Fung - The Potential Contributions of Behavioral Finance To Post Keynesian and Institutionalist Finance Theories

The potential contributions of behavioral finance to Post Keynesian and institutionalist
finance theories
Author(s): MATTHEW V. FUNG
Source: Journal of Post Keynesian Economics, Vol. 33, No. 4 (SUMMER 2011), pp. 555-573
Published by: Taylor & Francis, Ltd.
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MATTHEW V. FUNG
The potential contributions of

behavioral finance to Post Keynesian
and institutionalist finance theories
Abstract: In their paper "Behavioral Finance and Post Keynesian-Institutionalist

Theories of Financial Markets," Raines and Leathers discuss how the theories
of Keynes, Davidson, and Galbraith could explain financial bubbles and crises
and show how those theories are both confirmed by actual events and supported
by some findings in behavioral finance. The current paper comments on their
discussion and explores the potential contributions of behavioral finance to future
developments of Post Keynesian and Institutionalist theories in other fields in
finance, especially portfolio theory and asset pricing theory.
Key words: asset pricing theory, behavioral finance, financial bubbles, portfolio
theory.
The focus of the Raines and Leathers paper, "Behavioral Finance and
Post Keynesian-Institutionalist Theories of Financial Markets," in the
current issue of this journal (pp. 539-553) is to show how the work of
John Maynard Keynes, Paul Davidson, and John Kenneth Galbraith have
certain "behavioral tendencies" and how their theories are both confirmed
by actual events and the findings of behavioral finance. Another aim of
their paper is to analyze how some economists have applied findings of
behavioral finance to modify but not fundamentally change neoclassical
theories, and to argue that the resulting models are incompatible with
Post Keynesian and Institutionalist economics. This critical review of
behavioral finance was the kind of response I was hoping for when I
wrote the paper "Developments in Behavioral Finance and Experimental
Economics and Post Keynesian Finance Theory," published in the fall
2006 issue of this journal.
Matthew V. Fung is an associate professor in the Department of Economics and Fi

nance at Saint Peter's College.
Journal of Post Keynesian Economics/Summer 2011, Vol. 33, No. 4 555

© 2011 M.E. Sharpe, Inc.
0160-3477/2011 $9.50 + 0.00.
DOI 10.2753/PKE0160-3477330402
556 JOURNAL OF POST KEYNESIAN ECONOMICS
It is not surprising that Raines and Leathers chose to focus on

on financial bubbles and crises, for these phenomena challenge t
of the efficient market hypothesis (EMH) that market prices o
cial assets fully reflect all relevant information about them. Ra
Leathers perform a service to economists who may not be we
in the behavioral finance literature by introducing some findings t
relevant to financial markets. In particular, their discussion of emo
finance suggests a new way of understanding financial behavior tha
otherwise appear irrational and not amenable to study.
The survey presented by Raines and Leathers concentrates on
Keynesian and Institutionalist writers whose work attacked EM
though EMH is an important component of the neoclassical th
finance, Post Keynesian critics of neoclassical theory have rec
other important elements of that theory. Findlay and Williams desc
neoclassical finance theory as "an equilibrium pricing model c
with a notion about the efficiency of financial markets" (2008-9
suggesting the importance of the neoclassical equilibrium pricin
Thompson et al. included in their list of the basic models of neo
computational finance "the portfolio selection algorithm of Ma
the capital market line of Sharpe, and the option pricing model
Scholes-Merton" (2006, p. 3). It is interesting to explore how be
finance can help in the development of alternatives to some o
neoclassical finance models.
In this paper, I supplement the Raines and Leathers paper by suggesting
what light behavioral finance sheds on portfolio theory and asset pricing
and how in some cases it can provide an alternative to the neoclassical
models. But first I evaluate some of the issues discussed by Raines and
Leathers and try to argue that there are more ways in which behavioral
finance can be profitably used by Post Keynesian and Institutionalist
economists.
Next, I review Raines and Leathers's discussion of financial market
bubbles and crises and suggest some ways in which they can better sup
port their conclusion that the findings of behavioral finance and emotional
finance could strengthen the Post Keynesian-Institutionalist theories of
financial markets. In the third section, I discuss how behavioral finance
can in some cases help us read Keynes's works in a new light. In the
fourth section, I discuss how behavioral finance can affect research in
portfolio theory. In the fifth section, I discuss how it can affect research
in asset pricing theory. This leads me to some remarks about irrational
ity and economic modeling in the sixth section. The seventh section
concludes my discussion.
POST KEYNESIAN AND INSTITUTIONALIST FINANCE THEORIES 557
Financial market bubbles and crises
In their paper, Raines and Leathers discuss the works of Keynes, David
son, and Galbraith that touch upon financial bubbles and crises. They
argue that real-world events validate their theories of financial markets.
It is clear that the real-world events they had in mind are financial market
crises. They wrote:
Most vividly, the stock market bubble that ended with the crash of October
1987, the "new economy" stock market bubble of the 1990s that collapsed
in 2000-2001, and the subprime mortgage bubble that collapsed in 2007
exhibited the euphoric mood and controlling institutional circumstances
and followed the contours of Galbraith's theory of speculative bubbles,
(this issue, p. 544)
They argued correctly that Keynes, Davidson, and Galbraith developed

