Question

Discuss some key arguments of behavioral finance. What assumption(s) of traditional finance does behavioral finance undermine? Why? Does behavioral finance have any weaknesses? If so, what are they and how damaging are they?

Answer 1

Behavioral finance models often rely on a concept of individual investors who are prone to judgment and decision-making errors.

the most common behavior that most investors do when making investment decision are (which undermine the assumption of traditional finance)

(1) Investors often do not participate in all asset and security categories,

(2) Individual investors exhibit loss-averse behavior,

(3) Investors use past performance as an indicator of future performance in stock purchase decisions,

(4) Investors trade too aggressively,

(5) Investors behave on status quo,

(6) Investors do not always form efficient portfolios,

(7) Investors behave parallel to each other, and

(8) Investors are influenced by historical high or low trading stocks.

Traditional Finance focuses on how individuals should behave. Individuals are considered as being “Rational Economic Men”. This leads to markets where prices reflect all available relevant information.

Main limitations of Behavioral Finance is that some testing within psychology use small or non-representative samples. However, as you can easily replicate many of the studies, it should make it easier to prove/disprove. Traditional finance on the other hand, tries to apply mathematical precision with models that won’t yield such accuracy.

Some examples of shortcomings of traditional finance:

• Many economic theories and financial theories such as CAPMassumes rational investors, according to utility maximization. People aren’t rational.
• Based on the assumption of rational participants, the efficient market hypothesis assumes that markets are rational. Markets aren’t rational.
• CAPM says that high risk yields high return. Beta is the measure of risk in CAPM. In fact, low risk yields high return.
• Information is a central concept in investing. It’s central in the sense that, it’s said an investor’s informational advantage can be the sole reason he or she makes money in the market. More Information ≠ More Money.

All research programs have limitations, of course. But those of behavioral finance undermine its purpose: that is, to enhance understanding of financial markets and investor behavior. Others have written eloquently on this subject, particularly Daniel Beunza and David Stark, and John Y. Campbell. What I have to add to this ongoing debate boils down to two points and their consequences:

1. 1. Failure to acknowledge the findings of the allied social sciences
   One of the cardinal laws in scholarship is to acknowledge the work of others and avoid reinventing the wheel. But when you read works of behavioral finance, you’d never know that deviations from rational, self-maximizing behavior are old news in psychology, political science, sociology and anthropology. Check the references section of a behavioral finance article or book and see how many citations from those fields you can find. Chances are, there will be zero. Behavioral finance scholars generally cite each other, or work from mainstream economics and finance.
   This is particularly strange since so much of contemporary behavioral finance depends on the contributions of social psychologists like Daniel Kahneman (a 2002 Nobel laureate for his work in behavioral finance) and the late Amos Tversky, as well as much older work by people like Herb Simon, who was a Professor of Political Science and Industrial Administration at various points in his career. Simon won the Nobel Prize in economics for work done half a century ago on “bounded rationality“—a concept closely tied to many of the key phenomena examined by behavioral finance, but which is virtually ignored in their publications.
   While a lot of academic research speaks to a rather small group of other academics, behavioral finance is distinctive within the social sciences for restricting its scholarly conversation so tightly. This isn’t the case in the closely-related disciplines of economic sociology, neo-institutionalist political science, and economic anthropology, all of which regularly cite and engage with one another, to the enrichment of all.
   In the case of behavioral finance, reluctance to acknowledge the many research interests it shares with the allied social sciences may be part of the larger project of rigid separation and boundary enforcement that has been carried out by economists since the time of Pareto. This has created what Schumpeter described as a regime of “mutual vituperation” which has kept economics and finance in a state of self-imposed incommunicado with sociology, limiting the advancement of knowledge on our shared interests. Behavioral finance, it seems, is sticking to the party line on this point.

1. 2. A narrow, limited critique of economic theory
   Cataloging the many ways humans fail to think rationally about money, investments and risk is a good start. But in most ways, behavioral finance leaves intact the problematic assumptions of traditional finance, pulling its punches, so to speak. Among the most noteworthy examples:

1. a. Behavioral finance remains stuck at the individual level of analysis
   As in traditional finance and economics, the object of inquiry in behavioral finance is the individual—despite rafts of evidence going back decades that individuals don’t make decisions about money, risk or investing in a vacuum, but as a result of social influences. Of course, this evidence comes from those allied social sciences that are being so studiously ignored. For example, economic psychologist George Katona showed 35 years ago that most people choose investments based on word of mouth recommendations from their friends and neighbors. This influence of social forces in economic decision-making has been demonstrated with equal or greater impact among finance professionals—for instance, in a study of Wall Street pension fund managers by economic anthropologists O’Barr and Conley, and more recently in a sociological study of arbitrage traders by Beunza and Stark.
   In the past, there were encouraging signs that behavioral finance might break through the limitations imposed by sticking to the individual level of analysis, most strikingly in Robert Shiller’s 1993 statement that “Investing in speculative assets is a social activity.” But thus far, the implications of such statements, and the plethora of evidence supporting them, remain unexplored.

1. b. Behavioral finance limits itself to pointing out failures of cognition and calculation
   As important as those factors are in distorting financial decision-making, there are a host of others that we know about—based on research in those allied social sciences that behavioral finance doesn’t acknowledge—that are excluded from research in behavioral finance. This includes emotions, and social phenomena like status competition, both of which play a significant role in the findings of economic sociology, psychology and anthropology. The cognitive/calculative failures may interact with the socio-emotional phenomena, but we won’t know as long as behavioral finance pretends the latter don’t exist. That’s a loss for all of us interested in markets, money and investing.
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1. c. Behavioral finance doesn’t explain how individual acts and decisions produce aggregate outcomes
   As a consequence of keeping the analytical focus on individuals—avoiding the social and interactive aspects of economic activity—behavioral finance doesn’t have the theoretical means to address mechanisms through which individual acts and decisions aggregate. That means it can’t explain institutions and other manifestations of collective behavior which form the context for all the individual behavior it examines. Of course behavioral finance can’t answer all questions about money and markets, but it ought to be able to explain what happens when hundreds, or hundreds of millions, of people fall prey to the “hot hand” fallacy or availability bias? If behavioral finance won’t touch questions like that, who will?

The consequences for ignoring the other social sciences and mounting a very narrow critique of traditional finance and economics, include:

• Limited predictive power
  Behavioral finance tells us more about what people won’t do (e.g., behave according to notions of rationality outlined in economic theory) than what they will do.

• Contradictory implications
  Are investors risk-averse or overconfident? How should we reconcile seemingly contradictory findings like these? Behavioral finance doesn’t tell us, because of its…

• Failure to offer a viable alternative to the theories it challenges
  Pointing out all the ways that real life behavior doesn’t bear out the predictions of traditional economics and finance is interesting—even fascinating, at times—but it’s not an alternative theory. “People aren’t rational” isn’t a theory: it’s an empirical observation. An alternative theory would need to offer an explanation, including causal processes, underlying mechanisms and testable propositions.

All this keeps behavioral finance dependent on traditional economics and finance rather than allowing it to grow into a robust theoretical realm in its own right. Perhaps someday the field will develop into something more truly challenging to economic orthodoxy. Until then, behavioral finance will have to play Statler and Waldorf to the Muppet Show of mainstream finance—providing entertaining critique, but not replacing the marquee acts