Behavioral economics
Behavioral finance as well as Behavioral economics applies scientific research on human and social cognitive and emotional biases (see cognitive bias) to better understand economic decisions and how they affect market prices, returns and the allocation of resources.
It analyses mostly the effects of market decisions, but also public choice, another source of economic decisions with some similar biases.
Key observations
Notable theorists include Daniel Kahneman, Ron Dembo and Richard Thaler. Key observations made in behavioral finance 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.
Shefrin (2002) identifies three main themes of behavioral finance:
- heuristic driven bias - people make investment decisions based on approximate rules of thumb rather than a rigorous analysis.
- frame dependence - a problem expressed in two different (but equivalent) ways will lead people to come to different conclusions.
- market inefficiency (mispricings, return anomalies) - the negation of the conclusions about market efficiency of the broad body of economists.
In other social sciences, the more general problems of heuristic cognitive bias, "herding" confirmation bias, and tolerances versus preferences frame issues, are well known. So behavioral finance / behavioral economics in some ways simply observes the same dynamics in play in economics. Law and economics is another field where the lessons of one discipline are brought into economics.
A very specific version of behavioral finance, prospect theory, was first advanced by Amos Tversky and Kahneman in 1979. This sought to define economics as a subfield of cognitive science, an effort which was not entirely successful, but which attracted significant attention to the field.
However, critics of the field, who support the Efficient market theory (such as Eugene Fama), contend that it is more a collection of anomalies rather 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.
Here, a distinction has to be made 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 équilibrium of the "fair price"
Behavioral finance models
Some financial models used in money management and asset valuation use behavioral finance parameters, for example
- Thaler's model of price reactions to information, with three phases, underreaction - adjustment - overreaction, creating a price trend
- the stock image coefficient
Research methodology
The methodology of behavioral economics / behavioral finances includes observations, games where participants engage in simulations of economic behaviour, such as investing, auctions, etc. In recent years, some research was done using fMRI to determine which areas of the brain are active during various steps of economic decision making.
References
- Shefrin, Hersh (2002) Beyond Greed and Fear: Understanding behavioral finance and the psychology of investing. Oxford Universtity Press
- Shleifer, Andrei (1999) Inefficient Markets: An Introduction to Behavioral Finance, Oxford University Press