theories that could explain financial bubbles or other crises whereas
supporters of EMH could not.
But how do they view the contribution of behavioral finance to the theo
ries of the four economists whose work they have surveyed? Summing up
their review of the behavioral finance literature, they wrote: "At best, the
psychological tendencies that define behavioral finance offer superficial
confirmation of the behavioral tendencies in Post Keynesian-Institution
alist theories" (this issue, p. 549). I agree, but I would like to suggest that
behavioral finance can do more than confirm those theories.
According to Raines and Leathers,
Shiller's explication of the "psychological anchors" in terms of the ten

dency of people to attribute views to real or imagined experts in whose
judgments they place greater confidence than in their own and to sup
pose that the "experts" have thought through and resolved the apparent
contradictions (Shiller, 2001, p. 163) is essentially Galbraith's tendency
of people to trust the "big men." (this issue, p. 550)'
Despite similarities between Shiller's experts and Galbraith's "big men,"

I think that Shiller's views are different from Galbraith's. Shiller talked
about quantitative anchors and moral anchors, but it is the quantitative
anchors that Raines and Leathers had in mind. About the quantitative
1 Raines and Leathers refer to the first edition of Robert J. Shiller's Irrational
Exuberance (Broadway Books, 2001). I have used the second edition of the same
title (Princeton University Press, 2005), which includes a new chapter (ch. 2) on the
real estate market. When Raines and Leathers refer to "Shiller, 2001" and I refer to
"Shiller, 2005," we are referring to the same book, but because the second edition has
an additional chapter, the page references I have cited will generally be different.
558 JOURNAL OF POST KEYNES1AN ECONOMICS
anchors, Shiller wrote: "In making judgments about the level of

prices, the most likely anchor is the most recently remembered
(2005, p. 149). In terms of the impact of quantitative anchors on
formation of bubbles, investors tend to bid up stock prices when
have experienced a bullish market, but their trades are based on the m
recently remembered high prices rather than on the trades made b
fessional traders (Galbraith's "big men").
More important, Shiller was careful not to consider the sole imp
quantitative anchors but how they interact with the tendency for inv
to follow herd behavior. At the end of the chapter in which he dis
psychological anchors, Shiller wrote: "But the anchors can ha
nificance for the market as a whole only if the same thoughts ent
minds of many. In the next chapter, we turn to the social basis of
ing: the tendencies toward herd behavior and the contagion of i
(ibid., p. 156). In his discussion of herd behavior, Shiller drew upo
psychological experiments of Asch (1952) and Milgram (1974) sho
that "people are ready to believe the majority view or to believe a
ties even when they plainly contradict matter-of-fact judgment" (Shi
2005, p. 159). Shiller added that such behavior is rational: "Most p
have had prior experiences of making errors when they contradict
judgments of a larger group or of an authority figure" (ibid., p. 1
Shiller did not further explore the implications of his discussi
people's tendency to believe in authorities. But if we combin
discovery about human behavior with Davidson's argument that
nonergodic world it is not possible to arrive at an estimate of the cor
market price of a financial asset, we have a stronger explanation o
ordinary investors tend to believe in the recommendations of au
ties on stock values such as stock analysts. Davidson has argued t
no information can be obtained from historical asset prices and th
efforts of technical analysts to try to detect patterns from them are f
Davidson wrote:
Time series of spot financial prices are merely the stringing together of
momentary, hourly, daily, etc., historical price observations ... which pri
marily reflect the actions of those who are attempting to outguess average
opinion. No wonder that despite billions of man hours... spent search
ing... for systematic repetitive patterns, no one has ever succeeded. These
spot price movements reflect the non-ergodic ebb and flow of speculative
expectations. (1988, p. 85)
People do not need to consult authorities on things they can do for

themselves, but Davidson has argued that they cannot estimate the true
POST KEYNESIAN AND INSTITUTIONALISE FINANCE THEORIES 559
market value of financial assets. Thus it seems that by combinin

insights of Davidson and Shiller, we can get a fuller explanation of
in a nonergodic world stock prices can be bid up to irrationally
levels by ordinary traders who believe in the recommendations of
analysts.
Shiller has made another point that Post Keynesian and Institutionalist
economists should consider relevant. In chapter 3 of his 2005 book, Shiller
discussed 12 factors that propelled market bubbles, and the optimistic
forecasts of analysts constitute one of those factors. He argued, and sup
ported with evidence from data published by Zacks Investment Research,
that analysts issued considerably more buy recommendations than sell
recommendations, thus providing an upward bias toward their forecasts
of stock prices. Among the reasons Shiller gave for the preponderance of
buy recommendations is the institutional detail that analysts are reluctant
to issue sell recommendations because they "might have incurred the
wrath of the company involved, and companies would retaliate by refusing
to talk with analysts whom they viewed as submitting negative reports,
excluding them from information sessions, and not offering them access
to key executives as they prepared earnings forecasts" (2005, p. 45). To
this Shiller added another fear of the analysts: "an increasing number
of them were employed by firms that underwrite securities, and these
firms did not want their analysts to do anything that might jeopardize
this lucrative side of the business" (ibid., p. 45). Shiller's attention to
institutional detail is something that can be found in the work of Keynes,
Davidson, and Galbraith, and other Post Keynesian and Institutionalist
economists.
Raines and Leathers mentioned in their paper that, according to Gal

