DePaul University in Chicago made a major investment in studying the psychology of finance this fall when it opened the Driehaus Center in Behavioral Finance and hired a pioneer in the field, Werner De Bondt, to teach, conduct research and organize conferences on investor and market psychology.

De Bondt, who earned his doctoral degree in managerial economics from Cornell University, and renowned economics professor Richard Thaler of the University of Chicago are acknowledged as founders of behavioral finance with the publication of their 1985 academic paper, titled “Does the Stock Market Overreact?” The paper analyzed U.S. stock price data since 1925 and found that investors often overreact to both good and bad news, sending prices higher or lower than justified by economic fundamentals. This implies that there are predictable reversals in stock prices that astute money mangers can exploit, benefiting their clients.

Recent market volatility shows the importance of understanding investor psychology and its effect on the financial markets, De Bondt said. “Investors are feeling a deep sense of uncertainty right now because of global instability, accounting scandals, corporate governance problems as well as the economic recession, which has already lasted longer than expected,” De Bondt said. “But they may be overreacting to these events, much like the ‘irrational exuberance’ of investors in the 1990s—but in the opposite direction. If you look at this from a historical perspective, valuations are still pretty high. Economic fundamentals dominate in the long run, but human psychology sways the market in the short run.”

Understanding the psychology and motivations of individual investors also has become more important because of their growing role in investment markets, De Bondt said. “The average investor has no sense of how to build the best portfolio,” he said. “They make mistakes all the time. They chase stocks that have gone up in price recently, manage portfolio risk poorly and they may not be fully diversified. These issues have important social consequences.”

To promote study in the behavioral finance field, Chicago investment Manager Richard H. Driehaus, a DePaul alumnus and chief executive officer of Driehaus Capital Management, Inc., gave DePaul $3.45 million to open the Driehaus Behavioral Finance Center and hire De Bondt. Behavioral finance received a further boost this fall when psychologist Daniel Kahneman of Princeton University was chosen as co-winner of the Nobel Prize in Economics. “The Nobel committee recognized that economic decision-making is not only pure logic,” De Bondt said. “People are not calculating machines. Human emotions and the quality of cognition matter a great deal in understanding what people actually do.”

Editors’ Note: De Bondt is available for reporter interviews on investor and market psychology, financial decision-making, effects of news events on the market, organizational behavior and the behavior of corporate boards. He can be reached at 312-362-8394.