'Behavioral finance' and 'behavioral economics' are closely related fields which apply scientific research on human and social cognitive and emotional
biases to better understand
economic decisions and how they affect
market prices,
returns and the
allocation of resources. The fields are primarily concerned with the
rationality, or lack thereof, of
economic agents.
Behavioral models typically integrate insights from
psychology with
neo-classical economic theory. Behavioral Finance has become the theoretical basis for
technical analysis.
[1]
Behavioral analyses are mostly concerned with the effects of
market decisions, but also those of
public choice, another source of economic decisions with some similar biases.
History
During the
classical period, economics had a close link with psychology. For example,
Adam Smith wrote ''
The Theory of Moral Sentiments'', an important text describing psychological principles of individual behavior; and
Jeremy Bentham wrote extensively on the psychological underpinnings of
utility. Economists began to distance themselves from psychology during the development of neo-classical economics as they sought to reshape the discipline as a
natural science, with explanations of economic behavior deduced from assumptions about the nature of economic agents. The concept of
homo economicus was developed, and the psychology of this entity was fundamentally rational. Nevertheless, psychological explanations continued to inform the analysis of many important figures in the development of neo-classical economics such as
Francis Edgeworth,
Vilfredo Pareto,
Irving Fisher and
John Maynard Keynes.
Psychology had largely disappeared from economic discussions by the mid 20th century. A number of factors contributed to the resurgence of its use and the development of behavioral economics.
Expected utility and
discounted utility models began to gain wide acceptance, generating testable
hypotheses about decision making under
uncertainty and
intertemporal consumption respectively. Soon a number of observed and repeatable anomalies challenged those hypotheses. Furthermore, during the 1960s
cognitive psychology began to describe the brain as an information processing device (in contrast to
behaviorist models). Psychologists in this field such as
Ward Edwards,
Amos Tversky and
Daniel Kahneman began to compare their cognitive models of decision making under risk and uncertainty to economic models of rational behavior. In
Mathematical psychology, there is a longstanding interest in the transitivity of preference and what kind of measurement scale uitility consistutes (
Luce, 2000).
Perhaps the most important paper in the development of the behavioral finance and economics fields was written by Kahneman and Tversky in 1979. This paper, '
Prospect theory: Decision Making Under Risk', used cognitive psychological techniques to explain a number of documented divergences of economic decision making from neo-classical theory. Further milestones in the development of the field include a well attended and diverse conference at the University of Chicago (see Hogarth & Reder, 1987), a special 1997 edition of the Quarterly Journal of Economics ('In Memory of Amos Tversky') devoted to the topic of behavioral economics and the award of the
Nobel prize to Daniel Kahneman in 2002 "for having integrated insights from psychological research into economic science, especially concerning human judgment and decision-making under uncertainty."
Prospect theory is an example of
generalized expected utility theory. Although not commonly included in discussions of the field of behavioral economics, generalized expected utility theory is similarly motivated by concerns about the descriptive inaccuracy of
expected utility theory.
Behavioral economics has also been applied to problems of intertemporal choice. The most prominent idea is that of
hyperbolic discounting, in which a high rate of discount is used between the present and the near future, and a lower rate between the near future and the far future. This pattern of discounting is dynamically inconsistent (or time-inconsistent), and therefore inconsistent with some models of rational choice, since the rate of discount between time ''t'' and ''t+1'' will be low at time ''t-1'', when ''t'' is the near future, but high at time ''t'' when ''t'' is the present and time ''t+1'' the near future. As part of the discussion of hypberbolic discounting, has been animal and human work on
Melioration theory and
Matching Law of
Richard Herrnstein. They suggest that behavior is not based on expected utility of on just previous
reinforcement experience.
Methodology
At the outset behavioral economics and finance theories were developed almost exclusively from experimental observations and survey responses, though in more recent times real world data has taken a more prominent position.
fMRI has also been used to determine which areas of the brain are active during various steps of economic decision making. Experiments simulating market situations such as
stock market trading and
auctions are seen as particularly useful as they can be used to isolate the effect of a particular bias upon behavior; observed market behavior can typically be explained in a number of ways, carefully designed experiments can help narrow the range of plausible explanations. Experiments are designed to be incentive compatible, with binding transactions involving real money the norm.
Key observations
There are three main themes in behavioral finance and economics (Shefrin, 2002):
★
Heuristics: People often make decisions based on approximate
rules of thumb, not strictly rational analyses. See also
cognitive biases and
bounded rationality.
★
Framing: The way a problem or decision is presented to the decision maker will affect his action.
★ Market inefficiencies: There are explanations for observed market outcomes that are contrary to rational expectations and market efficiency. These include mispricings, non-rational decision making, and return anomalies.
Richard Thaler, in particular,
has written a long series of papers describing specific market anomalies from a behavioral perspective.
