One of the hottest topics in finance and economics for the past two decades has been Behavioral Economics, a field that originated in the research of Daniel Kahneman and Amos Tversky. Tversky died in 1996, and Kahneman was awarded The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel in 2002. The Nobel committee cited their joint work on “prospect theory as an alternative, that better accounts for observed behavior” of humans making decisions “when future consequences are uncertain” (aren’t they always?).
Classical financial modeling assumes that people make decisions in a cold-blooded utilitarian way that is therefore susceptible to mathematics and statistics. Kahneman and Tversky (K&T) cataloged a collection of irrational warm-blooded peculiarities in the way people choose between alternative bets on their own potential profits and losses when playing games of chance. Here are two of their many discoveries: (i) people are found to dislike the probability of losing $5 more than they like the equal probability of winning $5; and (ii) people typically underestimate the likely occurrence of rare (“black swan”) events.
In essence, claim K&T, people are psychologically inept at making rational decisions in games of chance.
Not everyone agrees with K&T. Real life is not always a game of chance; while the probability of throwing heads and tails is known exactly, the probability of human behavior is not. Animate individuals are driven by motives that can defy statistics. Our legal system recognizes this, and finds defendants guilty or innocent not on the basis of statistical evidence but on the basis of judgement and believability. You can find some criticism of K&T’s approach in an interesting article by Professor Alex Stein (“ARE PEOPLE PROBABILISTICALLY CHALLENGED?” to appear in the Michigan Law Review in 2013.)
But put these criticisms aside for now and accept K&T’s proof that people are bad at making rational decisions. Proceeding from there, K&T developed what they call prospect theory. In prospect theory, as opposed to classical economic theory, K&T replaced homo economicus’s rational notions of losses and gains and their probabilities by the empirically determined “irrational” values used by everyday fearful and greedy hot-blooded homo affectus.
Classical economic theory was elegant but flawed, and prospect theory was a beautiful idea/ideal that aimed to fix it by taking account of actual human preferences in determining economic value.
Unfortunately, that isn’t what happened. First, the ambitions of prospect theory as a science of human behavior foundered in a maelstrom of increasing mathematical complexity. Second, academics use the cover of behavioral economics to write papers on all sorts of irrelevant apparent irrationalities. Third, the part of behavioral economics that did flourish enormously is the notion that people are probabilistically challenged, and that it requires governments and agencies, helped by academics, to nudge people into doing what is “good” for them. Let me illustrate.
Some strange interests of behavioral finance
Research in behavioral finance has taken a strange byway, devoted more to “psychology” rather than finance. Here are some titles and excerpts from abstracts of recent research papers from a newsletter I subscribe to. I’ve omitted author names but you can find the papers on ssrn.com:
The Financial Psychology of Worry and Women (“… the emerging hypothesis that researchers should explore is (that) women reveal greater degrees of worry than their male counterparts for … financial services and investment products.)