Behavioral economics and
behavioral
finance are closely related fields that have evolved to be
a separate branch of economic and financial analysis which applies
scientific research on human and social,
cognitive and emotional factors to better
understand
economic decisions by consumers, borrowers,
investors, and how they affect
market
prices,
returns and the
allocation of resources.
Behavioral economics is that branch of one, which deals with the
study and application of analysis with scientific approach on
social,emotional factors for understanding the consumers,investors
and the market,and the resources.
The field is primarily concerned with the
bounds of
rationality (selfishness, self-control) of
economic agent.
Behavioral models typically integrate
insights from
psychology with
neo-classical economic theory.
Behavioral Finance has become the theoretical basis for
technical analysis.
Behavioral analysts are mostly concerned with the effects of
market decisions, but also those of
public choice, another source of economic
decisions with some similar biases towards promoting
self-interest.
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. However, this
introduced serious errors.
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.
Although psychology had nearly disappeared from economic
discussions, during the 20th century there appeared an economic
psychology in works of the French
Gabriel
Tarde the American
George Katona
and the Hungarian
Laszlo Garai 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 had begun 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,
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).
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 in the
development of the field include a well attended and diverse
conference at the University of Chicago, 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, 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
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 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."
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:
- 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) and 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 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).
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.
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) 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
bubble and
crash). 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:
- 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, Vladimira Ilieva, Ahmet
Duran,). Studies by Ray Sturm and others have demonstrated
significant behavioral effects in stocks and exchange traded
funds.
The research can be grouped into the following areas:
- Empirical studies that demonstrate significant deviations from
classical theories
- Modeling using the concepts of behavioral effects together with
the non-classical assumption of the finiteness of assets
- Forecasting based on these methods
- 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
- Tarde, G. Psychologie économique (1902),
- The Powerful Consumer: Psychological Studies of the American
Economy. 1960.
- Garai,L. Identity Economics - An Alternative Economic
Psychology. 1990-2006.
- K Daniel, D Hirshleifer, A Subrahmanyam - The Journal of
Finance, 1998
- How Obama Is Using the Science of
Change. Michael Grunwald, TIME, April 2, 2009.
References
- 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
- Faruk Gul (2008). "behavioural economics and game theory."
The New Palgrave Dictionary of Economics, 2nd Edition.
Abstract.
- Luce, R Duncan (2000).
Utility of Gains and Losses: Measurement-theoretical and
Experimental Approaches. Lawrence Erlbaum Publishers, Mahwah,
New Jersey.
- Simon, Herbert A. (1987).
"behavioural economics," The New Palgrave: A
Dictionary of Economics, v. 1, pp. 221–24.
External links
Top topics
Wikis
Quiz
Map
Search