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Behavioral Economics and Behavioral Finance are closely related fields making up a separate branch of economic and financial analysis using social, cognitive and emotional factors in understanding the economic decisions of consumers, borrowers and investors, and their effects on market prices, returns and the allocation of resources.

The field is primarily concerned with the bounds of rationality (selfishness, self-control) of economic agents. Behavioral models typically integrate insights from psychology with neo-classical economic theory. Behavioral Finance has thus become the theoretical basis for technical analysis.[1]

Behavioral analysts are not only concerned with the effects of market decisions but also with the issues of public choice, another source of economic decisions with some similar biases towards promoting self-interest.

Contents

History

During the classical period, economics had been closely linked to 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. However, 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. This well-intentioned advance, however, led to the appearance of unintended, and unforeseen, errors.

Psychological explanations continued to inform the analysis of many important figures in the development of neo-classical economics, Figures such as Francis Edgeworth, Vilfredo Pareto, Irving Fisher and John Maynard Keynes.

Although psychology had nearly disappeared from economic discussions, the 20th century witnessed the emergence of economic psychology in the works of the French Gabriel Tarde[2] the American George Katona[3] and the Hungarian Laszlo Garai[4]. 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, it was during the 1960s that cognitive psychology began to shed more light on the brain as an information processing device (in contrast to behaviorist models). Psychologists in this field, such as Ward Edwards,[5] 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 utility constitutes (Luce, 2000).[6]

An important paper in the development of the behavioral economics and finance fields was written by Kahneman and Tversky in 1979. This paper, 'Prospect theory: An Analysis of Decision Under Risk', used cognitive psychological techniques to explain a number of documented divergences of economic decision making from neo-classical theory (Kahneman, 2003). However, 'Theory of Crime' written by Nobel Laureate Gary Becker in 1967 was a seminal work that factored in psychological elements into economic decision making; Becker, however, insisted on maintaining strict consistency of preferences. In tracing the history of behavioral economics, reference should be made to the theory of Bounded Rationality by Nobel Laureate Herbert Simon who explained how people irrationally tend to be satisfied, instead of maximizing utility, as generally assumed. Other prominent forerunners of modern behavioral economics include Maurice Allais, whose "Allais Paradox" represented a crucial early challenge to expected utility.

Over time many other psychological effects have been incorporated into behavioral economics, such as overconfidence, projection bias, and the effects of limited attention. Further milestones were reached in the development of the field, and these include a well attended and diverse conference at the University of Chicago,[7] 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".[8]

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, proposed by George Ainslie (1975) and developed by David Laibson, Ted O'Donoghue, and Matthew Rabin, 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 hyperbolic 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 rather it is based on previous reinforcement experience, verbal framing, direct-acting and verbally-governed contingencies. Thus, financial and utilitarian choice making becomes a deterministic process amendable to empirical modelling, investigation, understanding and influence.

Other branches of behavioral economics represent less of a challenge to neoclassical utility theory, enriching the model of the utility function without implying inconsistency in preferences. A great deal of work on "fairness" and "reciprocal altruism" by scholars such as Ernst Fehr, Armin Falk, and Matthew Rabin has weakened the neoclassical assumption of "perfect selfishness." This work is particularly applicable to wage setting in labor markets. Work on "intrinsic motivation" by Gneezy and Rustichini and on "identity" by Akerlof and Kranton allow agents to derive utility from meeting personal and social norms in addition to consumption.

Note that behavioral economics (enriching economic models by applying psychology) is distinct from experimental economics (using experimental methods to study economic questions). Not all economics experiments are psychological. While many experimental economics studies (such as the ultimatum game and the public goods game) probe psychological aspects of decision making, other experiments explore institutional features or serve as "beta testing" for new market mechanisms. And not all behavioral economics uses experiments; behavioral economists rely heavily on theory and on observational studies "in the field."

Recently the field of behavioral economics has caught on among laypeople, with the success of books like Dan Ariely's Predictably Irrational and the appointment of well-known behavior economists like Larry Summers to high government offices.

Methodology

At the outset behavioral economics and finance theories had been developed almost exclusively from experimental observations and survey responses, although in more recent times real world data have taken a more prominent position. Functional magnetic resonance imaging (fMRI) has complemented this effort through its use in determining 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 being the "norm".

Key observations

There are three main themes in behavioral finance and economics:[9]

  • Heuristics: People often make decisions based on approximate rules of thumb, not strictly rational analysis. 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: There are explanations for observed market outcomes that are contrary to rational expectations and market efficiency. These include mis-pricings, non-rational decision making, and return anomalies. Richard Thaler, in particular, has described specific market anomalies from a behavioral perspective.

