Behavioral finance
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. The concept of homo economicus was developed, and the psychology of this entity was fundamentally rational.Africa · North America South America · Asia Europe · Oceania Microeconomics · Macroeconomics History of economic thought Methodology · Heterodox approaches Behavioral · Cultural · Evolutionary Growth · Development · History International · Economic systems Monetary and Financial economics Public and Welfare economics Health · Labour · Managerial Business · Information · Game theory Industrial organization · Law Agricultural · Natural resource Environmental · Ecological Urban · Rural · Regional Economic geography Mathematical · Econometrics Experimental · National accounting Journals · Publications Categories · Topics · Economists Anarchism · Capitalism Communism · Corporatism Fascism · Georgism Islamic · Laissez-faire Market socialism · Mercantilism Protectionism · Socialism Syndicalism · Third Way 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 to understand 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. Psychologists in this field such as Ward Edwards, An important paper in the development of the behavioral economics and finance fields was written by Kahneman and Tversky in 1979.
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. 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. During the classical period, economics had a close link with psychology.
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). 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 Expected utility and discounted utility models began to gain wide acceptance, generating testable hypotheses about decision making under uncertainty and intertemporal consumption respectively.
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. These models assume that errors or biases are correlated across agents so that they do not cancel out in aggregate.
Behavioral economists have also incorporated these criticisms by focusing on field studies rather than lab experiments. 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.
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. Behavioral models typically integrate insights from psychology with neo-classical economic theory.
In general, economics sits within the neoclassical framework, though the standard assumption of rational behavior is often challenged. 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.
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. In some behavioral models, a small deviant group can have substantial market-wide effects (e.g.
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. 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.
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. 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, and others have demonstrated significant behavioral effects in stocks and exchange traded funds. The research can be grouped into the following areas: .
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). 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. Some central issues in behavioral finance include Why investors and managers (lenders and borrowers as well) make systematic errors .
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. 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.
Fehr and Schmidt, 1999). 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. 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.
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). Experiments are designed to be incentive-compatible, with binding transactions involving real money being the norm . There are three main themes in behavioral finance and economics: Barberis, Shleifer, and Vishny (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.
creating an artificial market by some kind of simulation software to study people s decision-making process and behavior in financial markets. Some financial models used in money management and asset valuation use behavioral finance parameters, for example: Critics of behavioral finance, such as Eugene Fama, typically support the efficient-market hypothesis (though Fama may have reversed his position in recent years). 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.
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. 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).
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. 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.
In addition, professional investors and fund managers seem to hold more bonds than one would expect given return differentials. Quantitative behavioral finance is a new discipline that uses mathematical and statistical methodology to understand behavioral biases in conjunction with valuation. 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.
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. Economists typically stress revealed preferences over stated preferences (from surveys) in the determination of economic value.
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. a home) might be totally lost.
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. Behavioral finance and economics rests as much on social psychology within large groups as on individual psychology.
It shows how those errors affect prices and returns (creating market inefficiencies). 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.
And not all behavioral economics uses experiments; behavioral economists rely heavily on theory and on observational studies in the field. 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. Not all economics experiments are psychological.
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). As part of the discussion of hypberbolic discounting, has been animal and human work on Melioration theory and Matching Law of Richard Herrnstein.
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. 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).
Further milestones in the development of the field include a well attended and diverse conference at the University of Chicago, Prospect theory is an example of generalized expected utility theory. 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.
