behavioural thinking defies logic

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BEHAVIOURAL THINKING Defies logicAuthor Hunt, BenPublication info Fund Strategy (Dec 6, 2010): 25.ProQuest document link

Abstract In their recent work Animal Spirits, the economists George Akerlof and Robert Shiller apply andconsiderably 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.

Full text 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.

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 anddecision 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

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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.

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.

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 priceswould 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.

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



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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.

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



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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.

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 whetherhumans are rational or irrational, many over-generalise from selected examples.

Cognitive biases of decision-making and belief

* Anchoring - overreliance on one piece of information when making decisions

* Bandwagon effect - tendency to interpret information/situations according to others' decisions and behaviours

* Confirmation bias - misinterpret information through existing assumptions

* Endowment effect - valuing the same asset differently owing to it being owned or not

* Framing effect - interpretation of the same information differently due to presentation and context

* Hyperbolic discounting - preference for immediate rather than later pay-offs

* Loss aversion - tendency to value losses more heavily than gains

* Planning fallacy - underestimation of time taken to complete tasks/projects

* Availability heuristic - interpret according to examples in recent memory

* Optimism bias - tendency to be over-optimistic regarding forecasts



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* Overconfidence effect - tendency to misinterpret realities owing to the overestimation of personal abilities

Behavioural finance - key texts

* Fischer Black (1972) Psychological Study of Human Judgment: Implications for Investment Decision Making

(The Journal of Finance, Vol. 41 No. 3).

* Werner De Bondt and Richard Thaler (1985) Does the Stock Market Overreact? (The Journal of Finance, Vol.

40 No. 3).

* Narasimhan Jegadeesh and Sheridan Titman (1993) Returns to Buying Winners and Selling Losers:

Implications for Stock Market Efficiency (The Journal of Finance, Vol. 48 No. 1).

* Andrew Lo (2004) The Adaptive Markets Hypothesis: Market Efficiency from an Evolutionary Perspective (The

Journal of Portfolio Management, Vol. 30 No. 5).

* Robert Shiller (1981) Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?

(The American Economic Review Vol. 71 No. 3).

* Andrei Shleifer and Rorbert Vishny (1997) The Limits of Arbitrage (The Journal of Finance, Vol. 52, No. 1).

* Paul Slovic (1972) Psychological Study of Human Judgment: Implications for Investment Decision Making

(The Journal of Finance Vol. 27 No. 4).

Copyright: Centaur Communications Ltd. and licensors

Subject Economic theory; Psychology; Economic crisis; Public policy;Location United Kingdom--UK

Classification 1130: Economic theory; 1200: Social policy; 9175: Western Europe

Publication title Fund Strategy

Pages 25

Publication year 2010

Publication date Dec 6, 2010

Year 2010

Publisher Centaur Communications Ltd.

Place of publication London

Country of publication United Kingdom

Publication subject Business And Economics--Investments

ISSN 14723042

Source type Trade Journals

Language of publication English

Document type Feature

ProQuest document ID 815982963

Document URL http://search.proquest.com/docview/815982963?accountid=39490

Copyright (Copyright (c) 2010. Centaur Communications Limited. Reproduced with permission of the copyrightowner. Further reproduction or distribution is prohibited without permission.)

Last updated 2011-10-12Database ABI/INFORM Complete

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