braith, "less is understood about 'the mass psychology of the speculative
mood' than about the behavioral tendencies" (this issue, p. 550). If we
put together all the observations that have been made so far, we may
be able to flesh out what is lacking in Galbraith's theory of speculative
bubbles. The explanation would run something like this: because we live
in a nonergodic world, it is impossible for ordinary investors to estimate
the true value of stocks. Herd behavior drives them to believe in the
recommendations of authorities such as stock analysts. The institutional
reasons discussed above prompt analysts to issue buy recommendations
which, when acted upon by a large number of ordinary investors, drive
up stock prices and produce the euphoric stage of a stock price bubble.
The herd behavior of ordinary investors is reinforced by the quantita
tive anchor of remembering the most recent prices, so that during a bull
market investors tend to remember high stock prices that feed into their
desire to get rich quickly, a point made by Galbraith in his theory

speculative bubbles.
Thus, we can see that behavioral finance can not only reinforce t
insights of Post Keynesian and Institutionalist economists but can h
them fill in gaps in their theories (the example here being the gap
Galbraith's theory of speculative bubbles).
Interpreting Keynes with the aid of findings in

behavioral finance
Another way in which it can make an important contribution not consid

ered by Raines and Leathers is helping us see the writings of Keynes (and
Post Keynesian and Institutionalist literature) in a new light. Consider
the following passage from Keynes, which Raines and Leathers quoted
in their paper:
human decisions affecting the future, whether personal or political or

economic, cannot depend on strict mathematical expectation, since the
basis for making such calculations does not exist; and ... it is our innate
urge to activity which makes the wheels go round, our rational selves
choosing between the alternatives as best we are able, calculating where
we can, but often falling back for our motive on whim or sentiment or
chance. (Keynes, 1936, pp. 162-163)
The comments of Post Keynesian economists on this passage mostly con

cern Keynes's point that the basis for making calculations of mathematical
expectation does not exist, and these economists use that insight to attack
the mathematical models of neoclassical economists. But a fresh way to
look at the passage is that Keynes invites later economists to investigate
the factors that human beings often fall back on when they cannot use
calculations to make decisions. Among the factors mentioned by Keynes,
whim and chance are both too irregular to be fruitful subjects of study,
but sentiment is something that behavioral finance has investigated. It is
something that until now Post Keynesian and Institutionalist economists
have paid little attention to. But if they read what behavioral finance has
found regarding the impact of investor sentiment on behavior, they may
see that what Keynes hinted at but did not investigate, that sentiment can
affect human behavior, is a subject that they may profitably explore. In
this endeavor they do not have to be pioneers, for by now some studies
have shed light on how investor sentiment affects asset prices.
Shiller included the optimistic sentiment of analysts in his discussion
of their forecasts: "Analysts had few worries about being uniformly op
POST KEYNESIAN AND 1NSTITUTIONALIST FINANCE THEORIES 561
timistic regarding the distant future; they apparently concluded that such
generalized optimism was good for business" (2005, p. 46). He add
that the optimism of some analysts reinforced the optimism of other
because "there was, after all, safety in numbers" (ibid., p. 46). But mor
research on investor sentiment has been published since the publicatio
of Shiller's 2005 book.
Baker and Wurgler (2007) observed that mainstream finance theory

"has considerable difficulty" reconciling their theory with financial
bubbles such as "the Great Crash of 1929, the 'Tronics Boom of the
early 1960s, the Go-Go Years of the late 1960s, the Nifty Fifty bubble
of the early 1970s, the Black Monday crash of October 1987, and the
Internet or Dot.com bubble of the 1990s" (ibid., p. 129). To remedy
this defect, they tried to develop an alternative model from a behavioral
finance approach. Baker and Wurgler's model is based on two assump
tions. The first is that investors are subject to sentiment, where investor
sentiment is defined as "a belief about future cash flows and investment
risks that is not justified by the facts at hand" (ibid., p. 129). The second
is that "betting against sentimental investors is costly and risky" (ibid.,
p. 129). Before Baker and Wurgler discussed their approach and data
manipulations, they considered the research that had already been done
on investor sentiment and concluded that "[n]ow, the question is no
longer, as it was a few decades ago, whether investor sentiment affects
stock prices, but rather how to measure investor sentiment and quantify
its effects" (ibid., p. 130).
Baker and Wurgler examined six measures of investor sentiment and
combined them into an overall sentiment changes index. They hypoth
esized that
[t]he stocks most sensitive to investor sentiment will be those of compa

