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 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.
During the classical period, economics had a close link with psychology. For example, Adam Smith wrote an important text describing psychological principles of individual behavior, The Theory of Moral Sentiments 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 deducted 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 which generated testable hypotheses about decision making under uncertainty and intertemporal consumption respectively, and a number of observed and repeatable anomalies challenged these 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 benchmark their cognitive models of decision making under risk and uncertainty against economic models of rational behavior.
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 anomalies in rational economic decision making. Further milestones in the development of the field include a well attended and diverse conference at the University of Chicago (see Hogarth & Reder, 1987) and a special 1997 edition of the respected Quarterly Journal of Economics ('In Memory of Amos Tversky') devoted to the topic of behavioral economics.
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.
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 their action.
- Market inefficiencies: Attempts to explain observed market outcomes which 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.
Market wide anomalies can not generally be explained by individuals suffering from cognitive biases, as individual biases often do not have a large enough effect to change market prices and returns. In addition, individual biases could potentially cancel each other out. Cognitive biases have real anomalous effects only 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 as on individual psychology.
There are two exceptions to this general statement. First, it might be the case that enough individuals exhibit biased (ie. different from rational expectations) behavior that such behavior is the norm and this behavior would, then, have market wide effects. Further, some behavioral models explicitly demonstrate that a small but significant anomalous group can have market-wide effects (eg. Fehr and Schmidt, 1999).
Behavioral finance topics
Key observations made the 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.
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
- The stock image coefficient
Criticisms of behavioral finance
Critics of behavioral finance, such as Eugene Fama, typically support the efficient market theory. 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 appeal 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 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.
Prospect theory - Loss aversion - Status quo bias - Gambler's fallacy - Self-serving bias
Cognitive framing - Mental accounting - Reference utility - Anchoring
Endowment effect - Equity premium puzzle - Money illusion - Fairness - Efficiency wage hypothesis - Reciprocity - Intertemporal consumption - Present biased preferences - Behavioral life cycle hypothesis - Wage stickiness - Price stickiness - Visceral influences - Income and happiness
Criticisms 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 sceptical 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.
Shlomo Benartzi - Colin Camerer - Stefano DellaVigna - Ron Dembo - Ernst Fehr - Daniel Kahneman - Jack Knetsch - Botond Koszegi - David Laibson - George Loewenstein - Sendhil Mullainathan - Ted O'Donoghue - Matthew Rabin - Hersh Shefrin - Richard Thaler - Amos Tversky
- Kahneman, D. & Tversky, A. 'Prospect Theory: An Analysis of Decision under Risk,' Econometrica, XVLII (1979), 263–291
- Shefrin, Hersh (2002) Beyond Greed and Fear: Understanding behavioral finance and the psychology of investing. Oxford Universtity Press
- Camerer, C. F.; Loewenstein, G. & Rabin, R. (eds.) (2003) Advances in Behavioral Economics
- 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.
- Matthew Rabin 'Psychology and Economics,' Journal of Economic Literature, American Economic Association, vol. 36(1), pages 11-46, March 1998.
Last updated: 09-12-2005 02:39:13