Behavioural finance

2007 Schools Wikipedia Selection. Related subjects: Economics

Behavioural finance and behavioural economics are closely related fields which apply scientific research on human and social cognitive and emotional biases to better understand economic decisions and how they affect market prices, returns and the allocation of resources. The fields are primarily concerned with the rationality, or lack thereof, of economic agents. Behavioural models typically integrate insights from psychology with neo-classical economic theory.

Behavioural analyses are mostly concerned with the effects of market decisions, but also those of public choice, another source of economic decisions with some similar biases.


During the classical period, economics had a close link with psychology. For example, Adam Smith wrote an important text describing psychological principles of individual behaviour, The Theory of Moral Sentiments 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 behaviour 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. 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 Fisher and 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 behavioural economics. Expected utility and discounted utility models began to gain wide acceptance which generated testable hypotheses about decision making under uncertainty and intertemporal consumption respectively, and a number of observed and repeatable anomalies challenged these hypotheses. Furthermore, during the 1960s cognitive psychology began to describe 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 benchmark their cognitive models of decision making under risk and uncertainty against economic models of rational behaviour.

Perhaps the most important paper in the development of the behavioural 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), a special 1997 edition of the respected Quarterly Journal of Economics ('In Memory of Amos Tversky') devoted to the topic of behavioural 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 behavioural economics, generalized expected utility theory is similarly motivated by concerns about the descriptive inaccuracy of expected utility theory.

Behavioural 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.


At the outset behavioural 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. fMRI has 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 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 behaviour 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 behavioural finance and economics (Shefrin, 2002):

  • Heuristics: People often make decisions based on approximate rules of thumb, not strictly rational analyses. See also cognitive biases and bounded rationality.
  • Framing: The way a problem or decision is presented to the decision maker will affect his 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 papers describing specific market anomalies from a behavioural perspective.

Market wide anomalies cannot 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 herding and groupthink. Behavioural finance and economics rests as much on social psychology as 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 behavioural models explicitly demonstrate that a small but significant anomalous group can have market-wide effects (eg. Fehr and Schmidt, 1999).

Behavioural finance topics

Key observations made in behavioural 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 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 behaviour 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.

Presently, some researchers in Experimental finance use experimental method, e.g. creating an artificial market by some kind of simulation software to study people's decision-making process and behaviour in financial markets.

Behavioural finance models

Some financial models used in money management and asset valuation use behavioural finance parameters, for example

  • Thaler's model of price reactions to information, with three phases, underreaction - adjustment - overreaction, creating a price trend

The 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 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.

  • The stock image coefficient

Criticisms of behavioural finance

Critics of behavioural finance, such as Eugene Fama, typically support the efficient market theory (though Fama may have reversed his position in recent years). They contend that behavioural 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 appeal 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.

Behavioural economics topics

Models in behavioural 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, behavioural economics sits within the neoclassical framework, though the standard assumption of rational behaviour is often challenged.

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

Cognitive framing - Mental accounting - Reference utility - Anchoring

Disposition effect - endowment effect - equity premium puzzle - money illusion - dividend puzzle - fairness ( inequity aversion) - Efficiency wage hypothesis - reciprocity - intertemporal consumption - present biased preferences - behavioural life cycle hypothesis - wage stickiness - price stickiness - Visceral influences - Earle's Curve of Predictive Reliability - limits to arbitrage - income and happiness - momentum investing

Criticisms of behavioural economics

Critics of behavioural 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 behaviour. Others note that cognitive theories, such as prospect theory, are models of decision making, not generalized economic behaviour, 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 behavioural 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 behaviour 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. Behavioural 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 behavioural 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 behavioural economists note that these revised models not only reach the same correct predictions as the traditional models, but also correctly predict outcomes where the traditional models failed.

Key figures

George Akerlof - Dan Ariely - Colin Camerer - Ernst Fehr - Daniel Kahneman - Werner Güth - David Laibson - George Loewenstein - Sarah Lichtenstein - Lola Lopes - Matthew Rabin - Robert Shiller - Richard Thaler - Amos Tversky - Paul Slovic - Andrei Shleifer - Hersh Shefrin - Werner De Bondt

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 - Andrew Caplin

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