nies that are younger, smaller, more volatile, unprofitable, non-dividend
paying, distressed, or with extreme growth potential (or companies having
analogous characteristics). Conversely, "bond-like" stocks will be less
driven by sentiment, (ibid., p. 132)
Using returns data from the Center for Research in Securities Prices
(CRSP), they sorted stocks in that database by the standard deviation of
monthly returns (a measure of volatility) over the prior year. Baker and
Wurgler assumed that "[h]igh volatility is characteristic of stocks with
strong speculative appeal; low volatility is a bond-like feature" (ibid.,
p. 144). The sorting allowed them to place the stocks in the database,
each month, into "one of ten portfolios according to the decile of their
return volatility of the previous year" (ibid., p. 144).
Baker and Wurgler ran a time series regression with the monthly
of each of the ten portfolios as the dependent variable and the sent
changes index as the explanatory variable. The estimated coeffi
the regressions are called "sentiment betas" because they meas
percent change in monthly returns resulting from a one standard d
change in the sentiment changes index. They predicted that the mo
returns would be higher (indicated by higher sentiment betas) t
volatile the portfolios are, and their regression results, plotted in f
panel B of their paper, agreed with their predictions (ibid., p. 14
interpreted the results as follows:
Sentiment betas also increase as stocks become more speculat

harder to arbitrage. Figure 4, Panel B, shows that controlling for
returns, a one standard-deviation increase in the sentiment change
increases returns on the eighth volatility decile portfolio, for ex
by about one percentage point. The effect on the tenth decile port
over two percentage points. For particularly bond-like stocks, on th
hand, the effect is slightly negative, (ibid., p. 146)
Thus, they found evidence that investor sentiment had an impac

returns of speculative stocks but not on bond-like stocks. Bec
dot-com stocks are an example of speculative stocks, their mode
used to explain the Internet stock bubble of the 1990s.
The Baker and Wurgler study is interesting because the auth
sumed that there are two types of investors: "rational arbitrage
are sentiment-free and irrational traders prone to exogenous sen
(ibid., p. 131). These two types of investors can be interpreted
who rely on calculation to make decisions and those who fall b
sentiment in the quotation from Keynes (1936). It is not unre
to associate those who rely on calculation with the rational arbit
and those who are prone to exogenous sentiment with those w
back on sentiment. The impact of sentiment on stock returns th
and Wurgler attempted to discover would be the net result of th
that these two types of investors engage in. Baker and Wurgler pre
that because of limits to arbitrage, the trades of the rational arbitr
may not be able to dominate the trades of the irrational trades
stock prices "are not always at their fundamental values" (2007,
They added that "[a] large body of research shows that arbitrag
to be particularly risky and costly for certain stocks: namely th
are young, small, unprofitable, or experiencing extreme growth
p. 132). They also noted that such stocks have higher volatility
typical stocks. This enabled them to argue that "in practice, t
POST KEYNES1AN AND INSTITUTIONALIST FINANCE THEORIES 563
securities that are difficult to value also tend to be difficult to arbit

(ibid., p. 132). It is this argument that justifies their hypothesis that i
more volatile stocks that would be most sensitive to investor sentiment.
Keynes did not specify whether those who rely on calculation would
dominate those who fall back on sentiment, but the results of the Baker
and Wurgler paper suggest that for stocks that are volatile and difficult
to estimate by calculation, the trades of those who fall back on sentiment
dominate those who rely on calculation.
The Baker and Wurgler study is not the only one finding an impact of
investor sentiment on stock prices and hence returns. In their literature
review, Lawrence et al. (2007) mentioned a 1998 study by Neal and
Wheatley finding that two out of the three measures of investor sentiment
(the two measures are the level of discount on closed-end funds and net
mutual fund redemptions) predicted the size premium and the difference
between small- and large-firm returns (Lawrence et al., 2007, p. 162).
They also surveyed a 2003 study by Fisher and Statman, who found
that "increases in the consumer confidence index are accompanied by
statistically significant increases in the bullishness of individual inves
tors" (Lawrence et al., 2007, p. 162). Although Lawrence et al. did not
perform any econometric tests, their plots of month-end stock prices for
the Dow Jones companies for 244 months (February 1984 to December
2004) showed steep price climbs and drops. They argued that the large
fluctuations in stock prices are more consistent with bubbles than with
the EMH (see the discussion in Lawrence et al., 2007, pp. 167-170).
The studies showing that investor sentiment affects stock prices and
returns have implications for other areas of finance theory than financial
bubbles or crises. At the end of their paper, Baker and Wurgler (2007,
pp, 149-150) noted that investor sentiment affects the cost of capital
and capital budgeting decisions. Estimates of the cost of capital depend
on asset pricing models, and neoclassical models such as the capital
asset pricing model (CAPM), arbitrage pricing theory, and the Fama
French three-factor model (Fama and French, 1995), all do not account
for investor sentiment and should be viewed with suspicion by Post
Keynesian and Institutionalist economists. Given that Keynes made use
of a discount rate in his definition of the marginal efficiency of capital
in chapter 11 of The General Theory ("I define the marginal efficiency
of capital as being equal to that rate of discount which would make the
present value of the series of annuities given by the returns expected from
the capital-asset during its life just equal to its supply price," Keynes,
1936, p. 135), it is relevant to develop an appropriate discount rate. But
the discount rate depends from asset pricing theories, and the studies on
the effects of sentiment suggest that sentiment should be incor

