Behavioral Finance and its Assumptions - Book Report/Review Example

Beyond Greed and Fear: A Review of Behavioral Finance and its Aassumptions Behavioral finance is a new field that seeks to complement, rather than replace, conventional finance theory. Under the traditional view, participants in markets are rational. However, behavioral finance disagrees with the assumption that individuals are fully rational, one hundred percent of the time. In cases where the rationality assumption fails, behavioral finance is then used to identify where emotions and other cognitions have come to influence decisions, causing agents to behave in random ways. Hersh’s Beyond Greed and Fear provides an opening argument to the public on behalf of behavioral finance, building on three themes: errors based on rules of thumb, identifying risk depending on how problems are framed, and deviations of markets from fundamental value [Her07]. Both Hersh’s text and the field generally rely on concepts borrowed from psychology, perhaps to its discredit, making itself a subset of a social science rather than of financial analysis. Throughout this paper, several objections to behavioral finance will be presented along with reasons why these objections are significant both in Hersh’s text but also in terms of shaping the way that finance generally is conducted in the 21st century. Although a relatively new field, behavioral finance already has attracted a fair amount of attention in the literature, including from Eugene Fama, who is a well-known American economist working in portfolio theory and asset pricing. Fama is considered one of the founders of the efficient-market hypothesis, which is the idea that financial markets are “informationally” efficient meaning that the market has already priced all of the available information into the price of an asset. Efficient market theory rests on a different underlying assumption than behavioral finance, which thinks that random, unpredictable behavior (that is, behavior which is not rational) can make a significant impact on the price of assets. As a result, Fama and other supporters of the efficient market hypothesis tend to see behavioral finance as a set of anomalies and biases established in the social sciences rather than as a true branch of finance [Fam97]. Anomalies like those studied in behavioral finance and in psychology will eventually be explained by logic, according to the efficient market hypothesis. Although whether the efficient market hypothesis is true is the subject of a classical debate, the fact remains that behavioral finance’s underlying foundations are not solid enough to be taken seriously by economists. Seemingly for that reason, Hersh’s text was written for a public audience and may itself have been overconfident (which is one form of questionable heuristic that the author identifies) in his interpretation of investor illogic. In addition, Hersh deals mostly with individual biases rather than social biases. The former can be priced out of the market relatively easily while the latter can be influential enough to move a market significantly away from fundamental value. As an example, there may have been entry barriers for individuals into a market that are either practical or psychological at one point, but the increasing use of technology resources has opened up markets to more traders. With more access to technology and a wider population of participants in a market, information is acquired faster and decisions are made on a shorter time frame. Also, decisions are better from the standpoint that they are more well-informed. Support, in this case, for the efficient market hypothesis also serves as support for the idea that participants in markets are using widely available information to make more rational decisions, although this may not be true in all individual cases. In response to the idea that irrationality still exists in markets, a supporter of the efficient market hypothesis would only need to ask for proof of the idea that individual decisions truly matter in a market. It seems that social biases are, in fact, much more important in making an impact on the price of an asset, rather than the individual biases and heuristics that Hersh addresses in his text. Another way of taking a critical approach to behavioral finance, including its underlying assumptions, is by looking at the usefulness of its approach to economic theory. As mentioned previously, there is a problem not present in psychology but that is present in finance with looking just at the level of an individual. Since behavioral finance is closely linked to psychology, which tends to emphasize collecting data on individuals, one can object that behavioral finance is too linked to individual levels of analysis, when in fact individuals tend to make decisions as a direct result of social influences (as an example, one can image stock-investing websites, TV channels, and their friends giving advice on investments). One can see that social influence clearly in George Katona’s work showing people tend to take recommendations from friends and neighbors more often than making rational decisions based on fundamental or technical analysis. That social influence also extends to finance professionals. Regardless, what is truly important is whether finance can rely on looking solely at individuals or whether it must look at a