Defies logic

The rise of behavioural thinking in economics and finance subordinates scientific measures of well-being, underestimates human potential, stymies the pursuit of rational debate and, ultimately, hampers progress writes Ben Hunt.

In their recent work Animal Spirits, the economists George Akerlof and Robert Shiller apply and considerably extend John Maynard Keynes’ observations about the role of psychology in the economy. Subtitled “how human psychology drives the economy,” they argue that the financial crisis can only be explained by sentiments such as “confidence, temptations, envy, resentment and illusions.”

While over the years, the economy has been understood from many perspectives, in recent years psychological perspectives have gained ground among economists and policymakers. The elevation of psychology is perhaps best expressed in the rise of behavioural economics.

The central theme here is that consumers, investors and others are far more prone to error-ridden, “irrational” decisions than was previously realised. In the popular literature, economists propose that we are closer to Homer Simpson in how we think and behave than Homo Economicus – the model of “Economic Man” used in standard economics.

Today’s policymakers seem drawn to such ideas. In Britain a “behavioural unit” has already been established at Number 10 Downing Street, directly influenced by Richard Thaler, a behavioural economist. In financial markets, behavioural finance is gaining acceptance. The Efficient Markets Hypothesis, explored later, has taken a critical battering after the crisis, creating space for psychological theories of market behaviour to gain acceptance.

”It is necessary to be more cautious of the rising tendency to explain the economy and markets through the prism of psychology”

The rise of psychological perspectives to understand the economy might seem for many to be quite a ­peculiar trend. Another key expression is the desire of governments around the world to rethink measures of social progress. In particular, many want to see a reorientation away from traditional economic measures of material well-being, such as GDP, towards measures of psychological well-being or happiness.

Now might be a good time therefore, to look more dispassionately at how and why psychological perspectives and behavioural theories have risen to prominence, both for economics and finance theory. In doing so, a key distinction might be helpful. It is common sense for investors to consider behavioural thinking for strategy and decision making, given that market behaviour can be complex, and that standard theories do fall short in explaining various trends. Many will want to consider how a competitive advantage can be gained.

But it is necessary to be more cautious of the rising tendency to explain the economy and markets through the prism of psychology. Such explanations can confuse and mislead, perhaps generating more heat than light. They can prevent us from understanding the deeper causes of problems. (article continues below)

To examine the rise of behavioural economics and finance we can briefly backtrack a few steps to understand the tradition from which it has emerged, neoclassical economics, the dominant tradition taught in today’s economics textbooks.

Neoclassical economics took off in the mid-to-late 19th century when economists aspired to make economics a more practical science that would have predictive power. The focus of economists’ attention shifted to quantitative measures and practical issues such as pricing strategy and forecasting supply and demand. A central problem was assessing consumer demand. Any forecast of quantities of goods bought in the future, in various mixes under income constraints, would require a theory of how consumers perceived the usefulness of different goods.

Nobody can know for sure how consumers will choose between different goods with different qualitative uses, but for modelling and forecasting purposes the challenge was to develop quantitative concepts of use-value, and ideas of “utility” were proposed. The marginal theory of utility, for instance, claimed that the amount of extra utility decreased with each unit bought. Over time, more sophisticated notions of how consumers “maximised utility” were put forward, each relying on mathematical formulas of varying degrees of complexity, and assumptions that individuals would evaluate choices in a sophisticated and mathematical fashion.

From the beginning, however, questions were raised as to whether consumers made choices in this mathematical way. In the much-discussed book Nudge, Richard Thaler and Cass Sunstein commented that: “If you look at economics textbooks, you will learn that homo economicus can think like Albert Einstein, store as much memory as IBM’s Big Blue, and exercise the willpower of Mahatma Gandhi.”

Economists increasingly drew on cognitive psychology in the latter half of the 20th century to suggest that consumers made choices in alternative, less “rational” ways (see box, below).

Herbert Simon proposed “bounded rationality”: people do not aim for optimal outcomes and evaluate all information as implied. Amos Tversky and Daniel Kahneman, both psychologists, put forward “prospect theory” in the late 1970s, a challenge to the 18th century “expected utility hypothesis” which suggested that people reason probabilistically to pursue certain outcomes. Richard Thaler is credited as the first economist to explore the implications of such ideas for economics and finance.

At the same time, behavioural finance emerged as a critical response to neoclassical ideas of market efficiency and investor rationality. The Efficient Market Hypothesis had been formulated in the 1960s by a group of academics at Chicago University, of which Eugene Fama was the most prominent member.

It proposed that, while prices can certainly deviate from intrinsic values because people have subjective opinions of the future, prices will eventually revolve around such values through the processes of investors’ reactions to information and competitive arbitrage. The implication was that prolonged bubbles in asset prices would be rare. However, the continuing existence of bubbles and the various ways in which investors do not react to information in a straightforward sense cast doubt on the theory. Post financial-crisis, a new consensus emerged in the market. Efficient markets theory makes sense to a degree, and processes of competitive arbitrage still exist. But markets are not as efficient, and investors not as rational, to the extent that was thought.

