Normal Investors, Then and Now

Investors were “normal” in 1945 when the first issue of the Financial Analysts Journal was published, and they remain normal today, 60 years later. But in between was a long period, starting in the late 1950s, when investors were described as “rational.” The portrait of investors as rational is the first foundation block of standard finance. Other foundation blocks are market efficiency, mean–variance portfolio theory, and the capital asset pricing model. This article provides descriptions of normal investors as they were portrayed in the FAJ and other finance journals before standard finance was introduced and as they have emerged recently in behavioral finance. Investors were “normal” in 1945 when the first issue of the Financial Analysts Journal was published, and they remain normal today, 60 years later. But in between was a long period, starting in the late 1950s, when investors were described as “rational.” The portrayal of investors as rational is the first foundation block of standard finance. Other foundation blocks are market efficiency, mean–variance portfolio theory, and the capital asset pricing model (CAPM). In this article, I describe normal investors as they were portrayed in the FAJ and other finance journals before standard finance was introduced and as they have emerged recently in behavioral finance. Behavioral finance offers a replacement block for each block of standard finance. In behavioral finance, investors are described as normal, subject to cognitive biases and emotions. In behavioral finance, markets are not efficient in that price deviates from fundamental value, so behavioral capital asset pricing theory accounts for factors beyond fundamental value, such as sentiment. In behavioral finance, investors construct portfolios as layered pyramids, bonds in a low layer and stocks in a high one, by the rules of behavioral portfolio theory. In 1957, before the introduction of standard finance, the author of an FAJ article was trying to teach normal investors “how to take a loss and like it.” He noted that realizing losses increases wealth by reducing taxes. But he also noted that, human nature being what it is, normal investors are reluctant to realize losses. We tend to hang on in the hope that one day we will look at the asset and find it has not only recovered its value but risen. In contrast, the rational investors of standard finance realize their losses quickly and can hardly understand why any investor would procrastinate. The observed reluctance of normal investors to realize losses was reintroduced by early researchers in behavioral finance in the 1980s as the “disposition effect”—the disposition to sell winners too early and ride losers too long. In a behavioral framework, investors—normal investors—are affected by cognitive biases and emotions, consider their stocks one by one in mental accounts distinct from their overall portfolios, and distinguish paper losses from realized losses. Much of finance has changed since the FAJ was founded in 1945, but the drive to uncover facts and make sense of them remains. The facts of investor behavior indicate that investors are not the rational investors of standard finance. They are the normal investors of behavioral finance.