{"id":436,"date":"2015-09-22T15:30:58","date_gmt":"2015-09-22T15:30:58","guid":{"rendered":"http:\/\/blogs.stthom.edu\/cameron\/?p=436"},"modified":"2017-04-13T20:54:15","modified_gmt":"2017-04-13T20:54:15","slug":"a-critique-of-behavioral-finance","status":"publish","type":"post","link":"https:\/\/blogs.stthom.edu\/cameron\/a-critique-of-behavioral-finance\/","title":{"rendered":"A Critique of Behavioral Finance"},"content":{"rendered":"

By Dr. Hassan Shirvani—The recent global financial crisis has\u00a0raised serious questions about the rationality of the securities markets<\/a>. \u00a0In rational markets, prices tend to closely\u00a0track their\u00a0fundamental values, so that\u00a0there is little or no chance of getting price\u00a0bubbles.\u00a0\u00a0During the\u00a0run-up to the\u00a0recent\u00a0crisis, however,\u00a0many asset prices, including those in the\u00a0housing\u00a0sector, seemingly\u00a0deviated\u00a0from their correct values, resulting in subsequent\u00a0financial\u00a0crashes around the\u00a0globe. \u00a0Thus,\u00a0for\u00a0those wedded strongly to the idea that the\u00a0securities markets\u00a0are\u00a0rational, the recent crisis has once again highlighted the need to explain why these markets\u00a0are periodically subject to such destructive\u00a0bouts\u00a0of\u00a0booms and busts.<\/p>\n

 <\/p>\n

Irrational Investors<\/strong><\/p>\n

One possible culprit,\u00a0often singled out\u00a0in the financial literature, is investor irrationality. Enslaved by\u00a0their\u00a0emotions and\u00a0manipulated by their\u00a0animal spirits, many investors seem to\u00a0regularly\u00a0succumb to their baser instincts and to engage in excessive speculative behavior. \u00a0Indeed, a whole new field of behavioral finance has recently emerged that attributes\u00a0all financial crises to\u00a0investor\u00a0follies and\u00a0the\u00a0madness of crowds.\u00a0 Based on the application of psychology to finance,\u00a0this\u00a0new school asserts that\u00a0most\u00a0investors are subject to a host of\u00a0cognitive\u00a0biases and defects, including loss aversion,\u00a0myopia, and\u00a0overconfidence.<\/p>\n

As a result, these investors\u00a0often\u00a0fall prey to their\u00a0unpredictable\u00a0waves of optimism and pessimism,\u00a0causing\u00a0them\u00a0to\u00a0invest\u00a0impulsively,\u00a0with disastrous consequences. \u00a0To document these assertions, the proponents of behavioral finance<\/a>\u00a0often rely\u00a0on carefully designed\u00a0laboratory experiments, the\u00a0findings\u00a0of which are\u00a0then\u00a0casually\u00a0extended to\u00a0real life situations.<\/p>\n

 <\/p>\n

A Cottage Industry<\/strong><\/p>\n

Whatever the merits of the behavioral finance as an academic discipline,\u00a0there is little question that it has become a\u00a0very\u00a0lucrative\u00a0cottage\u00a0industry.\u00a0\u00a0The proponents of the school have capitalized on this new gold rush to get professorships at prestigious schools, to obtain\u00a0impressive\u00a0research grants, and to command substantial consulting and speaking fees\u00a0on Wall Street. \u00a0In addition, the members of the behavioral finance fraternity have enriched themselves by publishing a host of books on how\u00a0market participants can learn to become more successful investors by both fighting their own irrational impulses and by exploiting those of the others.<\/p>\n

 <\/p>\n

Irrationality Defined<\/strong><\/p>\n

What is left unexplained in the behavioral finance literature, however, is the exact nature of irrationality. \u00a0Based on a\u00a0few psychological glitches, one can\u00a0hardly\u00a0characterize\u00a0individual investors\u00a0as\u00a0irrational. \u00a0If investors were indeed irrational, they should have intentionally\u00a0aimed at\u00a0achieving\u00a0the worst, rather than\u00a0the best,\u00a0possible\u00a0investment results. \u00a0Thus, instead of maximizing their returns and minimizing their risks, investors should have been observed to do the exact opposites. \u00a0But such an inverted investment behavior is rarely observed in the securities markets. \u00a0For all that we know, almost all investors try to strike it rich on Wall Street. \u00a0In other words,\u00a0while\u00a0investors may on occasion\u00a0display\u00a0a\u00a0lack of\u00a0sound\u00a0judgement,\u00a0this is\u00a0not the same thing as asserting that they are\u00a0therefore\u00a0intentionally\u00a0acting out of sheer stupidity\u00a0to harm their own interests.<\/p>\n

