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In building the case for BPM, I frequently reference three books: Daniel Kahneman’s Thinking, Fast and Slow, Nassim Taleb’s Fooled by Randomness, and Hersh Shefrin’s Behavioralizing Finance.

Kahneman, winner of the 2002 Nobel Memorial Prize in Economic Sciences, does a masterful job of presenting the major conclusions of Behavioral Science, providing numerous insights into how individuals actually make decisions using shortcuts and heuristics. The rational model it is not. Behavioral science came of age during the same time period over which MPT became the de facto standard in the investment management industry. I came to wish my own education and early experience would have included much more behavioral science and much less MPT, but it is better to be late than never as they say.

Taleb provides an eminently readable exposition on the challenge facing individuals in mastering one of the most difficult realties of the world: the random nature of events and markets. He contends that the complex and random nature of the investing world we face has outrun our brains’ evolutionary hard wiring. To be successful, an investor must think of the world in terms of probabilities and previously unobserved dramatic events (black swans in his parlance). This requires a dose of heavy-duty analytic thinking – what Kahneman refers to as System 2 thinking. The BDI spends most of the time engaging the cerebral cortex portion of the brain and little time engaging the intuitive limbic portion of the brain.

Shefrin, in Behavioralizing Finance, provides a systematic analysis of how behavioral assumptions impact various aspects of modern finance theory. He posits a world in which investors begin with unequal wealth endowments, have different probability assessments of future events (some are pessimistic, some are optimistic, some are overconfident, and some are rational, with probability assessments changing over time), and have different risk preferences.

The result is a composite probability distribution of future events which differs in important respects from the true probability distribution. The differences between composite and true probabilities leads to pricing distortions. Individual securities, as well as market-wide indices, can go from being undervalued to overvalued and back again. Shefrin believes that “the future of finance will combine realistic assumptions from behavioral finance and rigorous analysis from neoclassical finance.” I hope to take a step in this direction by showing the implications of such a dynamic pricing model for how investing decisions should be made in light of emotional investors.

I must mention Robert Haugen and his book The Inefficient Stock Market. In the mid-90s as I was actively questioning the validity of MPT, I came across this excellent book which confirmed many of the things I was thinking at the time. It provided arguments and empirical results challenging the pillars of MPT. He essentially posited a behavioral market in which pricing distortions were common. He captured these distortions by means of a multi-factor proxy model based on PE ratios, growth rates, debt ratios, and other company characteristics. I used his book in my securities classes at Daniels for nearly 20 years. Haugen provided an important stepping stone on my journey to BPM, and for that I am thankful.

I would like to thank Craig Callahan, friend and colleague, for posing the initial questions and providing support for the research project which has produced one surprising result after another and is the basis for this book. Gary Black of Janus Capital saw early potential in this project and provided initial research funding. For many years I have enjoyed and benefited from my conversations with my friend and industry veteran Andrew Cox. Academic colleagues Russ Wermers, Levon Goukasian, Hersh Shefrin, Oliver Boguth, Russ Goyenko, Randy Cohen, Malcolm Baker and Gene Fama have provided useful insights over the years. Jeff Wurgler, Ken French and Jay Ritter generously provided data for testing purposes. This book would not have been possible without the support and infrastructure development provided by my colleagues at AthenaInvest: Andy Howard, Joel Coppin and Lambert Bunker.

And most importantly, the unwavering love and support of my wife Mitch has been indispensable. She has stood by me for 40 years, through the trying years of the PhD program and now through the trying years of launching a new business. To her I dedicate this book with love.