”We use behavioural finance to examine anomalies that in conventional finance theory should be arbitraged away”

Over time, observations of anomalies in financial markets led to further conclusions that standard finance theory could not fully explain market behaviour. Investors combined new insight with older knowledge about the role psychology plays in financial markets.

Gulnur Muradoglu, a professor of finance and director of the behavioural finance working group at Cass Business School, says that there are two broad areas where behavioural finance provides an edge for fund managers.

“The first is where you can exploit certain behaviours that have been well-researched, such as momentum and overreaction, for abnormal profits. The second is how you can learn from your own biases when it comes to important decision-making processes.” In her own research, Muradoglu has found evidence of overconfidence in financial forecasts. She has also found, however, that good adjustments can be made once feedback has been provided.

An example of the first area is JP Morgan Asset Management, which is applying behavioural finance in strategy. “We use behavioural finance to examine anomalies that in conventional finance theory should be arbitraged away,” says James Glover, a client portfolio manager, European equities team. “We ascribe a behavioural finance reason to why these anomalies keep appearing.” Valuations are understood with reference to concepts such as anchoring (the tendency to be influenced by fixed reference points in making judgments, rather than changing market conditions) and over-optimism.

An example of the second area, where advisers are using behavioural finance to improve financial decision-making, is Barclays Wealth, which has a behavioural finance team, headed by Greg Davies. It offers “financial personality” assessments to clients, to discover such things as personal attitudes to risk, and emotional attachment to short-term time-frames.

“Investors who are quite different from each other are typically lumped together in a portfolio,” says Davies. “However, the role of the personal journey in investing is crucial, and each individual is different. I might feel comfortable with prices rising, but not falling, and this might lead to the classic error of buying high and selling low. Sometimes it may be good to purchase some emotional comfort, and structure your portfolio accordingly to achieve this. It might cost you a bit more upfront, and not conform to conventional theories of investing, but by being emotionally comfortable with your portfolio, it becomes easier to make good choices along the journey. The rewards in the long-term may be greater.”

Practical applications of behavioural finance make sense and it is worth applying psychological concepts to try to understand how investors behave and assets are valued. However, psychological theories become more problematic when they try to explain broader trends or problems in the economy and markets.

In this context, behavioural economics is undergoing rapid change. It started off as a discipline with legitimate assumptions to explore alternative concepts of utility, the nuances of how consumers and investors make choices. Cognitive psychology was drawn on.

”Behavioural economists frequently claim that small-scale errors really matter for the economy”

Over time, however, economists have started to use such ideas to explain broader trends and problems, such as the financial crisis, or the ups and downs of the business cycle. In doing so, they have shifted from a position of questioning technical notions of rationality in how people make choices, to suggesting far more broadly that people are irrational and struggle to make rational choices. This amounts to blaming people for broader economic problems. Behavioural economics has gone from being a practical project within economics to rethink aspects of choice, decision-making and market dynamics, to being a political project with fixed ideas of human nature.

An illustration is how Thaler and Sunstein analyse the recent financial crisis in their book Nudge. For them, “three characteristics of humans…help to explain” the crisis: bounded rationality, limited self-control, and social influences. Humans have floundered in a world of complexity and difficult financial choices; were too keen to refinance mortgages; and got caught up with the excessive exuberance of bubbles.

No doubt, such views contain an element of truth. But left at this level, they can remain misleading. Issues of how investments are allocated in the economy, from productive to speculative investments, and the broader imbalances between the financial ­sector and the economy, receded into the shadows.

One basic problem area of behavioural economics is that fundamental objective characteristics of the market economy are not discussed properly. Subjective factors are therefore not placed in a proper context.

In Animal Spirits for example, Shiller and Akerlof discuss concerns such as economic depressions and unemployment without really enquiring properly about fundamental economic processes. For instance, certain conditions of profitability have to be satisfied for production and employment to run at certain capacities, yet such factors are not properly discussed.

The same problem is also in evidence in the context of the discussion of individual psychological errors in decisions. Because a wider economic context is often missing, it becomes unclear what role they play in the overall economy.

For instance, behavioural economics stresses that we all fall prey to systematic biases in our thinking and individual decision. But then they tend to make two much broader claims.

The first is that we often do not make conscious decisions in our best interests. Rather than assess things objectively, our decisions are channelled in particular ways by such things as anchor or reference points; the way that decisions are framed or presented; or examples close at hand, which might mean that we do not assess risk in a probabilistic fashion. As Dan Ariely, a behavioural economist, suggests in his work, we think we are making choices consciously, but in fact we are not. Cognitive factors influence our choices. Ariely says that much more of the economy should be restructured around the notion that humans have cognitive limitations.

”Our brains do not change much in a few decades, but social attitudes do, pointing to social explanations of certain outlooks”

A second claim is that, as individuals and as a society, humans are not as motivated by economic or material gain as had been assumed under the model of Economic Man.

Ariely suggests in his book, Predictably Irrational, that we might value a good not because we “need” it, for example, but because it seems a bargain relative to another good. Or, we might want a pay rise not because we “need” the extra money, but because others have received a better pay rise or are paid more.