 <\/p>\n

Role of Uncertainty<\/strong><\/p>\n

What seems more likely\u00a0is that the supposed irrationality is in fact nothing more than rational behavior in the face of uncertainty.\u00a0\u00a0Lacking 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. \u00a0Such rules may include extrapolating the past into the future, herd behavior, or following\u00a0the advice of\u00a0established\u00a0security analysts.\u00a0\u00a0In addition, given the shaky foundations of the field of financial analysis, even the best advice offered by these\u00a0analysts is subject to\u00a0a\u00a0wide margin of error. \u00a0Indeed, many financial models are based on such unrealistic assumptions concerning the stochastic<\/a> properties of the underlying security returns that their findings\u00a0regarding the correct investment values of these securities should be\u00a0taken with a hefty grain of salt.<\/p>\n

This explains why\u00a0on occasion\u00a0many\u00a0investors simply forego such models in favor of their own intuitive judgements. \u00a0In addition, given this lack of knowledge about\u00a0the exact investment values of most securities, it is not surprising that their market prices can temporarily over or undershoot their correct values. \u00a0In\u00a0the long run, however, as more information becomes available, the market\u00a0prices will eventually tend to revert to\u00a0their more rational values.<\/p>\n

 <\/p>\n

Roles of Deregulation and Leverage<\/strong><\/p>\n

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. \u00a0In particular, much of the observed short run excess volatility of the security prices can be attributed to such funding issues as margin calls<\/a>, short coverings<\/a>, and derivatives trading<\/a>. \u00a0Thus, 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. \u00a0Indeed, historically, most major financial crises have been preceded by new financial and lending deregulations. \u00a0While these accommodative policies are often reversed in the aftermath of the crises, they are as readily relaxed once again as the storms are passed. \u00a0Thus, the stage will be set for a new cycle of boom and bust. \u00a0All that will be required will be a new “new thing” to serve as the trigger for the next wave of speculative fever.<\/p>\n

 <\/p>\n

Conclusion<\/strong><\/p>\n

The foregoing discussion should make it clear that\u00a0any 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\u00a0to prevent\u00a0short run inefficiencies and\u00a0excessive speculations in\u00a0the securities\u00a0markets\u00a0is to\u00a0render\u00a0these\u00a0markets more transparent,\u00a0more regulated, and more prudent in the use of funds in financing leveraged investments.\u00a0\u00a0Indeed, 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.<\/p>\n

\n
\n

Hassan Shirvani, Ph.D.<\/a>
\nProfessor Cullen Foundation Chair in Economics<\/p>\n

See more posts by this author<\/a><\/p>\n

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By Dr. Hassan Shirvani—The recent global financial crisis has\u00a0raised serious questions about the rationality of the securities markets. \u00a0In rational markets, prices tend to closely\u00a0track their\u00a0fundamental values, so that\u00a0there is little or no chance of getting price\u00a0bubbles.\u00a0\u00a0During the\u00a0run-up to the\u00a0recent\u00a0crisis, however,\u00a0many asset prices, including those in the\u00a0housing\u00a0sector, seemingly\u00a0deviated\u00a0from their correct values, resulting in subsequent\u00a0financial\u00a0crashes around…<\/p>\n","protected":false},"author":5,"featured_media":437,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_jetpack_newsletter_access":"","_jetpack_dont_email_post_to_subs":false,"_jetpack_newsletter_tier_id":0,"_jetpack_memberships_contains_paywalled_content":false,"_jetpack_memberships_contains_paid_content":false,"footnotes":""},"categories":[44,33,37,6,46,8,47],"tags":[221,18,275,73,22,220],"class_list":["post-436","post","type-post","status-publish","format-standard","has-post-thumbnail","hentry","category-critical-thinking","category-commentary","category-csb-faculty","category-economics-economics","category-ethics","category-finance","category-global-awareness","tag-behavioral-finance","tag-economics-2","tag-ethics","tag-financial-markets","tag-hassan-shirvani","tag-investing"],"yoast_head":"\nA Critique of Behavioral Finance - 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