Is Behavioural Finance Relevant?
The answer to this question lies in fact in the tenets of economics. After all finance and related field are an off shoot of the larger economic picture.
The debate in fact stems from the existence of such behaviour and psychology in economics in the first place. Economics fundamentally deals with the behavior of economic agents such as farmers, investors, customers, bankers, governments, etc. then, what is the need to have a field of study called behavioral economics or finance? How is it different from the other sub fields of economics?
If you see modern history, economics conceptualizes a world populated by calculating, unemotional maximizers that have been dubbed Homo Economicus.
In a sense, neo-classical economics has defined itself as explicitly “anti-behavioural”, for almost all the behaviour studied by cognitive and social psychologists is either ignored or ruled out in a standard economic framework. This ‘unbehavioral’ economic agent has been defended on numerous occasions. Some claimed that the model was “right”; most others simply argued that the standard model was easier to formalize and practically more relevant.
Behavioral economics came into being with the realization that neither point of view was correct. Thus imbibing the need to make a study of behavioral finance and its sphere of influence.
The experimental evidence mounted against the stark predictions of unbounded rationality. Further work made clear that one could formalize psychological ideas and translate them into testable predictions. With this the behavioral economics research program flourished and classified itself into two components:
1. Identifying the ways in which behaviour differs from the standard model
2. Showing how this behaviour matters in economic contexts
The argument against behavioural finance is that some combination of market forces, learning and evolution is enough to deal with the financial market thus rendering the human qualities or psychological decision making irrelevant?
However, proponents of behavioural finance would sound a resounding no to such an argument. They believe that this idea germinates from the notion that because of limits of arbitrage less than perfect agents survive and influence market outcomes, had only rational tools been maintained only the perfect agents using the market information to the fullest would have survived.
Behavioural Finance postulates that there are three important ways in which humans deviate from the standard economic model: Firstly, Bounded Rationality which reflects the limited cognitive abilities that constrain human problem solving. Second, Bounded Willpower that captures the fact that people sometimes make choices that are not in their long-run interest. And finally Bounded Self-interest incorporates the comforting fact that humans are often willing to sacrifice their own interests to help others.
Financial markets have greater arbitrage opportunities than other markets, so behavioral factors might be thought to be less important here, but numerous research results show that even here the limits of arbitrage create anomalies that the psychology of decision making helps explain.
Behavioral economics increases the explanatory power of economics by providing it with more realistic psychological foundations. And the three significant bounded limitations above are seen in any aspect of human decision making, so why not financial decisions?
And therein lies the relevance of behavioural finance.
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Cool…
but how can regular investors like me use something that seems complex with psychology and economics for investing?
Hey Thom..
Thanks for commenting. Well let’s just put things this way. Any investor is looking for ways to beat the market.. that’s what all of us look to do. Yes, studying behavioural patterns ain’t easy.. knowing economics is not.. but if you do you stand to have a major advantage over others who don’t.. it’s like studying technical analysis..
If you can’t put in the time to learn these stuff investments won’t pay you as much as they can…
Let me know if I can help you with handy learning stuff
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