A Critique of Behavioral Finance
By Dr. Hassan Shirvani—The recent global financial crisis has raised serious questions about the rationality of the securities markets. In rational markets, prices tend to closely track their fundamental values, so that there is little or no chance of getting price bubbles. During the run-up to the recent crisis, however, many asset prices, including those in the housing sector, seemingly deviated from their correct values, resulting in subsequent financial crashes around the globe. Thus, for those wedded strongly to the idea that the securities markets are rational, the recent crisis has once again highlighted the need to explain why these markets are periodically subject to such destructive bouts of booms and busts.
Irrational Investors
One possible culprit, often singled out in the financial literature, is investor irrationality. Enslaved by their emotions and manipulated by their animal spirits, many investors seem to regularly succumb to their baser instincts and to engage in excessive speculative behavior. Indeed, a whole new field of behavioral finance has recently emerged that attributes all financial crises to investor follies and the madness of crowds. Based on the application of psychology to finance, this new school asserts that most investors are subject to a host of cognitive biases and defects, including loss aversion, myopia, and overconfidence.
As a result, these investors often fall prey to their unpredictable waves of optimism and pessimism, causing them to invest impulsively, with disastrous consequences. To document these assertions, the proponents of behavioral finance often rely on carefully designed laboratory experiments, the findings of which are then casually extended to real life situations.
A Cottage Industry
Whatever the merits of the behavioral finance as an academic discipline, there is little question that it has become a very lucrative cottage industry. The proponents of the school have capitalized on this new gold rush to get professorships at prestigious schools, to obtain impressive research grants, and to command substantial consulting and speaking fees on Wall Street. In addition, the members of the behavioral finance fraternity have enriched themselves by publishing a host of books on how market participants can learn to become more successful investors by both fighting their own irrational impulses and by exploiting those of the others.
Irrationality Defined
What is left unexplained in the behavioral finance literature, however, is the exact nature of irrationality. Based on a few psychological glitches, one can hardly characterize individual investors as irrational. If investors were indeed irrational, they should have intentionally aimed at achieving the worst, rather than the best, possible investment results. Thus, instead of maximizing their returns and minimizing their risks, investors should have been observed to do the exact opposites. But such an inverted investment behavior is rarely observed in the securities markets. For all that we know, almost all investors try to strike it rich on Wall Street. In other words, while investors may on occasion display a lack of sound judgement, this is not the same thing as asserting that they are therefore intentionally acting out of sheer stupidity to harm their own interests.
Role of Uncertainty
What seems more likely is that the supposed irrationality is in fact nothing more than rational behavior in the face of uncertainty. Lacking sufficient information about the future trends in security prices, many investors simply resort to a host of arbitrary rules of thumb to make investment decisions. Such rules may include extrapolating the past into the future, herd behavior, or following the advice of established security analysts. In addition, given the shaky foundations of the field of financial analysis, even the best advice offered by these analysts is subject to a wide margin of error. Indeed, many financial models are based on such unrealistic assumptions concerning the stochastic properties of the underlying security returns that their findings regarding the correct investment values of these securities should be taken with a hefty grain of salt.
This explains why on occasion many investors simply forego such models in favor of their own intuitive judgements. In addition, given this lack of knowledge about the exact investment values of most securities, it is not surprising that their market prices can temporarily over or undershoot their correct values. In the long run, however, as more information becomes available, the market prices will eventually tend to revert to their more rational values.
Roles of Deregulation and Leverage
At the same time, the short term deviations of the security prices from their investment values can be accentuated by both lax financial regulation and easy access to borrowed funds. In particular, much of the observed short run excess volatility of the security prices can be attributed to such funding issues as margin calls, short coverings, and derivatives trading. Thus, in the case of the recent financial crisis, a combination of significant deregulation of the mortgage-backed securities market and highly accommodative monetary policy in the early 2000s played a far more important role in the crisis than a supposed sudden surge in investor greed. Indeed, historically, most major financial crises have been preceded by new financial and lending deregulations. While these accommodative policies are often reversed in the aftermath of the crises, they are as readily relaxed once again as the storms are passed. Thus, the stage will be set for a new cycle of boom and bust. All that will be required will be a new “new thing” to serve as the trigger for the next wave of speculative fever.
Conclusion
The foregoing discussion should make it clear that any worthy study of finance should pay close attention to the underlying historical contexts and the relevant financial markets characteristics, instead of just focusing on investor behavior and cognition. In particular, the best way to prevent short run inefficiencies and excessive speculations in the securities markets is to render these markets more transparent, more regulated, and more prudent in the use of funds in financing leveraged investments. Indeed, the more the availability of the relevant information, the less the need for investors to rely on their own arbitrary heuristic rules, and therefore the greater the scope for the stability of the financial system.
