A Crash Course in Behavioral Finance

As you go about your daily life, especially when making choices involving some sort of trade-off (exchanging money for goods and services, exchanging time for money, making investment decisions, deciding how to get the best value for money on your weekly grocery trip), you probably think of yourself as cool, calm, rational, and in control. You probably like to think that you’re ever so slightly better at making these choices than the next guy. 

You’re wrong on all counts.  

But don’t be too hard on yourself. Until recently, the prevailing (nearly axiomatic) view of neoclassical economics was that people are rational, risk-averse, have perfect information, and are perfectly consistent in their choices (i.e., they never change their minds). In this framework, people were referred to as “rational economic men,” “economic agents,” or “econs.”

While neither economics nor finance are sciences the same way physics, mathematics, or biology are, they used to be (and still often are) approached in broadly the same ways: as quantitative, analytical, and rational. In short, everybody assumed that money simply has to function within a rational, quantifiable, consistent framework. You know, because it’s money, and everyone takes money seriously.

Now let’s think of asset bubbles. Market crashes. Investors jumping on the bandwagon of the latest hot technology IPO. Flashy overpriced electronics. Impulse purchases. Advertising. Would any of these ever take place in a world where everyone is rational, consistent, and has perfect information?

Of course not.

Facing Reality

We are an impulsive, often irrational, inconsistent, emotion-driven species. It’s largely what makes humans humans. And this is why a new perspective on the way we make economic choices was needed.

This new conception is called behavioral finance (or behavioral economics—both terms are used interchangeably). The idea that our economic choices have psychological underpinnings isn’t new: it dates back as far as the 18th-century writings of Adam Smith. However, it wasn’t until the second half of the 20th century that the first economic theories that factored in human psychology began to emerge.

The big turning point was the publication of the seminal work “Prospect Theory: An Analysis of Decision Under Risk” by two “godfathers” of behavioral finance: Daniel Kahneman and Amos Tversky (Kahneman was awarded the Nobel Prize in Economics in 2002 for his work on prospect theory. Had Amos Tversky been alive at the time—he passed away in 1996—he would have likely shared the prize with Kahneman). Prospect theory used neoclassical economy’s utility theory as a reference point and then challenged and modified its assumptions.

Changing Assumptions

First, the assumption of having perfect information was relaxed. We don’t have perfect information; what we have is what we have (Kahneman, in his 2011 bestseller Thinking Fast and Slow, called this WYSIATI: what you see is all there is; a more formal term is “bounded rationality”). We make our decisions based on the information we have, however (in)complete it is. 

The next assumption to go was risk aversion. People, posited Kahneman and Tversky, are more loss-averse than risk-averse. Gain and loss of the exact same amount are experienced differently: loss of amount X is much more painful than the gain of the same amount. It’s not rational, but very human.

Lastly, prospect theory introduces the concept of the reference point, against which potential losses or gains are measured. For a regular college student, the subjective value of, say, USD 1,000 is much greater than it is to someone like Bill Gates or Michael Bloomberg. Again, this contradicts the assumption of rationality and consistency, but it’s very, very human. In fact, if Michael Bloomberg (worth an estimated  USD 48 billion as of 2017) applied the same subjective and emotional value to USD 1,000 as an average college student, his behavior would be considered irrational under prospect theory.

Reference point is very easy to (self)observe when it comes to one of the most important things in our lives: our salary. Imagine your current job pays USD 30,000. You get an offer for a new one that pays USD 40,000. Later, you’re on the job market again, and you come across a really great job, perfectly suited to your skills, that pays USD 35,000. Chances are you will not accept it because, from your perspective, you’d be trading down. However, if you came across this very same job when you were making USD 30,000, chances are you’d accept, and you’d be very happy: you’d be getting a great job and a salary increase!  

What changed, then? You changed—or, more specifically, your reference point moved.

New Frameworks

Behavioral finance employs two concepts previously not included in economic theories: cognitive biases and heuristics.

According to Wikipedia, cognitive bias can be defined as a “systematic pattern of deviation from norm or rationality in judgment, whereby inferences about other people and situations may be drawn in an illogical fashion.” What makes biases extremely powerful is that they are overwhelmingly not consciously realized. We behave in highly biased ways without (usually) knowing.

We will discuss a number of behavioral biases in subsequent posts—for an extensive list (much broader than required by the CFA curriculum) and a stunning infographic, please see Buster Benson’s post on Better Humans.

Heuristics can be defined as mental shortcuts. Analytical thinking is strenuous (just think about how tired you feel after a couple of hours’ worth of CFA study), and so people tend to avoid, or at least simplify, it. You can think of heuristics as “rules of thumb” or the kind of educated guesses we use so often in our daily lives. We will discuss some of these in subsequent posts, too.

A Blossoming Paradigm

Behavioral finance is currently at a very interesting point. It has slowly made its way into mainstream economics, with Kahneman’s 2002 Nobel Prize likely being one of the turning points. In 2001, Nassim Taleb published Fooled by Randomness, followed by his 2007 bestseller Black Swan. Both books touched on a variety of topics largely related to how people react to random events, construct (false) narratives, always look for causality etc.

Meanwhile, the 2008 financial crash shone a spotlight on irrationality, asset bubbles, and many biases that ultimately lead to disaster. A number of books on the topic gained considerable attention in recent years, including 2013 Nobel Prize in Economics winner Robert J. Schiller’s Irrational Exuberance, Richard Thaler’s Misbehaving and the critically acclaimed Thinking, Fast and Slow by Kahneman himself. You may have also heard of the Behavioral Insights Team, aka “the nudge unit” launched in recent years by the British government to apply behavioral insights to shaping public policy.

Current Critique

There are, of course, criticisms as well. The most frequent one is that the discipline is too vague;  another is that it’s overhyped. Yet another criticizes the discipline for coming up with too many theories applicable to increasingly small special cases. 

As a new field in economics, behavioral finance has a way to go to to solidify its theories and integrate them into mainstream economics. On the other hand, it has so far been very successful in challenging the “rational economic agent” status quo and identifying numerous biases and heuristics that govern our economic choices, helping explain numerous anomalies in the financial markets we see on a regular basis. It’s clear that the time of behavioral finance is only beginning.

 

About the Author

Wojtek Buczynski, CFA, FRM, is an investment risk and compliance consultant with Northern Trust in London. He is part of the global investment risk and analytical services team. Prior to Northern Trust, Wojtek spent four years working for Bloomberg’s analytics team as an advanced specialist. He is a graduate of London Business School. His interests include behavioral finance (especially asset bubble formation), indie cinema, documentaries, and current affairs. He is an avid reader and a fan of Wired magazine.

You can connect with Wojtek via LinkedIn at https://www.linkedin.com/in/wojtekbuczynski/.