don't necessarily do that.

So, that's why we have a lot of weaknesses outlined and we

won't see significant or serious exploitation of them

as characteristic.

Now as you know, I have chapters from my forthcoming

book assigned for this course.

And I looked back on what I put up for you to read and I

keep thinking, gee, this really wasn't ready.

So, I had a chapter for this section of the reading list

about Behavioral Finance.

And I thought, I didn't really get it right.

I know what I was trying to say, but maybe I should --

what I start out in that chapter is talking about Adam

Smith and his book The Theory of Moral Sentiments.

Now just to remind you, Adam Smith was a professor in

Scotland in 1759.

He was a professor of moral philosophy, because there were

no professors of economics in those days.

And he wrote in 1759 --

Maybe I should write some of this on the board. --

He's probably the most important figure in the

history of economic thought.

So, in 1759 he wrote his The Theory of Moral Sentiments.

And in 1776, he wrote the more famous book,

The Wealth of Nations.

So, this is The Theory of Moral Sentiment.

The Wealth of Nations is considered the first real

treatise on economics and it's a wonderful book.

And it's still very readable today.

His The Theory of Moral Sentiments is

not so widely read.

But it's not really economics, it's a book about psychology

and morality.

I find it very good, even 250 years later.

He went through many editions on this book, because maybe he

thought it was his most important work.

But the book starts out about selfishness and altruism.

And the real question, which he thinks defines economics,

is, are people really completely selfish?

Sometimes it seems that way, that their presumed

benevolence is just an artifice

for their own benefit.

But he wonders, how does an economy work if everyone is

totally selfish?

And he ends up concluding that they're not.

I thought it was very interesting,

the way he put it.

The thing he emphasized right at the beginning of the book

is that people inherently love praise.

We crave the approval of other people.

And so, praise is a fundamental human desire.

But then he reflected on it and he said, do people really

want praise itself or is it something else that they want?

Well, think of it this way.

Suppose people made a big mistake and thought that you

had accomplished something, but there was a mix up.

You know, it was really somebody else

who did it, not you.

And it's just a complete mistake.

You had nothing to do with it, but you find lots of people

praising you.

Would that really be pleasurable?

And suppose you even know that they'll never find out that I

didn't do it.

Well, Smith said, it probably isn't.

Think about it.

You internally are thinking, I'm getting all this praise,

but I know I don't deserve it.

So, I don't enjoy it.

And then he went on to say that, especially among people

who are more mature, he says more mature people --

not everyone makes this step.

But he says, adults, normal, mature adults, make a

transition from a desire for praise to a desire for

praise-worthiness.

I want to know that I am the kind of person who will be

praised and I don't need to get the praise.

And he said, it's that tendency ultimately, which

makes an economy work, that people don't

care just about praise.

He gives an example of mathematicians.

And he said he's known many mathematicians in his life and

he finds that they're almost all obscure.

The public doesn't know about mathematicians.

They couldn't explain to the public what they do.

And they don't seem to care at all, because they know the

public doesn't appreciate mathematics.

And so, there's a few mathematician friends who

understand what they do and may praise them.

But ultimately, a mathematician can sometimes do

the work completely unknown.

And it's the praise-worthiness that drives these people.

You may think I'm being too idealistic, when I say this,

but I think that the finance profession --

this is what I was trying to say in that chapter.

That the finance profession, like other mature professions,

is really dominated --

although there's a lot of funny things that happen.

It is really dominated by people who have reached this

desire for praise-worthiness.

And so, you're not going to exploit people extravagantly.

Just because, why would I do that?

This is not a good thing.

I wouldn't feel good about it.

Well, some people will.

Now, I wanted to also mention, not everyone reaches this

mature state that Adam Smith describes.

And that's one of the complexities of human society.

And I think that the finance profession has a problem with

other kinds of people.

Now there's a whole branch of psychology called Personality

Psychology that categorizes people by their personality.

And we're not all the same.

And in our society, we have many different kinds of

personalities.

A successful society promotes people up who have the

praise-worthiness desire.

We try to recognize them and we try to put people of

character into important positions, with

not complete success.

But I wanted to just briefly talk about --

this is a lecture on psychology.

I wanted to talk about other personality types.

And I was going to use a book called The Diagnostic and

Statistical Manual Edition IV published by the American

Psychiatric Association.

They're coming out with a fifth edition in 2014.

DSM-IV is kind of a household word around my house, because

my wife is a psychologist. DSM-IV is actually

controversial among psychiatrists, because it's

too cut and dry for some of them.

What it tries to do is, identify mental illnesses and

personality types in a quantifiable, reproducible

way, so that we can define who has this mental illness or who

has this personality type.

And so, it gives you checklists and it says, the

patient must have exhibited at least three of the following

five behaviors.

And then, there will be another checklist. And so, you

keep score and you can actually

diagnosis personality disorders.

I'm just going to mention one of the

many personality disorders.

One of them is called APD, called

Antisocial Personality Disorder.

And so they have checklists, but just to

give you a sense --

oh, and the Antisocial Personality Disorder is called

psychopathy, or one kind of APD is psychopathy.

Another one is called sociopathy and --

I don't know.

There's a huge literature on these.

But according to DSM-IV, 3% of the male population in the

world is APD, and 1% of the female population.

A simple definition for APD is a jerk.

There are more male jerks than female jerks, apparently,

according to their --

this is all quantifiable and done.

But what is an Antisocial Personality Disorder?

It has the following characteristics: lack of

remorse, frequent lying, lack of empathy, superficial charm,

shallow emotions, distorted sense of self, constant search

for new sensations.

Have you met someone like that?

You probably have, because that's 3% of the population.

I'm not anti-male, when I point out there are three

times as many jerks among males as females.

Females have characteristically different

personality disorders.

And you can look down the list. It's much more than 3%

of the population that would be diagnosed

with one or the other.

So, you know, an APD person is manipulative, feigns

affectionate or warm feelings, but doesn't feel them, and is

trying to deceive you.

Once a student came to my office and asked to sign up as