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1. BEHAVIOURAL THINKING: Defies logic..................................................................................................... 1
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BEHAVIOURAL THINKING: Defies logic
Author: Hunt, Ben

Publication 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 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.
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 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
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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 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.

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 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 decisions. 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.
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
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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 whether
humans 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 copyright
owner. Further reproduction or distribution is prohibited without permission.)
Last updated: 2011-10-12
Database: ABI/INFORM Complete
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