Behavioural economists frequently claim that small-scale errors really matter for the economy. According to Ariely, they are not just for light-hearted dinner-party talk: “our mistakes of judgment can aggregate in the market, sparking a scenario in which, much like an earthquake, no one has any idea what is happening.” But he is talking in the context of financial markets, which are more sensitive to psychological changes, noted above.

If the supposed irrational choices and non-economic motivations of consumers really matter, we might expect to see expressions in the major product and service markets in the economy. Yet examples are not provided, and the case studies offered tend to be niche in nature: gym membership, aspirin, New York City cab drivers, baseball. Elsewhere, studies are presented on aspects of labour market negotiation, law, and health. Behavioural perspectives are applied to many new areas, but it does not add up to a convincing picture of how psychology affects the economy. In the popular literature, the emphasis seems more on individual “behaviour” than “economics”, with a focus on individual decision-making for health, diet, exercise, and financial decisions.

Some of the drawbacks with behavioural theory can be explored in more detail if the role that individual decisions play in the market economy more generally is considered. It is true, of course, that people can reason and make judgments in an almost unlimited number of strange and quirky ways. From strange phobias, to forms of self-delusion or false modesty, jealousies and many other states, the study of subjective behaviour can be endlessly entertaining. When it comes to buying things, or making investment decisions, many strange reasons can apply. Somebody might invest in a firm’s stock because they have used the firm’s products, and conclude that it represents a “good company”. Somebody might buy a particular brand of washing powder, car or television because they think it will fulfil them in ways that it possibly cannot.

The question is whether these subjective choices matter for the economy in a meaningful way. For instance, despite the undoubted way in which individuals make all sorts of subjective, odd decisions, society has managed to make significant economic progress over the past 200 years or so. The reasons have to do with broader economic processes: rising labour productivity, creativity and innovation, the accumulation of wealth, a widening division of labour. Through these processes, society has been able to devote more time and resources to areas such as culture, medicine, education, science and technology. More choices have been afforded to the individual as a result.

Psychological errors and irrationalities seem to play a marginal role when economic factors that make a substantial difference to our lives are considered. And for many other economic concerns, it is not clear how they play a role. For instance, psychological processes do not help explain why house building in Britain, is in such a poor state, chronicled by many; why western manufacturers struggle to compete with Chinese counterparts; why an African person on average has fewer opportunities than a European.

”Modern society for the past few centuries has been built on strong notions of rationality and reason. Humans have had strong ideas of what is in their ’best interests’”

Behavioural economics also seems poorly equipped to identify the more important subjective factors that are having an influence in today’s economy. Risk aversion is a case in point. Sociologists point out that risk aversion has become a new social phenomenon, due to social processes such as greater individual alienation. Examples abound, from children not being allowed to walk to school because of parental fears, or the adoption of the precautionary principle because of social fears of new technological risks. Elsewhere, others have noted that a range of institutions react defensively with the world. Loss of reputation, for example, has become an elevated boardroom concern.

Such issues might be taken up by behavioural economics as interesting ones to explore. Current behavioural thinking, however, seeks to locate behaviour and decision making in fixed, cognitive conditions. As Thaler and Sunstein write in Nudge, in a discussion on risk aversion, “the availability heuristic helps to explain much risk-related behaviour, including both public and private decisions to take precautions.” But trying to explain risk-averse behaviour in relation to cognitive factors is likely to be a frustrating task. Our brains do not change much in a few decades, but social attitudes do, pointing to social explanations of certain outlooks and attitudes.

A final area worth questioning is the current discussion of “rationality” and “irrationality”. At present, it seems the discussion is confusing. Economic progress would not be possible if people did not consciously choose options that enhance their material well-being over time. Regardless of how subjective and “irrational” people can be at the individual level, modern society for the past few centuries has been built on strong notions of rationality and reason. It seems humans have had strong ideas of what is in their “best interests”, and what are superior choices to advance human interests, from notions of law and justice, to democracy, science, material progress, education, and so on. To claim that individuals are “irrational” on the basis of observations made from psychological experiments and apparent cognitive limitations seems strangely one-sided.

All these observations prompt a final question. If psychological errors and apparent irrationalities at the individual, subjective level seem to be of marginal importance when set in the context of the major economic processes that make a real difference to our lives, why has economics elevated them so much?

The short answer is that economists have been retreating from analysing deeper and more fundamental economic processes and relationships for some time. On the one hand there seems to be more fatalism that basic changes cannot be made to a market economy. On the other, economists and policymakers are far more indifferent to, or even sceptical of, questions of economic progress. Such attitudes essentially take away incentives to understand the economy in a deeper sense. Without a broader context, it becomes possible to argue that psychological factors are driving the economy.

A second trend is what may be called a new cynicism about human nature, which is evident across the humanities and social sciences today, and wider society. Instead of having a balanced discussion of whether humans are rational or irrational, many over-generalise from selected examples.


* Note: Dec 6 amendment to “Behavioural finance – key texts” box. Fischer Black (1985) Noise (The Journal of Finance, Vol. 41 No. 3) added as first reference and Fischer Black (1972) Psychological Study of Human Judgment: Implications for Investment Decision Making (The Journal of Finance, Vol. 41 No. 3) removed.