1. Behavioral Finance: Introduction
  2. Behavioral Finance: Background
  3. Behavioral Finance: Anomalies
  4. Behavioral Finance: Key Concepts - Anchoring
  5. Behavioral Finance: Key Concepts - Mental Accounting
  6. Behavioral Finance: Key Concepts - Confirmation and Hindsight Bias
  7. Behavioral Finance: Key Concepts - Gambler's Fallacy
  8. Behavioral Finance: Key Concepts - Herd Behavior
  9. Behavioral Finance: Key Concepts - Overconfidence
  10. Behavioral Finance: Key Concepts - Overreaction and Availability Bias
  11. Behavioral Finance: Key Concepts - Prospect Theory
  12. Behavioral Finance: Conclusion

By Nathan Reiff

Before we examine the specific concepts central to behavioral finance, let’s take a broader look at this branch of economic theory. In this section of the tutorial, we’ll explore how behavioral finance compares to conventional finance, introduce you to three major contributors to the field and take a look at behavioral finance from the perspective of a critic.

Why is behavioral finance necessary?

For clarification, when we use labels like “conventional” or “modern” to describe finance, we are referring to the type of finance which is based on logical, rational theories. These include the capital asset pricing model (CAPM) and the efficient market hypothesis (EMH), among many others. Theories like these take as an assumption that participants in an economy, for the most part, exhibit behaviors that are rational and predictable. (For more insight, see The Capital Asset Pricing Model: An Overview, What Is Market Efficiency? and Working Through The Efficient Market Hypothesis.)

There was a time when theoretical and empirical evidence seemed to suggest that CAPM, EMH and other conventional financial theories were reasonably successful at predicting and explaining certain types of economic events. Nonetheless, as time went on, academics in the financial and economic realms detected anomalies and behaviors which occurred in the real world but which could not be explained by any available theories. It became increasingly clear that conventional theories could explain certain “idealized” events, but that the real world was in fact a great deal more messy and disorganized, and that market participants frequently behave in ways which are difficult to predict according to those models.

Homo Economicus

One of the fundamental assumptions in the world of conventional economics and finance asserts that people are, for the most part, rational “wealth maximizers” who seek to increase their own financial well-being through reasonable decision-making. According to conventional theories, people are able to separate out emotions and various other extraneous factors so that they are not susceptible to their influence.

In reality, though, this assumption does not reflect how people tend to behave. Indeed, nearly every participant in an economy behaves irrationally in some way or other. To take a common example: consider how many people purchase lottery tickets in the hopes of winning a big jackpot. Taken logically, it does not make any sense to buy a lottery ticket if the odds of winning are overwhelmingly against the ticket holder (the chances of winning the Powerball jackpot are roughly 1 in 146 million, or 0.0000006849%). However, in spite of this, millions of people spend countless dollars taking part in the lottery.

Anomalies like this one provoked academics to turn to cognitive psychology in order to account for irrational and illogical behaviors which are unexplained by modern financial theory. Behavioral science is the field which was born out of these efforts; it seeks to explain our actions, whereas modern finance seeks to explain the actions of the idealized “economic man” (Homo economicus).

Important Contributors
Behavioral finance has developed to the point it has today thanks to the contributions of many individual theorists and researchers. Below, we’ll take a look at three of the most significant contributors to major theoretical and empirical components of behavioral finance.

Daniel Kahneman and Amos Tversky
Kahneman and Tversky are considered by many to be the fathers of behavioral finance. These two cognitive psychologists began to collaborate with one another in the late 1960s, ultimately publishing about 200 works in the field. Most of the work of Kahneman and Tversky focuses on how various psychological concepts relate to behavior in the financial realm. In 2002, Kahneman received the Nobel Memorial Prize in Economic Sciences for his contributions to the study of rationality in economics.

Kahneman and Tversky have specialized on cognitive biases and heuristics (i.e. ways of problem solving) which cause individuals to engage in behavior which is both irrational and unanticipated. Some of their most popular and important works include writings on prospect theory and loss aversion, which we’ll explore later in this tutorial.

Richard Thaler
If it can be said that Kahneman and Tversky were the founders of behavioral finance, it follows that Richard Thaler brought the field out of its nascent state and into the mainstream.

Thaler developed his theories out of a growing awareness of the shortcomings of conventional financial theories as they pertain to real-world behaviors. After he read a draft version of a work by Kahneman and Tversky on prospect theory, Thaler came to the realization that psychological theory (rather than conventional economics) could help to account for this irrationality.

Over time, Thaler collaborated with Kahneman and Tversky, combining economics and finance with elements of psychology in order to develop concepts like mental accounting, the endowment effect and other biases which have an impact on people’s behavior. (For more, see Who is Richard Thaler, Economics Nobel Prize Winner?)

Critics of Behavioral Finance
Behavioral finance has come to a place of prominence in the past decades, with many academics adhering to its principles. However, this set of theories is not without critics, too. For instance, some supporters of the efficient market hypothesis (EMH) are vocal critics of behavioral finance.

EMH is widely considered to be one of the foundations of modern finance. However, this hypothesis fails to account for irrationality, because it assumes that the market price of a security reflects the impact of any and all relevant information as it becomes available.

Eugene Fama is one of the most notable critics of behavioral finance. Fama is the founder of market efficiency theory. He suggests that even though there do exist some anomalies for which modern financial theory is not able to account, market efficiency theory remains the best model for examining and predicting economies.

Fama even goes so far to note that many anomalies inherent in conventional theories could be seen as shorter-term chance events which are eventually corrected as time goes on. In a 1998 paper entitled “Market Efficiency, Long-Term Returns And Behavioral Finance,” Fama argued that many elements of behavioral finance seem to be in contradiction with one another, and that all in all, behavioral finance itself may be a collection of anomalies, the sum of which can actually be explained by market efficiency.

 

 

Critics
Although behavioral finance has been gaining support in recent years, it is not without its critics. Some supporters of the efficient market hypothesis, for example, are vocal critics of behavioral finance.

The efficient market hypothesis is considered one of the foundations of modern financial theory. However, the hypothesis does not account for irrationality because it assumes that the market price of a security reflects the impact of all relevant information as it is released.

The most notable critic of behavioral finance is Eugene Fama, the founder of market efficiency theory. Professor Fama suggests that even though there are some anomalies that cannot be explained by modern financial theory, market efficiency should not be totally abandoned in favor of behavioral finance.

In fact, he notes that many of the anomalies found in conventional theories could be considered shorter-term chance events that are eventually corrected over time. In his 1998 paper, entitled "Market Efficiency, Long-Term Returns And Behavioral Finance", Fama argues that many of the findings in behavioral finance appear to contradict each other, and that all in all, behavioral finance itself appears to be a collection of anomalies that can be explained by market efficiency.


Behavioral Finance: Anomalies
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