Behavioral finance - Logic, Psychology, Economics & More ! ! !

Author :Rachit Srivastava , NMIMS 

Economics is probably the science that arguably has had the most impact in today’s times. In fact it can barely be called a science in a strict sense, since human behavior is not governed by laws of nature unlike other non living objects, which makes the prediction and forecasting stock prices, economic conditions  all the more difficult.  In recent decades economists have tried to give a more structured and mathematical explanation to their theories concerning how human beings make their decisions. However these theories have come under immense criticism as they don’t hold true in real time. In reality, human beings rarely behave rationally which is the basic assumption in many of the economic theories; rather we make a lot of our decisions based on our intuition and limited knowledge available to us. When the financial crisis of 2008 came upon us, a lot of questions were raised on the apparent predictive abilities of the various economic theories. Merely 12 economists were able to foresee the massive crisis which now shows signs of deepening into a double dip recession.

Since then economists have looked at alternative theories to explain and predict the real world dynamics. This is where the behavioral economics comes in. Among other things, it seeks to explain why humans behave how they behave, what are the impacts of this in the economy (here we are particularly concerned with financial markets), how we can avoid various biases to make better investment decisions.

What is the role of investor’s confidence in the financial markets? Why a downgrade of the US treasury sends ripples in the stock markets all over the world .How do investors react to such kind of information? Do we take all the information into account before making an investment decision?  Can we really predict the stock prices?

In 1985 Werner Bondt and Richard Thaler published a research paper “Does the stock market overreact?” forming the start of what has become known as behavioral finance. They discovered that people systematically overreact to unexpected and dramatic news events results in substantial weak-form inefficiencies in the Stock market. This was both surprising and profound.

Behavioral finance is a relatively new branch of economics which is gaining acceptance in the academic as well as non academics world. In simple language, is seeks to explain how various social and psychological attributes of human beings  affect their behavior, particularly decision making, while making financial and investment decisions. What drives us to make seemingly rational yet blatantly irrational decisions?  For example; even when people were constantly warned by experts that Speak Asia, an alleged market research company was nothing more than a Ponzi scheme, they still invested money in it. What drives this brave risk taking behavior on one hand and loss aversion on the other?

An interesting TED talk by Dan Ariely points this flaw in humans out, “Are we control of our own decisions” he asks. The crux of his point was that human beings have a very strong tendency to make decisions not in absolute, but in relative terms. Dan Ariely is a behavioral economics professor at MIT, a very interesting experiment he did to prove his point was as follows: He presented the students at MIT with the following economist newspaper subscription advert.

	Subscription Type	Subscription price (Yearly subscription in $)	Percentage of students who took the option.
1.	Print only	75	16%
2.	Online only	125	0%
3.	Print and online both	125	84%

 

He then did the same experiment again, only this time he removed option number 2;

	Subscription Type	Subscription price (Yearly subscription in $)	Percentage of students who took the option.
1.	Print only	75	75
2.	Print and online both	125	35

That point that he makes here is that when there was option 2 present , we not only tend to compare between option 2 and 3 but we also tend to ignore option one ,thus reaffirming the fact that we  think relatively. This can have potential impact on the way investors and brokers choose portfolios etc.

How do human beings look at random events? There have been numerous theories in the field of risk analysis and psychology about randomness, both measurable and non measurable. Yet human behavior assigns value to random events which are not rational. Nicholas Taleb has captured the essence of how human beings respond to random events in his bestseller “Fooled by Randomness”. Among other things he talks about how human beings attribute their success to themselves and hard work and failures to others performances, how we focus  more on one success story and ignore thousands of failures ( survivor ship bias) ,how we tend to respond differently when the same scenario is presented to us in different forms, and so on. In his other book The Black Swan Prof. Taleb talks about how we perceive and ignore to some extent highly improbable events which have a huge impact , e.g.; financial crisis.

Anchoring, one of the most evident biases occurs when our brain gets fixated on the first information that we receive. For example, a professor asks two kids to estimate the pop of country xyz and the first one gives the answer 10 mn. Now it is almost certain  that the second boy would give an answer which would be very close to 10 mn or very far away, because he got hinged on the figure 10 million.  

People also tend to act “foolishly” when it comes to picking portfolios. A research done by The Economist newspaper through an investment research firm about how good people are at picking portfolios showed that people particularly in U.S chase fads. The statistics showed that investors tend to invest in funds that have had strong returns in the past 12 months. But, these popular funds lost steam subsequently and performed lower than the average. The statistics showed that the most popular sectors declined in terms of returns after people invested heavily in them.

We now move to another aspect of human behavior, which is loss aversion. Loss aversion is the human tendency to value losses more than proportionate gains, that is, they assign a value to loss which is higher to the value assigned to a gain of equal amount. Risk has been central to trading not just in the financial markets but in the olden days as well. Multiple theories are present to show how humans judge risk, how they accept some gambles and reject others. There was the expected utility hypothesis, which stated that we ascertain whether to take a bet or not on the basis of utility derived.

Another theory by Daniel Kahneman and Amos Tversky called the Prospect theory, explains how humans attach values to different gains and losses rather than the final outcome, and thus take or avoid risk. They say that since human beings derive different utility from the same event and they tend to value outcomes that are certain more than uncertain outcomes. In general empirical studies have shown that humans are risk averse, and they value loss more than gains from a bet, which means that wealth shows diminishing marginal utility.

There is a lot of research work going on in this particular field, more so since the crisis of 2008. The purpose of this article was to make readers aware of the subject .Behavioral finance is an interesting mix of logics, psychology and economics. Budding investors and management students should look into this in more detail so that they are better equipped to make financial decisions.