into asset pricing theories. I provide further discussion of this s
the Behavioral Finance and Asset Pricing section.
Behavioral finance and portfolio theory
It is good to know that the theories of economists such as Dav

and Galbraith can explain financial bubbles and crises much bet
neoclassical finance theories. But financial markets are not alw
periencing a bubble or crisis, and it is important to develop theorie
can help economic actors make financial decisions during ordinar
Modern portfolio theory, based on the pioneering work of Ma
(1952), has been widely used by professional investors to make a
cation decisions. But Markowitz's portfolio theory, which has be
mainstream theory, has been subjected to criticism by Post Keynesi
Institutionalist economists. It is worthwhile to examine their criticisms
and to explore the alternatives made available by behavioral finance.
Thompson et al. (2006) provided a critical review of Markowitz s
portfolio theory. Markowitz assumed that the only two attributes of a
security that investors care about are expected return (|i in Thompson
et al.) and volatility of returns as measured by standard deviation (c
in Thompson et al.). Thompson et al. commented: "Herein lies a seri
ous problem, for, because stock prices do not follow a Gaussian path,
|i and a are insufficient to describe the attributes of a security" (ibid.,
p. 7). They also pointed out that the Markowitz model implies that "[i]f
a high c security is ever to be purchased, then it must have a higher p
than lower a securities. In an efficient market, then, there should be a
positive correlation between the expected return of a portfolio and its
volatility (standard deviation)" (ibid., p. 5). The neoclassical explanation
of this positive relationship is that investors have to be compensated for
bearing greater risk by a higher expected return. But when Thompson et
al. plotted the Ibbotson data for a large cap stock index for 1926-2000,
they found a negative instead of positive correlation (of -0.317) between
expected return and volatility (see ibid.).2
2 It is interesting to note that the negative relationship between expected return

and risk was not only found by Thompson et al. (2006). In a much publicized 1992
paper, two mainstream economists, Fama and French (1992) also found that negative
relationship after they had controlled their data for firm size. Fama and French thought
that their results contradicted the CAPM, which also posited a positive relationship
between expected return and risk, rather than the Markowitz portfolio model.
POST KEYNESIAN AND 1NSTITUTIONALIST FINANCE THEORIES 565
Thompson et al. s criticism should make economists regard Markow

portfolio theory with skepticism, but many will not abandon a
accepted theory without another theory to replace it with. It is g
note that a behavioral portfolio theory has been proposed. The pionee
work was done by Shefrin and Statman (2000) and Statman (1999)
paper, Statman maintained that "investors build behavioral portf
pyramids of assets, in which layers of assets are associated with part
goals and particular assets toward risk, and in which correlations bet
assets are overlooked" (ibid., p. 13). Nofsinger (2008) interpreted
layers of assets as the result of people having separate mental ac
for different investments goals.
The tendency for people to use mental accounts is part of "pr
theory," developed by Kahneman and Tversky (1979). The term i
to describe people's tendency to divide their investments into se
accounts in order to track gains and losses periodically. This pr
documented by experiments in behavioral finance, contrasts with th
reduction that is possible in a Markowitz portfolio by combining
with negative or low positive correlations.
Speaking of investors who use the pyramid of assets, and kno
that foreign stocks have lower correlations with some domestic
than the correlation of those stocks with other domestic stocks, Stat
commented that "they are overlooking the risk-reduction benefi
foreign stocks provide to the overall portfolio. Instead, they are
ing on the risk of each asset in isolation from all other portfolio
(1999, p. 13).
Explaining how the pyramid of assets works, Nofsinger wrote:
First, investors have a goal of safety. Therefore they allocate enough assets
in the safest layer (the bottom of the period), as required by their mental
accounts. Then mental accounts with higher levels of expected return and
risk tolerance could allocate assets to appropriate investments in another
layer. (2008, p. 58)
Note that there is an order of preferences: the safety goal is met first
before goals that are considered less important. The allocation of invest
ment funds is to asset layers rather than to asset classes, although some
asset classes may be especially suitable for the goal underlying a given
asset layer. Nofsinger noted that "the total asset allocation of an inves
tor's portfolio is determined by how much money is designated for each
asset class by the mental accounts" (ibid., p. 59). The major difference
between this behavioral portfolio theory and Markowitz portfolio theory,
Nofsinger added, is that "investor diversification comes from investment
goal diversification rather than from a purposeful asset diversif