Recently, Barberis, Shleifer, and Vishny (1998), as well as Daniel, Hirshleifer, and Subrahmanyam (1998) have built models based on extrapolation (seeing patterns in random sequences) and overconfidence to explain security market over- and underreactions, though such models have not been used in the money management industry. These models assume that errors or biases are correlated across agents so that they do not cancel out in aggregate. This would be the case if a large fraction of agents look at the same signal (such as the advice of an analyst) or have a common bias.
More generally, cognitive biases may also have strong anomalous effects in aggregate if there is a social contamination with a strong emotional content (collective greed or fear), leading to more widespread phenomena such as
herding and
groupthink. Behavioral finance and economics rests as much on
social psychology within large groups as on individual psychology. However, some behavioral models explicitly demonstrate that a small but significant anomalous group can also have market-wide effects (eg. Fehr and Schmidt, 1999).
Behavioral finance topics
Key observations made in behavioral finance literature include the lack of symmetry between decisions to acquire or keep resources, called colloquially the "bird in the bush" paradox, and the strong
loss aversion or regret attached to any decision where some emotionally valued resources (e.g. a home) might be totally lost. Loss aversion appears to manifest itself in investor behavior as an unwillingness to sell shares or other equity, if doing so would force the trader to realise a nominal loss (Genesove & Mayer, 2001). It may also help explain why housing market prices do not adjust downwards to market clearing levels during periods of low demand.
Applying a version of
prospect theory, Benartzi and Thaler (1995) claim to have solved the
equity premium puzzle, something conventional finance models have been unable to do.
Presently, some researchers in
experimental finance use experimental method, e.g. creating an artificial market by some kind of simulation software to study people's decision-making process and behavior in financial markets.
Behavioral finance models
Some financial models used in money management and asset valuation use behavioral finance parameters, for example
★ Thaler's model of price reactions to
information, with three phases,
underreaction-adjustment-overreaction, creating a price
trend
One characteristic of overreaction is that the average return of asset prices following a series of announcements of good news is lower than the average return following a series of bad announcements. In other words, overreaction occurs if the market reacts too strongly or for too long (persistent trend) to news that it subsequently needs to be compensated in the opposite direction. As a result, assets that were winners in the past should not be seen as an indication to invest in as their risk adjusted returns in the future are relatively low compared to stocks that were defined as losers in the past.
★ The
stock image coefficient
Criticisms of behavioral finance
Critics of behavioral finance, such as
Eugene Fama, typically support the
efficient market theory (though Fama may have reversed his position in recent years). They contend that behavioral finance is more a collection of anomalies than a true branch of
finance and that these anomalies will eventually be priced out of the market or explained by appealing to
market microstructure arguments. However, a distinction should be noted between individual biases and social biases; the former can be averaged out by the market, while the other can create
feedback loops that drive the market further and further from the equilibrium of the "
fair price".
A specific example of this criticism is found in some attempted explanations of the
equity premium puzzle. It is argued that the puzzle simply arises due to
entry barriers (both practical and psychological) which have traditionally impeded entry by individuals into the stock market, and that returns between stocks and bonds should stabilize as electronic resources open up the stock market to a greater number of traders (See Freeman, 2004 for a review). In reply, others contend that most personal investment funds are managed through superannuation funds, so the effect of these putative barriers to entry would be minimal. In addition, professional investors and fund managers seem to hold more bonds than one would expect given return differentials.
Behavioral economics topics
Models in behavioral economics are typically addressed to a particular observed market anomaly and modify standard neo-classical models by describing decision makers as using
heuristics and being affected by framing effects. In general, behavioural economics sits within the
neoclassical framework, though the standard assumption of rational behaviour is often challenged.
Heuristics
Prospect theory -
Loss aversion -
Status quo bias -
Gambler's fallacy -
Self-serving bias -
money illusion
Framing
Cognitive framing -
Mental accounting -
Anchoring
Anomalies (economic behavior)
Disposition effect -
endowment effect -
inequity aversion -
reciprocity -
intertemporal consumption -
present-biased preferences -
momentum investing -
Greed and fear -
Herd instinct -
Sunk cost fallacy
Anomalies (market prices and returns)
equity premium puzzle -
Efficiency wage hypothesis -
price stickiness -
limits to arbitrage -
dividend puzzle -
fat tails -
calendar effect
Critical conclusions of behavioral economics
Critics of behavioral economics typically stress the
rationality of economic agents (see Myagkov and Plott (1997) amongst others). They contend that experimentally observed behavior is inapplicable to market situations, as learning opportunities and competition will ensure at least a close approximation of rational behavior.
Others note that cognitive theories, such as
prospect theory, are models of
decision making, not generalized economic behavior, and are only applicable to the sort of once-off decision problems presented to experiment participants or survey respondents.
Traditional economists are also skeptical of the experimental and survey based techniques which are used extensively in behavioral economics. Economists typically stress
revealed preferences over stated preferences (from surveys) in the determination of economic value. Experiments and surveys must be designed carefully to avoid systemic biases, strategic behavior and lack of incentive compatibility, and many economists are distrustful of results obtained in this manner due to the difficulty of eliminating these problems.
