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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.

History

   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.

Methodology

   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.

   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 - 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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