"The economist may
attempt to ignore psychology, but it is sheer impossibility for him to ignore
human nature. … If the economist borrows his conception of man from the
psychologist, his constructive work may have some chance of remaining purely
economic in character. But if he does not, he will not thereby avoid
psychology. Rather, he will force himself to make his own, and it will be bad
John Maurice Clark
"Economics and modern psychology,"
Journal of Political Economy, 1918
WHAT IS BEHAVIORAL FINANCE?
finance theory is probably the least behavioral of the various subdisciplines
of economics. In other areas of
economics, what people actually do is, if not in the foreground, at least part
of the picture. In finance, we simply insist that whatever people do, they do
it right. People optimize but otherwise
their behavior is like a black box.
Much of mainstream finance reveals little interest in investor
decision processes or in the quality of judgment.
has not always been this way. Earlier
generations of economists, starting with Adam Smith (and including Vilfredo
Pareto, Wesley Mitchell, Irving Fisher, John Maynard Keynes, Friedrich von
Hayek, Benjamin Graham, and others) put great emphasis on the fallible nature of
human decision-making. The interest of finance academics and practitioners in
the human factor waned during the 1960s and the 1970s. It rebounded during the
1990s after it was shown that there are predictable trends and reversals in
stock prices, likely related to shifts in investor sentiment.
problems with modern finance theory are created by its dual purpose to characterize
optimal choice and to describe actual choice.
The validity of the theory for the first purpose is not in question.
However, there is a pressing need to develop explicitly descriptive models
of financial decision making behavior in households, organizations, and
markets. This research program is called behavioral finance.
make progress, we need to better portray behavior in the usual domains of
finance theory (e.g., portfolio selection and stock valuation) and to enrich
the theory to incorporate new domains upon which finance has been silent. For
instance, at this point, finance has little to say about the role of social
norms. Efforts along these lines are made by behavioral economists,
psychologists, sociologists, and other social scientists.
We illustrate the
new world of behavioral finance with brief descriptions of four concepts:
Overreaction, overconfidence, mental frames, and fashion.
financial predictions made as if people have a working knowledge of Bayes’
rule? Numerous studies conclude that
the answer to this question is no.
People appear to make probability judgments using similarity or what
psychologists call the ‘representativeness heuristic’. People evaluate the probability of an
uncertain event by the degree to which it reflects the salient features of an
underlying class of events, for instance, to the degree that it matches a
well-known stereotype. Representativeness leads to systematic errors in
judgment. It induces people to give too much weight to recent new evidence and
too little weight to the base rate or prior odds. Representativeness may
explain why financial markets overreact to economic news and why there appear
to be predictable reversals in equity prices.
robust finding in the psychology of judgment is that people are
overconfident. For instance, many
people overestimate the reliability of their knowledge. When people say hat they are 90% sure that
event will happen or that a statement is true, they may only be correct 70% of
the time. Widespread overconfidence may
affect the structure of asset prices. It is an important reason why some
investors trade as much as they do.
Mental frames in the psychology of choice
strong intuition about preferences is that people treat gains and losses differently
and, in particular, that losses loom larger than gains. This intuition was formally
incorporated into Kahneman and Tversky’s prospect theory, a descriptive theory
of decision making under uncertainty that is an alternative to expected utility
theory. In prospect theory the carriers of value are changes in wealth, rather
than levels, and negative changes are weighted more heavily than gains.
aversion implies that decision-making is sensitive to the way that the
alternatives are described or "framed." Individuals often have
opportunities to create their own frames, a process called mental accounting.
Mental accounting can mitigate self-control problems, for example by setting up
special accounts (e.g., the children’s education account) that are considered
off-limits to spending urges.
investors and money managers are influenced by their social environment, and
they often feel pressure to conform. In many instances, conformist behavior
is seen as prudent behavior. However, herding can lead people astray, e.g.,
when they follow a market guru. In general, it is found that fashions and fads
are as likely to emerge in financial markets as anywhere else.