Barberis, Shleifer, and Vishny (1998)[10] and Daniel, Hirshleifer, and Subrahmanyam (1998)[11] have built models based on extrapolation (seeing patterns in random sequences) and overconfidence to explain security market over- and underreactions, though the source of misreactions continues to be debated. 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 the aggregate if there is a social contagion of emotions (causing collective euphoria or fear) and ideas, leading to phenomena such as herding and groupthink. Behavioral finance and economics rests as much on social psychology within large groups as on individual psychology. In some behavioral models, a small deviant group can have substantial market-wide effects (e.g. Fehr and Schmidt, 1999).[citation needed]

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, economics sits within the neoclassical framework, though the standard assumption of rational behavior is often challenged.

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Heuristics

Framing

Anomalies (economic behavior)

Anomalies (market prices and returns)

Criticism of, and support for, 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)[13] 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.

Behavioral finance

Behavioral finance topics

Some central issues in behavioral finance include "Why investors and managers (lenders and borrowers as well) make systematic errors". It shows how those errors affect prices and returns (creating market inefficiencies). It also shows what managers of firms, other institutions and financial players might do to take advantage of market inefficiencies (arbitrage behavior).

Behavioral finance highlights certain inefficiencies and among these inefficiencies are underreactions or overreactions to information, as causes of market trends and in extreme cases of bubbles and crashes). Such misreactions have been attributed to limited investor attention, overconfidence / overoptimism, and mimicry (herding instinct) and noise trading.

Other key observations made in behavioral finance literature include the lack of symmetry (disymmetry) 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.

Benartzi and Thaler (1995), applying a version of prospect theory, claim to have solved the equity premium puzzle, something conventional finance models have been unable to do so far.

Some current researchers in experimental finance use the 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 two 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.

Criticisms of behavioral finance

Critics of behavioral finance, such as Eugene Fama, typically support the efficient-market hypothesis (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.

Quantitative behavioral finance

Quantitative behavioral finance is a new discipline that uses mathematical and statistical methodology to understand behavioral biases in conjunction with valuation. Some of this endeavor has been led by Gunduz Caginalp (Professor of Mathematics and Editor of the Journal of Behavioral Finance from 2001–2004) and collaborators including Vernon Smith (2002 Nobel Laureate in Economics), David Porter, Don Balenovich,[14] Vladimira Ilieva, Ahmet Duran,[15]). Studies by Ray Sturm[16] and others have demonstrated significant behavioral effects in stocks and exchange traded funds.

The research can be grouped into the following areas:

  1. Empirical studies that demonstrate significant deviations from classical theories
  2. Modeling using the concepts of behavioral effects together with the non-classical assumption of the finiteness of assets
  3. Forecasting based on these methods
  4. Studies of experimental asset markets and use of models to forecast experiments

Key figures in behavioral economics

Key scholars in behavioral finance

See also

Notes

  1. ^ Kirkpatrick, Charles D.; Dahlquist, Julie R. (2007). Technical Analysis, The Complete Resource for Market Technicians. pp. 49. 
  2. ^ Tarde, G. Psychologie économique (1902),
  3. ^ The Powerful Consumer: Psychological Studies of the American Economy. 1960.
  4. ^ Garai,L. Identity Economics - An Alternative Economic Psychology. 1990-2006.
  5. ^ "Ward Edward Papers". Archival Collections. http://www.usc.edu/libraries/archives/arc/libraries/collections/records/427home.html. Retrieved 2008-04-25. 
  6. ^ Luce, R Duncan (2000). Utility of Gains and Losses: Measurement-theoretical and Experimental Approaches. Mahwah, New Jersey: Lawrence Erlbaum Publishers. 
  7. ^ Hogarth, R. M.; Reder, M. W. (1987). Rational choice: The contrast between economics and psychology. Chicago: University of Chicago Press. 
  8. ^ "Nobel Laureates 2002". Nobelprize.org. http://nobelprize.org/nobel_prizes/lists/2002.html. Retrieved 2008-04-25. 
  9. ^ Shefrin, Hersh (2002). Beyond Greed and Fear: Understanding behavioral finance and the psychology of investing. Oxford University Press. 
  10. ^ Barberis, N; A. Shleifer, R. Vishny (1998). "``A Model of Investor Sentiment". Journal of Financial Economics 49: 307–343. doi:10.1016/S0304-405X(98)00027-0. http://jfe.rochester.edu/. Retrieved 2008-04-25. 
  11. ^ Daniel, K; D. Hirshleifer, A. Subrahmanyam (1998). "``Investor Psychology and Security Market Under- and Overreactions". Journal of Finance 53: 1839–1885. 
  12. ^ K Daniel, D Hirshleifer, A Subrahmanyam - The Journal of Finance, 1998
  13. ^ Rabin, Matthew (March 1998). "Psychology and Economics". Journal of Economic Literature (American Economic Association) (1): 11–46. 
  14. ^ "Dr. Donald A. Balenovich". Indiana University of Pennsylvania, Mathematics Department. http://www.ma.iup.edu/people/dabalen.html. 
  15. ^ "Ahmet Duran". Department of Mathematics, University of Michigan-Ann Arbor. http://www.umich.edu/~durana. 
  16. ^ "Dr Ray R. Sturm, CPA". College of Business Administration. http://www.bus.ucf.edu/rsturm. 
  17. ^ "Predictably Irrational". Dan Ariely. http://www.predictablyirrational.com/?page_id=5. Retrieved 2008-04-25. 
  18. ^ How Obama Is Using the Science of Change. Michael Grunwald, TIME, April 2, 2009.
  19. ^ Sendhil Mullainathan: Solving social problems with a nudge

