Behavioral finance

Behavioral finance applies scientific research on human cognitive bias to better understand economic decisions. Notable theorists include Daniel Kahneman, Ron Dembo and Richard Thaler. Key observations made in behavioral finance include the lack of symmetry between decisions to acquire or keep resources, called colloquially the "bird in the bush" paradox, and the strong risk aversion or regret attached to any decision where some emotionally valued resources (e.g. a home) might be totally lost.

Shefrin (2002) identifies three main themes of behavioral finance:

  • heuristic driven bias - people make investment decisions based on approximate rules of thumb rather than a rigorous analysis.
  • frame dependence - a problem expressed in two different (but equivalent) ways will lead people to come to different conclusions.
  • market inefficiency - the negation of the conclusions of the broad body of economists.

In other social sciences, the more general problems of heuristic cognitive bias, "herd mentality" confirmation bias, and tolerances versus preferences frame issues, are well known. So behavioral finance in some ways simply observes the same dynamics in play in economics. Law and economics is another field where the lessions of one disipline are brought into economics.

However, critics of the field (such as Eugene Fama) contend that it is more a collection of anomalies rather than a true branch of finance and that these anomalies will eventually be priced out of the market or explained by appeal to market microstructure arguments.

A very specific version of behavioral finance, prospect theory, was first advanced by Amos Tversky and Kahneman in 1979. This sought to define economics as a subfield of cognitive science, an effort which was not entirely successful, but which attracted significant attention to the field.

References

Shefrin, Hersh (2002) Beyond Greed and Fear: Understanding behavioral finance and the psychology of investing. Oxford Universtity Press



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