BEHAVIOURAL FINANCE: A BACKROUND BRIEFING Professor

The principal purpose of this paper is to provide a background briefing on behavioural finance (BF) for those unfamiliar with this significant paradigm shift underway in finance scholarship. The paper synthesises and summarises a rapidly burgeoning literature on BF which, presently, is not as accessible as that concerned with modern finance theory. Attention is first given to what is meant by the rationality of financial agents, and the possibility is introduced that financial agents in an uncertain real world may be less than strictly rational. Thereafter, the various heuristics and cognitive biases that may characterise financial decision-making in an uncertain real world are catalogued and explained. The paper finishes with an assessment of the potential for BF to transform scholarship in finance. The economist may attempt to ignore psychology, but it is sheer impossibility for him to ignore human nature. . . . If the economist borrows his conception of man from the psychologist, his constructive work may have some chance of remaining purely economic in character. But if he does not, he will not thereby avoid psychology. Rather, he will force himself to make his own, and it will be bad psychology. Clark (1918, p. 4) Introduction Modern Finance Theory (MFT), as presented in textbooks and taught in universities around the world, has evolved over more than 50 years. Seminal works in the earlier stages of this evolution include Dean (1951) on capital budgeting, Markowitz (1952, 1959) on portfolio theory, Modigliani and Miller (1958, 1963) on capital structure decisions, Miller and Modigliani (1961) on dividend policy decisions, Sharpe (1964) and Lintner (1965a, 1965b) on capital asset pricing, Fama (1970) on capital market efficiency, Black and Scholes (1973) on option pricing, Jensen and Meckling (1976) on agency theory, Ross (1976) on arbitrage