(ibid., p. 59).
There are good reasons for Post Keynesian and Institutionahs
mists to prefer behavioral portfolio theory to Markowitz portfolio
The pyramid of assets in behavioral portfolio theory results fro
cographic ordering of preferences (e.g., the safety goal is more imp
than the next goal, which is the income goal in Nofsinger's expo
the theory). This ordering of preferences has been used by Post Key
economists such as Eichner (1987, see pp. 633-636) and Lavoie (
develop their consumption theory because they preferred this orde
preferences to the preferences represented by convex indifference
in neoclassical consumption theory. Consumption studies have
that people have priorities in consumption expenditures and ar
malleable as to be equally happy if they have to substitute one
good for another one (to stay on the same indifference curve).
(1999) and other behavioral studies have shown that actual inv
behave more like the way posited by behavioral portfolio theo
Markowitz portfolio theory.
Using the Survey of Consumer Finances (SCF) conducted every
years by the Federal Reserve Board, Polkovnichenko (2005) exa
how households diversified their investments. The surveys he u
from 1983 to 2001 and divided the households surveyed into f
horts based on the amount of wealth allocated to liquid financia
(FA), which included "checking, savings, and money market ac
CDs; publicly traded equities; mutual funds; bonds (governmen
corporate); annuities and trusts; and pension assets in accounts
permit either withdrawal and/or use of the assets as collatera
p. 1471). The four cohorts were Cohort 2 (0 < FA < $10,000), C
($10,000 < FA < $100,000), Cohort 4 ($100,000 < FA < $1 million
Cohort 5 (FA > $1 million) (see ibid.).
From the survey data, Polkovnichenko found "two wide-spread
sistent patterns in household portfolio diversification: (i) some hous
invest significant fractions of wealth simultaneously in well-div
mutual funds and in undiversified portfolios of individual stocks; (i
households with substantial savings do not have any investmen
uities, either directly or through mutual funds" (ibid., p. 1468)
found that the number of stocks held by households in Cohort
be alarmingly small: "Most direct household investors held the
of only one or two different companies. The median for all coh
two in 1983 and did not change until 2001 when it rose to thre
p. 1475). He added: "Across cohorts, median direct stockholding
from 15 to 33% of financial assets. While diversification improves wit

wealth, not all wealthy households, even in 2001, were well diversifie
(ibid., p. 1475). His interpretation of these patterns was that the observed
nonparticipation in the equity market "is inconsistent with friction-le
portfolio choice based on expected utility. Various participation costs may
prevent poor households from investing in equity, but there is also a stab
group of relatively rich households who do not own any equities, eith
directly or through mutual funds" (ibid., p. 1474). He concluded that these
patterns are more consistent with "rank-dependent preferences" (wh
I called the lexicographic ordering of preferences earlier in this pape
and suggested that they call for "further integration of rank-depende
preferences in portfolio theory and asset pricing" and added that "Shefrin
and Statman (2000) propose a portfolio choice model which is one st
in this direction, but more research is needed to better understand su
models" (Polkovnichenko, 2005, p. 1499). In other words, the survey
data he examined suggested that advances in portfolio theory should
in the direction of the behavioral portfolio theory proposed by Shefr
and Statman (2000).
Behavioral finance and asset pricing
One of the most important topics in finance is asset pricing becaus

many financial decisions involve estimating the present value of a ser
of future cash flows. I have already noted that Keynes used this proc
dure in his definition of the marginal efficiency of capital. Discounti
future cash flows requires a discount rate, and the discount rate has
be estimated. The discount rate depends on the prices of financial asse
issued by corporations. Most advanced mainstream theories of asset
pricing are based on some form of the consumption CAPM (CCAPM
which was originally proposed by Hansen and Singleton (see Campbe
and Cochrane, 2000, for references). But the CCAPM has come unde
a lot of criticism.
In Campbell and Cochrane, after opening with the remark "[t]he d
velopment of consumption-based asset pricing theory ranks as one
the major advances in financial economics during the last two decade
the authors admitted that "consumption-based asset pricing mod
prove disappointing empirically" (ibid., p. 2863). Behavioral economist
distrust the CCAPM because it is based on the assumption that all ec
nomic actors have rational expectations, and it does not account for th
pessimism, doubt, and the availability heuristic that behavioral finan
has found in actual human behavior. (See Semenov, 2009, for an attem
to incorporate these psychological traits into the CCAPM, alth

