Econ 138: Financial and Behavioral Economics

The Origin and Scope of Behavioral Financial Economics

January 18, 2017

Reading:
World Bank, World Development Report 2015: Mind, Society, and
Behavior. 1–23 (2015).

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OL. 106 NO. 7 THALER: BEHAVIORAL ECONOMICS: PAST, PRESENT, AND FUTURE 1589
Financial and Behavioral Economics
A recent example. Source: Thaler (2016) and Twitter.
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Figure 1. Price and Net Asset Value for CUBA Fund

te: On December 18, 2014, President Obama announced he was going to lift several restrictions against Cuba.
urce: Bloomberg

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Financial and Behavioral Economics

Agenda:
1 A little history.
2 What is finance?
3 What is behavioral finance?
4 Key Building Blocks.
5 Strengths and Weaknesses.

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Financial and Behavioral Economics

Overview
Behavioral finance endeavors to bridge the gap between finance an
psychology.

Proponents argue that “poorly informed” and “unsophisticated”

investors might lead financial markets to be inefficient.

This has resulted in a debate between neoclassical and behavioral

finance.

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Financial and Behavioral Economics

Some History

Behavioral finance emerged as a field in the early 1980s. Names

associated with this include:

Eugene Fama.

Robert Shiller.

Werner De Bondt.

Richard Thaler.

Daniel Kahneman and Amos Tversky.

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Financial and Behavioral Economics
Some History

Traditionally, economists model behavior in terms of rational

individual decision-makers who make optimal use of all available
information.
There is ample evidence that the rationality assumption is
unrealistic.
Work on
bounded rationality,

judgmental heuristics,

biases,

mental frames and prospect theory,

has provided new foundations for financial economics.

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Financial and Behavioral Economics

What is Finance?

Modern (or neoclassical) finance is the paradigm that has governed

thinking in academic finance since the late 1950s.

1 Rational Actors: logical, autonomous agents characterized by

expected utility maximization (over time),
risk aversion,
Bayesian updating, and rational expectations.
2 Perfect Markets:
liquid
competitive

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Financial and Behavioral Economics

What is Finance?

Modern (or neoclassical) finance is the paradigm that has governed

thinking in academic finance since the late 1950s.

3 In equilibrium, all agents reach their optimum. Investment

portfolios are mean-variance efficient.
4 Only systematic non-diversifiable risk is priced.
5 There are no opportunities left for rational arbitrage.
6 Conditional on what is known about the future, price equals
value.

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Financial and Behavioral Economics

What is Finance?

Modern (or neoclassical) finance is the paradigm that has governed

thinking in academic finance since the late 1950s.

7 Basis logically deductive way starting from axioms that have a

priori normative appeal.a
8 No surveys.
9 No experiments.
10 Logic trumps data.

a
The normative approach asks how decision-makers logically should act
while the positive approach looks at how decisions are truly made.

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Financial and Behavioral Economics

What is Behavioral Finance?

Behavioral finance is the study of how psychology impacts financial
decisions in households, markets and organizations.

1 does not assume rational agents or frictionless markets.

2 suggests that the institutional environment is vitally
important.
3 begins with bounded rationality.

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Financial and Behavioral Economics

What is Behavioral Finance?

Behavioral finance is the study of how psychology impacts financial
decisions in households, markets and organizations.

4 research methods are mostly (but not exclusively) inductive.

5 focussed initially on the cognitive psychology.
6 now includes social psychology.

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Financial and Behavioral Economics

What has Behavioral Finance found?

1 A catalog of biases: predictable mistakes including
overconfidence in judgment, wishful thinking, procrastination,
and myopia.
2 Features of speculative dynamics of asset prices in global
financial markets.
Noise traders exist (or more correctly; noise-trading happens).
Investor sentiment matters.
Arbitrage does not wipe out inefficiencies.
3 How decision processes shape decision outcomes.
The U.K. participation rate in organ donation is approximately
15% whereas in Belgium it is over 95%: the importance of the
status quo.

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Financial and Behavioral Economics

Price and Value

Friedman (1953) and Fama (1965) argue that sophisticated

traders will keep prices in line through arbitrage.
Behavioral finance finds otherwise:
1 “Siamese twins” stocks: e.g. Royal Dutch/Shell Group.
Contradicts “law of one price.”
2 Investing in low PE stocks is a profitable contrarian strategy.
3 Price volatility that is not linked to news: the 1987 crash.
4 Excess volatility (Keynes, 1937; Shiller 1981, 1993).
5 Earnings Momentum – post-announcement drift.

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Financial and Behavioral Economics

Price and Value

Friedman (1953) and Fama (1965) argue that sophisticated

traders will keep prices in line through arbitrage.
Behavioral finance finds otherwise:
6 Price Momentum.
7 The Equity premium puzzle (Mehra and Prescott, 1985).
8 Size and calendar effects.

The main point of the above examples is that business

fundamentals alone do not explain the structure and dynamics of
asset prices.

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Financial and Behavioral Economics

Key Building Blocks

Behavioral finance is based on three main building blocks:

1 sentiment.
2 behavioral preferences.
3 limits to arbitrage.

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Financial and Behavioral Economics

Key Building Blocks:

Examples of sentiment include:

Anchoring.

Representativeness.

Availability bias.

Overconfidence.

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Financial and Behavioral Economics

Key Building Blocks:

Examples of preferences include:

Loss aversion.

Mental accounting.

Myopic loss aversion.

Self-control.

Regret aversion.

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Financial and Behavioral Economics

Key Building Blocks:

Examples of limited arbitrage include:

Shorting restrictions.

Transaction costs.

Taxes.

Margin payments.

“The market can stay irrational longer than you can stay solvent.”
– Keynes?

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Financial and Behavioral Economics

Strengths and Weaknesses:

The primary weaknesses of behavioral finance are:

1 Unified theoretical core still under development.
2 Focus on cognitive, less on social.
3 Focus on “mistakes.”
4 Why are we collectively so strong, yet as individuals so weak?

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Financial and Behavioral Economics

Strengths and Weaknesses:

The primary strengths of behavioral finance are:

1 Productivity: many empirical findings.
2 Pragmatism: focus on impediments to optimal
decision-making illuminates potential solutions.
3 A new type of discipline to social science research: “Finance
you can believe in” requires more than mathematical proof.
4 People and money: what can fascinate more?

A social science, but with strong emphasis on both the social and
the science.
– De Bondt, Muradoglu, Shefrin and Staikouras, 2008
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Financial and Behavioral Economics

Our Approach to this Material (after Camerer & Malmendier, 2007):

1 “F&BE modifies the standard model to account for
psychophysical properties of preference and judgement.”
2 “Aim at providing parsimonious and psychologically sound
explanations for empirical findings.”
3 “Respect the comparative advantage of neighboring social
sciences.”
4 “See neighboring sciences as trading partners.”
5 “Empirical regularity and constructs [from] neighboring fields
. . . should often trump the seduction of mathematically
elegant economic theories that are empirically unmotivated.”

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