Behavioral finance

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Behavioral finance and behavioral economics are closely related fields which apply scientific research on human and social cognitive and emotional biasesto better understand economicdecisionsand how they affect market prices, returnsand the allocation of resources. The fields are primarily concerned with the rationality, or lack thereof, of economic agents. Behavioral modelstypically integrate insights from psychologywith neo-classical economic theory.

Behavioral analyses are mostly concerned with the effects of marketdecisions, 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 Smithwrote an important text describing psychological principles of individual behavior, The Theory of Moral Sentiments and Jeremy Benthamwrote 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 economicuswas 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 Fisherand 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 utilityand discounted utilitymodels began to gain wide acceptance which generated testable hypothesesabout decision making under uncertaintyand intertemporal consumptionrespectively, and a number of observed and repeatable anomalies challenged these hypotheses. Furthermore, during the 1960s cognitive psychologybegan to describe the brain as an information processing device (in contrast to behavioristmodels). Psychologists in this field such as Ward Edwards, Amos Tverskyand Daniel Kahnemanbegan 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.

Prospect theory is an example of generalized expected utilitytheory. 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 utilitytheory.

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 standard 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.

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. fMRIhas 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 markettrading and auctionsare 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 biasesand 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 mispricings, non-rational decision making, and return anomalies. Richard Thaler, in particular, has written a long series of papersdescribing 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 herdingand groupthink. Behavioral finance and economics rests as much on social psychologyas 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 aversionor 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 imagecoefficient

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 financeand 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 biasesand social biases; the former can be averaged out by the market, while the other can create feedback loopsthat 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 heuristicsand being affected by framing effects. In general, behavioural economics sits within the neoclassicalframework, though the standard assumption of rational behaviour is often challenged.

Heuristics
Prospect theory- Loss aversion- Status quo bias- Gambler's fallacy- Self-serving bias

Framing
Cognitive framing- Mental accounting- Reference utility- Anchoring

Anomalies
Disposition effect- Endowment effect- Equity premium puzzle- Money illusion- Fairness(Inequity aversion) - Efficiency wage hypothesis- Reciprocity- Intertemporal consumption- Present biased preferences- Behavioral life cycle hypothesis- Wage stickiness- Price stickiness- Visceral influences- Limits to Arbitrage- Income and happiness- momentum investing

Criticisms of behavioral economics

Critics of behavioral economics typically stress the rationalityof 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.

Key figures

Dan Ariely- Colin Camerer- Daniel Kahneman- David Laibson- George Loewenstein- Matthew Rabin- Robert Shiller- Richard Thaler- Amos Tversky- Paul Slovic- Andrew Lo- Andrei Shleifer- Hersh Shefrin

Non-specialists whose work is important to the field

Herbert Simon- Gerd Gigerenzer- Fischer Black- John Tooby- Leda Cosmides- Paul Rubin- Donald Rubin- Ronald Coase

References

• 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.

See also

• Cognitive psychology
• Important publications in behavioral finance(economics)
• Important publications in behavioral finance(sociology)
• Neuroeconomics
• Experimental economics
• Culture speculation

External links

• Behavioural Finance
• Behavioral Finance Initiativeof 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
• Born Suckers - The greatest Wall Street danger of all: you. By ... - Dec. 14, 2004
• "On the Robustness of Behavioral Economics" - an academic analysis in the Yale Economic Reviewde:Behavioral Finance

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It uses material from the http://en.wikipedia.org/wiki/Behavioral+finance Wikipedia article Behavioral finance.