am far from endorsing such an attempt because I think that th
should be discarded altogether.)
In looking for alternative asset pricing models, I explored the beh
finance literature hoping to find models that are more accepta
the CCAPM. The similarities between the Post Keynesian consu
theories of Eichner and Lavoie and the behavioral portfolio th
veloped by Shefrin and Statman made me approach the latter's w
asset pricing with hope. Unfortunately, I am disappointed by th
on asset pricing because it represents an attempt to modify the
by incorporating some findings of behavioral finance without devel
a totally new theory that is free of the criticisms of the CCAPM
The pioneering work in behavioral asset pricing was Shefrin a
man (1994). In that paper, they attempted to "focus on specific c
errors and show that the effect of noise traders in the market
crucially on the type of errors they commit" (ibid., p. 324). B
reluctance to abandon the assumption of efficient markets can be s
the following discussion of the difference between efficient and in
markets: "We argue that the key difference between the two m
what we call the single driver property. In markets where price
ficient, there is a single, specific variable that drives the mean-
efficient frontier, the return distribution of the market portf
premium for risk, the term structure, and the prices of option
They added: "Noise traders introduce a second driver into the
and drive prices away from efficiency" (ibid.).
This behavioral asset pricing theory is just an attempt to modi
stream asset pricing theory by grafting on it some behavioral e
and that can be seen in Shefrin's fuller development of that theory
2005 book A Behavioral Approach to Asset Pricing. But before I
that book, it is good to provide some background on the paradi
mainstream financial economists have adhered to in their work on asset
pricing.
In his 2000 survey of research on asset pricing, Campbell wrote:
"For roughly the last 20 years, theoretical and empirical developments
in asset pricing have taken place within a well-established paradigm"
(2000, p. 1516). Within this paradigm, a key component is the stochastic
discount factor (SDF), which prices all assets in the economy. Campbell
explained the SDF thus: "The SDF is a random variable whose realiza
tions are always positive. It generalizes the familiar notion of a discount
factor to a world of uncertainty; if there is no uncertainty, or if investors
are risk-neutral, the SDF is just a constant that converts expected payoffs
tomorrow into value today" (ibid., p. 1517). The SDF has some im
properties: "If the stochastic discount factor is linearly related to a s
common shocks, then asset returns can be described by a linear
model. If the economy has a representative agent with a well defined
ity function, then the SDF is related to the marginal utility of aggr
consumption" (ibid., p. 1516).
When Shefnn discussed the SDF in his 2005 book, he stated and
an important theorem in chapter 16. His Theorem 16.1 state
log-SDF can be expressed as a sum of sentiment and two funda
terms, as follows: m = A - YRln(g) + ln(SR II)" (Shefrin, 2005, p
He explained: "Theorem 16.1 states that the log-SDF is the sum
stochastic processes, a sentiment process and a fundamental pr
based on aggregate consumption growth. Note that prices are ef
when the sentiment variable A is uniformly zero, meaning that i
is zero at every node in the tree. Hence, when prices are efficient th
neither aggregate belief distortion nor discount factor aggregati
in which case there is only one effective driver in (16.5), the fundam
process" (ibid.).
It is clear that instead of developing an asset pricing theory with assump
tions fundamentally different from those used in mainstream theory (as
he did when he developed behavioral portfolio theory using lexicographic
preferences), Shefrin's behavioral asset pricing theory is only a modifica
tion of the mainstream theory by incorporating a sentiment variable into
the SDF. He allowed for the case when asset prices are efficient, and he
has stated that in that case, his SDF is driven by only one process, the
fundamental process found in mainstream asset pricing theory.
This kind of modification of mainstream asset pricing theory is not
acceptable to Post Keynesian and Institutionalist economists. Com
menting on the paradigm that Campbell (2000) described, after quot
ing more fully from that paper than I have done, Findlay and Williams
provided the following criticism: "financial economists have modeled
the real world as though it were one of risk (i.e., amenable to depiction
by probability distributions). These economists have then substituted the
one word for the other to arrive at an 'uncertain' world characterized by
'true' probability distributions" (2008-9, p. 220). They added: "General
equilibrium economists have done essentially the same thing with all
markets (goods, labor, capital, etc.), and this has led them down a blind
alley" (ibid., p. 220).
3 Findlay and Williams (2008-9) criticized Campbell's notion of uncertainty, as

will be seen below.
Irrationality and economic modeling
At the end of Findlay and Williams, the authors quoted Richar

pessimistic thoughts on the possibility of modeling asset prices
"In conclusion, there seem to be no really appealing choices for pr

to describe infinitely-lived asset price levels under rational expect
Convergence to a fixed price has never been witnessed but non-stati
seems equally bizarre and implausible. If neither condition is deem
ceptable, the alternative is irrational expectations. In that case, anyt
possible." (Roll quoted in Findlay and Williams, 2008-9, pp. 224-
They then added: "Of course, Roll is ultimately correct. Anyt

possible" (ibid., p. 225). They seemed to think that when trade
irrational expectations, it is impossible to study their behavior.
But the hope held out by the findings of behavioral finance is tha
tional actions are biased in a predictable way. For example, it is irra
to be overconfident about one's investment skills, but behaviora
have indicated the particular biases that such irrationality produces
confidence leads to excessive trading, and Barber and Odean (20
found that excessive trading results in lower returns. Gervais an
(2001) developed a measure of overconfidence (see section 3.2, p
of their paper) and used it to track its changes over time. In their
they "describe a dynamic by which overconfidence may wax an
both on an individual level and in the aggregate (though the latt
modeled formally)" (ibid., p. 19). In fact, their study of overco
enabled them to make the following predictions that provide
of a stock price bubble: "Overconfidence and its principal side
increased trading, are likely to rise late in a bull market and to fall
a bear market. A bull market may also attract more investment cap
part, because investors grow more confident in their personal inves
abilities. This increase in investment capital could cause price p
that send market prices even higher" (ibid.).
It is not necessarily true that irrational behavior cannot be s
In his survey of asset pricing, Campbell devoted several pages
ies attempting to model irrational expectations (see Campbell,
pp. 1554-1556). Post Keynesian and Institutionalist economi
object to some of these studies because they still retain some el
that are incompatible with the uncertain and nonergodic world
we live, but these studies may be useful starting points for new
that avoid the problematic elements. As long as there is some re
in behavior, behavioral finance promises to be a useful source f
ing models that try to explain how people actually behave.
Conclusion
The preceding discussions have shown that developments in behavioral

