A Behavioral Approach to Asset Pricing

By Simons, Howard L. | Futures (Cedar Falls, IA), September 2005 | Go to article overview
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A Behavioral Approach to Asset Pricing

Simons, Howard L., Futures (Cedar Falls, IA)

A Behavioral Approach to Asset Pricing By Hersh Shefrin Elsevier Academic Press (2005) $84.95, 456 pages

In addressing this complex material, Shefrin takes the reader on a review of the experimental evidence, followed by critical discussion of investor expectations. Then he offers some heavy quantitative analysis of utility functions better turning to risk tolerance and time discounting mechanisms, market sentiment and the creation of a behavioral-based stochastic discount factor (SDF).

Shefrin says the SDF underlies all asset prices; it and it alone can account for the impact of market sentiment in the search processes at the heart of all auctions. Finally, Shefrin explains prospect theory, the development of decisions under both risk and uncertainty. Behavioralists contend investors hold un-diversified portfolios combining very safe and very risky securities.

The risk in writing about quantitative analysis and psychological arguments is you can lose the social scientists with the first, lose the quants with the second and fail to resonate with experienced traders with the entire package. Shefrin does an excellent job of buttressing behavioral arguments with real data and of using his quantitative analysis to shed light on the problem rather than displaying his mathematical prowess.

Any economic theory has to explain asset pricing and this is Shefrin's goal. The first message to those relying on conventional pricing models is that investors are not uniformly risk-averse; our biases can and do drive us to be risk seeking in predictable ways. The implications for investor preferences for stocks over other asset classes, for the shape of the yield curve and for option smiles are profound.

The second message to the traditionalists concerns the notion of a representative investor.

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