broader picture. Hersh’s text and behavioral finance generally fail to see the bigger picture at times, making it difficult to take it seriously on its own accounts. Part of that objection is how behavioral finance moves from looking at the framing and heuristic problems that Hersh identifies to how those decisions produce results in the aggregate. It is easy for Hersh to make a sophisticated analysis of financial conditions and interpret those results in terms of his own theory, but it is quite another to use behavioral finance as a tool for telling us both why institutions or other collective behaviors led to certain outcomes for a market as a whole (rather than some subset of the market) or for what markets as a whole will do in the future. If the theory behind behavioral finance can produce a framework for explaining or predicting large market inefficiencies (assuming again that macro-level inefficiencies are common), then the practical use of the field is also within question. Another line of thinking in which behavioral finance can be seen as inadequate is in terms of borrowing, not stealing, from related social sciences. Hersh’s text borrows significantly from work done in psychology, political science, sociology, and anthropology. Although the implications for financial markets are still being explored, the underlying notions behind heuristics and deviations from rational behavior are old hat to these related fields. Behavioral finance, despite its relationship to social science, seems to represent itself as independent and as more related to publications in conventional finance, which looks like an attempt to be taken seriously by the public and by practitioners, rather than to be taken seriously by academics. Behavioral finance, as an insular field, could gain a great deal from newer concepts, especially like those presented in Herb Simon’s concept of “bounded rationality”, which proposed that rationality is limited to the presence of available information [Gig02]. Rather than changing the assumption behind the rationality of participants in a market, behavioral finance might recognize potential for seeing participants as irrational only in circumstances where information is less available and more rational in situations where information is more available. Instead of incorporating that Nobel-level research into the field, behavioral finance experts run with the assumption that humans are irrational, one hundred percent of the time. Part of the problem to being insular is that behavioral finance seems to lack in the presentation of a viable alternative to the theories and explanations it contradicts. For example, Hersh is quick to point out ways in which traditional economics or conventional finance theories fail to explain what is being observed in the real world. However, when it comes to proposing an alternative theory, Hersh’s notion of finance only provides a set of biases and heuristics, which is not a theory but instead of list of concepts borrowed from the social sciences. Although “people are not rational” is a rallying cry for behavioral finance generally, it is not a theory or an explanatory framework. An alternative theory to conventional finance would need to include way of identifying causal relationships between events as well as predictive mechanisms. Behavioral finance seems to be a long way from that point and instead must still essentially “piggy-back” off the ideas of social sciences without acknowledging where the ideas really came from. Although we have dealt primarily with problems with the underlying assumptions and focus of behavioral finance, the problem of “model dredging” is a practical, methodological concern that should be addressed briefly. Essentially, behavioral finance has been criticized for its flexibility in choosing which bias to emphasize. Rather than having a strict mode of analysis, behavioral finance analysts can look at a situation and choose to either look at the situation in terms of anchoring, herd behavior, gambler’s fallacy, prospect theory, and so on. Depending on the perspective one takes, one can predict either underreaction or overreaction from participants in a market. The problem there is that one can force a story to fit the facts to explain a perplexing issue in the real world[Jay03]. The issue is whether one can use those same modes of analysis to make a word of caution, rather than words based on hindsight. Until behavioral finance can prove that it is not just an interpretive guessing game, one will expect that it will be weighted less heavily in discussions than those who approach issues from a conventional finance perspective. We have looked at the general problems with the underlying assumptions of behavioral finance as well as some problems with how it is actually carried out in practice. Although the ideas put forward by Hersh are attractive in terms of opening up the analysis of financial markets to additional kinds of perspectives, behavioral finance has both failed to catch the attention of practitioners and of academics. Practitioners tend to not like it because it provides very little in the way of predictive tools and academics tend not to like it because it does not meaningfully interact with results from the social sciences. Works Cited Her07: , (Shefrin 4-10), Fam97: , (Fama 3-6), Gig02: , (Gigerenzer and Selten 3-8), Jay03: , (Ritter 5), Read More