finance can sometimes provide alternative models that are closer to Post
Keynesian and Institutionalist models than neoclassical models, but
behavioral models can sometimes be objectionable because they have
retained important elements of neoclassical models that are incompat
ible with the uncertain and nonergodic world in which we live. This is
not surprising because applications of findings in behavioral finance
are not always done by economists well-versed in Post Keynesian and
Institutionalist theories. These applications are nevertheless interesting
both because they attempt to incorporate something about how human
beings actually behave and because their attempts at modifying neoclas
sical theories show up the deficiencies of those theories. But they need
critical review from Post Keynesian and Institutionalist economists, which
happily is beginning to appear. The paper by Raines and Leathers in the
current issue of this journal and the paper by Jefferson and King in the
winter 2010-11 issue represent welcome responses to ongoing research
in behavioral finance and behavioral economics.
It is encouraging to see that Post Keynesian economists such as Lavoie
and Dow (for references to their work, see Jefferson and King, 2010-11)
have already become so knowledgeable about behavioral economics
and finance that they have applied findings in those disciplines to their
own research. When I called for greater engagement on the part of Post
Keynesian economists with behavioral finance and experimental econom
ics (another name for behavioral economics) in my paper published in the
fall 2006 issue of this journal, I was hoping for the kind of enthusiastic
response that I now see with the appearance of the Raines and Leathers
and Jefferson and King papers. It would be good if the publication of
these papers can stimulate further interest among Post Keynesian and
Institutionalist economists to engage themselves with behavioral finance
and economics.
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The potential contributions of behavioral finance to Post Keynesian and institutionalist

The potential contributions of

Abstract: In their paper "Behavioral Finance and Post Keynesian-Institutionalist

Matthew V. Fung is an associate professor in the Department of Economics and Fi

Journal of Post Keynesian Economics/Summer 2011, Vol. 33, No. 4 555

It is not surprising that Raines and Leathers chose to focus on

Financial market bubbles and crises

They argued correctly that Keynes, Davidson, and Galbraith developed

Shiller's explication of the "psychological anchors" in terms of the ten

Despite similarities between Shiller's experts and Galbraith's "big men,"

anchors, Shiller wrote: "In making judgments about the level of

People do not need to consult authorities on things they can do for

market value of financial assets. Thus it seems that by combinin

Raines and Leathers mentioned in their paper that, according to Gal

desire to get rich quickly, a point made by Galbraith in his theory

Interpreting Keynes with the aid of findings in

Another way in which it can make an important contribution not consid

human decisions affecting the future, whether personal or political or

The comments of Post Keynesian economists on this passage mostly con

Baker and Wurgler (2007) observed that mainstream finance theory

[t]he stocks most sensitive to investor sentiment will be those of compa

Sentiment betas also increase as stocks become more speculat

Thus, they found evidence that investor sentiment had an impac

securities that are difficult to value also tend to be difficult to arbit

the effects of sentiment suggest that sentiment should be incor

Behavioral finance and portfolio theory

It is good to know that the theories of economists such as Dav

2 It is interesting to note that the negative relationship between expected return

Thompson et al. s criticism should make economists regard Markow

goal diversification rather than from a purposeful asset diversif

from 15 to 33% of financial assets. While diversification improves wit

Behavioral finance and asset pricing

One of the most important topics in finance is asset pricing becaus

to incorporate these psychological traits into the CCAPM, alth

3 Findlay and Williams (2008-9) criticized Campbell's notion of uncertainty, as

Irrationality and economic modeling

At the end of Findlay and Williams, the authors quoted Richar

"In conclusion, there seem to be no really appealing choices for pr

They then added: "Of course, Roll is ultimately correct. Anyt

The preceding discussions have shown that developments in behavioral

Asch, S. Social Psychology. Englewood Cliffs, NJ: Prentice Hall, 1952.

Campbell, J.Y., and Cochrane, J.H. "Explaining the Poor Performance of Co

Davidson, P. "Financial Markets, Investment and Employment." In J.A. Kregel,

Kahneman, D., and Tversky, A. "Prospect Theory: An Analysis of Decision Under

Markowitz, H. "Portfolio Selection." Journal of Finance, March 1952, 7 (1), 77-91.

Polkovnichenko, V. "Household Portfolio Diversification: A Case for Rank-Dependent

. "Behavioral Portfolio Theory." Journal of Financial and Quantitative

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