Rabin (1998) dismisses these criticisms, claiming that results are typically reproduced in various situations and countries and can lead to good theoretical insight. Behavioral economists have also incorporated these criticisms by focusing on field studies rather than lab experiments. Some economists look at this split as a fundamental schism between
experimental economics and behavioral economics, but prominent behavioral and experimental economists tend to overlap techniques and approaches in answering common questions. For example, many prominent behavioral economists are actively investigating
neuroeconomics, which is entirely experimental and cannot be verified in the field.
Other proponents of behavioral economics note that neoclassical models often fail to predict outcomes in real world contexts. Behavioral insights can be used to update neoclassical equations, and behavioral economists note that these revised models not only reach the same correct predictions as the traditional models, but also correctly predict some outcomes where the traditional models failed.
Key figures in behavioral economics
★
Dan Ariely
★
Colin Camerer
★
Ernst Fehr
★
Daniel Kahneman
★
David Laibson
★
George Loewenstein
★
R. Duncan Luce
★
Matthew Rabin
★
Howard Rachlin
★
Paul Slovic
★
Richard Thaler
★
Amos Tversky
★
George Wu
Key scholars in behavioral finance
★
Nicholas Barberis
★
Shlomo Benartzi
★
Kent Daniel
★
David Hirshleifer
★
Harrison Hong
★
Terrance Odean
★
Hersh Shefrin
★
Robert Shiller
★
Andrei Shleifer
★
Meir Statman
★
Jeremy Stein
★
A. Subrahmanyam
★
Richard Thaler
★
Werner De Bondt
References
1. Technical Analysis, The Complete Resource for Market Technicians, Kirkpatrick, Charles D.; Dahlquist, Julie R., , , , ,
★ Camerer, C. F.; Loewenstein, G. & Rabin, R. (eds.) (2003) ''Advances in Behavioral Economics''
★ Barberis, N.; A. Shleifer; R. Vishny (1998) ``A Model of Investor Sentiment'' Journal of Financial Economics 49, 307-343.
★ Daniel, K.; D. Hirshleifer; A. Subrahmanyam, (1998) ``Investor Psychology and Security Market Over- and Underreactions'' Journal of Finance 53, 1839-1885.
★
Lawrence A. Cunningham, Behavioral Finance and Investor Governance, 59 Washington & Lee Law Review (2002)
★ Kahneman, D. & Tversky, A. 'Prospect Theory: An Analysis of Decision under Risk,' ''Econometrica'', XVLII (1979), 263–291
★ Kirkpatrick, Charles D.; Dahlquist, Julie R. (2007) ''Technical Analysis, The Complete Resource for Financial Market Technicians''
★ Luce, R Duncan (2000). ''Utility of Gains and Losses: Measurement-theoretical and Experimental Approaches''. Lawrence Erlbaum Publishers, Mahwah, New Jersey.
★ Rabin, Matthew; 'Psychology and Economics,' ''Journal of Economic Literature'', American Economic Association, vol. 36(1), pages 11-46, March 1998.
★ Shefrin, Hersh (2002) ''Beyond Greed and Fear: Understanding behavioral finance and the psychology of investing.'' Oxford Universtity Press
★ Shleifer, Andrei (1999) ''Inefficient Markets: An Introduction to Behavioral Finance'', Oxford University Press
★ Shlomo Benartzi; Richard H. Thaler 'Myopic Loss Aversion and the Equity Premium Puzzle' (1995) ''The Quarterly Journal of Economics'', Vol. 110, No. 1.
See also
★
Behavioral Operations Research
★
Cognitive bias
★
Cognitive psychology
★
Confirmation bias
★
Culture speculation
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Experimental economics
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Experimental finance
★
Hindsight bias
★
Important publications in behavioral finance(economics)
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Important publications in behavioral finance(sociology)
★
Journal of Behavioral Finance
★
List of cognitive biases
★
Neuroeconomics
★
Socionomics
External links
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new economics foundation - Behavioural economics: seven principles for policy makers
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Universiteit Amsterdam; Center for Experimental Economics and Political Decision Making
★
Behavioral Finance Initiative of the International Center for Finance at the
Yale School of Management
★
Behavioral-Finance Group FAQ / Glossary
★
History of Behavioral finance
★
Richard Thaler's 'anomalies' papers
★
Behavioural Finance at MoneyScience
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Born Suckers - The greatest Wall Street danger of all: you. By ... - Dec. 14, 2004
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"On the Robustness of Behavioral Economics" - an academic analysis in the Yale Economic Review
★
The Marketplace of Perceptions
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Behavioral Finance-Theory and Practical Application
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Integrating Traditional and Behavioral Finance
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Olivier Brandouy's Experimental finance Page
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JessX(java experimental simulated stock exchange), simulation software for Experimental finance
★
The Economist article
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Rationality Controversy and Economic Theory
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Institute of Behavioral Finance
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