References

  • Ainslie, G. (1975). "Specious Reward: A Behavioral /Theory of Impulsiveness and Impulse Control". Psychological Bulletin 82 (4): 463–496. PMID 1099599. 
  • Barberis, N.; Shleifer, A.; Vishny, R. (1998). "A Model of Investor Sentiment". Journal of Financial Economics 49 (3): 307–343. doi:10.1016/S0304-405X(98)00027-0. 
  • Benartzi, Shlomo; Thaler, Richard H. (1995). "Myopic Loss Aversion and the Equity Premium Puzzle". The Quarterly Journal of Economics 110 (1): 73–92. doi:10.2307/2118511. 
  • Bernheim, B. Douglas, and Antonio Rangel (2008). "behavioural public economics," The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
  • Bloomfield, Robert (2008). "behavioural finance." The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
  • Camerer, Colin F. (2008). "behavioural game theory," The New Palgrave Dictionary of Economics 2nd Edition. Abstract.
  • Camerer, C. F.; Loewenstein, G. & Rabin, R. (eds.) (2003) Advances in Behavioral Economics
  • Cunningham, Lawrence A. (2002). "Behavioral Finance and Investor Governance". Washington & Lee Law Review 59: 767. doi:10.2139/ssrn.255778. ISSN 19426658. 
  • Daniel, K.; Hirshleifer, D.; Subrahmanyam, A. (1998). "Investor Psychology and Security Market Under- and Overreactions". Journal of Finance 53 (6): 1839–1885. doi:10.1111/0022-1082.00077. 
  • Faruk Gul (2008). "behavioural economics and game theory." The New Palgrave Dictionary of Economics, 2nd Edition. Abstract.
  • Hens, Thorsten; Bachmann, Kremena (2008). Behavioural Finance for Private Banking. Wiley Finance Series. ISBN 0-470-77999-3. http://www.bfpb.ch. 
  • Hogarth, R. M.; Reder, M. W. (1987). Rational Choice: The Contrast between Economics and Psychology. Chicago: University of Chicago Press. ISBN 0226348571. 
  • Kahneman, Daniel; Tversky, Amos (1979). "Prospect Theory: An Analysis of Decision under Risk". Econometrica 47 (2): 263–291. doi:10.2307/1914185. 
  • Kahneman, Daniel; Ed Diener (2003). Well-being: the foundations of hedonic psychology. Russell Sage Foundation. 
  • Kirkpatrick, Charles D.; Dahlquist, Julie R. (2007). Technical Analysis: The Complete Resource for Financial Market Technicians. Upper Saddle River, NJ: Financial Times Press. ISBN 0131531131. 
  • Luce, R Duncan (2000). Utility of Gains and Losses: Measurement-theoretical and Experimental Approaches. Lawrence Erlbaum Publishers, Mahwah, New Jersey.
  • Mullainathan, S.; Thaler, R. H. (2001). "Behavioral Economics". International Encyclopedia of the Social & Behavioral Sciences. pp. 1094–1100. doi:10.1016/B0-08-043076-7/02247-6. 
  • Rabin, Matthew (1998). "Psychology and Economics". Journal of Economic Literature 36 (1): 11–46. doi:10.2307/2564950. 
  • Shefrin, Hersh (2002). Beyond Greed and Fear: Understanding behavioral finance and the psychology of investing. New York: Oxford University Press. ISBN 0195161211. 
  • Shleifer, Andrei (1999). Inefficient Markets: An Introduction to Behavioral Finance. New York: Oxford University Press. ISBN 0198292287. 
  • Simon, Herbert A. (1987). "behavioural economics," The New Palgrave: A Dictionary of Economics, v. 1, pp. 221–24.

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