Behavioral Economics

People and their economic life.
Behavioral economics and Behavioral finance.

How do we behave with money, production, work, spending, saving,
investment?

Behavioral economics and behavioral finance try to elucidate this and
to apply psychology to economics and finance.

Its findings show for example how individual and collective mental
bias can distort decisions and behaviors and bring undesired result
for the person and for the market / the economy.

Those behavioral biases and market anomalies are a dent in the
standard paradigms of market efficiency and economic equilibrium.

sous  brain Do we think and behave strangely
with money, production, work, spending, investment?

What is behind 
economic and financial decisions

Behavioral economics (BE)
and Behavioral finance (BF) are
two closely related areas of knowledge that explore the (important)
part played by psychology in economics and finance.
They tell how people and money live together.
They show more specifically how their interaction delivers
truckloads of
surprise surprises (unexpected consequences).
That explain why economists are often in the fog fog when
they make
predictions.
Nothing wrong as long as they present them as their pet hypothesis
and maybe give a range of others.

But deciders insist to be given precise previsions, instead of thinking
by themselves and trying their luck. They are not always ready to
admit that whatever they do is a bet, a speculation, a risk-taking.
To speculate is what makes human beings differ from lettuces.
Actually, economics and finance, like all social activities, rest largely on
people's
behaviors.
Those behaviors are driven by:
 
* intentions, motives, needs, preferences,
* feelings, (pleasant or unpleasant) emotions
* knowledge and reasoning,
* not to forget some automatic reflexes and habits.
* and collective contagions

One of the thing that
makes the taste of the economic and financial dishes
not fully predictable is that the players are only
sillymad partly rational.
Various mental biases tend to spoil their
decision decisions and bring
unexpected and undesired results. Surprise, surprise!
All of us are economic players.
Our motivations (or impulses) in this area are quite varied.
Rational management is far from being the only one.

You will never imagine some of the fantasies
behind some money decisions ;-).
Therefore, a main factor of uncertainty when doing economic
projections
is the difficuly to predict:
  • How those "economic players" will behave,
  • What economic effects those behaviors will bring.
The two main subfields:
people and markets

BE/BF is not too much interested when things
run in a smooth
and efficient way.

It focuses on cases when they turn wrong,
in other words A)
biases and B) anomalies
.

A) Micro BE/BF: the people and their biases

Drilling the brain

Micro BE/BF studies how individual people as well as
group groups of people make economic or financial
decisions.

Many of those researches got interested (how nosy!) in what kind of
mental and behavioral biases can distort those decisions.

Those human phenomena are
a topic in themselves. They are listed
and
sorted in the behavioral biases article, as
  • Cognitive:
lack of attention, logical flaws, memory biases, mistaken
representations ...
  • Or emotional:
pleasure / pain, affect, overconfidence, hope / greed, fear,
attractions, aversions, mimicry....
  • Or purely instinctive / reflexive (autopilot bias):
habits, reflexes, compulsions, addictions
  • Also heuristics  (mental shortcuts):
They are at the border between cognitive and emotional
biases on one side and
automatisms on the other.
However useful are run-of-the-mill analyses and decisions,
they are often forms of lazy thinking based on
superficial
impressions or feelings, shallow memories or anchored
mental habits / methods.

  • Not only individual flaws but also group collective traps,
because of social interactions / contagions (social learning,
mimicry
and herding...). We are not alone!

Let us be practical:

The windfall of those researches is that most
behavioral biases
and
decision traps do not relate only to financial / economic
matters, but also in most human activities.
In other words, those crucial
BE/BF's findings apply also to many
other decision making situations.


=>
Those flaws / traps  should be known by everybody and
        
taught at school. Yes, I insist! :-)
Of course some are more specific to economics / finance, such as the
loss aversion
(see the prospect theory article).
Specifically also, the
precautions for investors article draws lessons
for financial market players (many of them can be extended to
all economic players).

B) Macro BE/BF: the markets and their anomalies

Report from the playing ground

Macro BE/BF
studies how markets can be affected by deficient
behaviors
(impact on activities, prices, returns, resource allocations).


=> Stock markets are typical examples
, as they are well known
      for fast fluctuations.
      But this is also the case for commodity markets, foreign exchange
      markets...

More specifically, Macro BF and Macro BE try to identify and explain
market
distortasymm anomalies (mispricings...).
A well known one is the price cycle-trends (alternation
of rather long periods of price rise (bull markets) and price fall
(bear markets),
This roller coaster phenomenon often reflect, not only business
evolutions, but also a collective process of
misreaction to
information
(under-reaction -> adjustment -> overreaction).
It can lead to extreme mispricings and excessive evolutions such
as
bubbles and crashes.
As you need some weapons in that mental war, practical methods /
counter-measures used in market
trading entail:
  • Debiasing
(correcting the incidence of emotional biases, cognitive
fallacies or Pavlovian reflexes on market prices / returns /
trends)
  • And rebiasing
(trying to project how those components will evolve).

It can be used in stock markets
   * at the
stock valuation level (for example by using the stock image
      coefficient),
   * or at the trend spotting level when looking at
misreactions (notably
      under-
reaction / overreaction)

BE/BF vs. standard theories

Did traditional economists forget a few things?

BE/BF findings oppose (and erode) standard theses such as:
  • In economics, the rational choice
    (the self centered / interest-wise "economic man"...).
  • In finance, the efficient market hypothesis (EMH)
    and its cousin, the random walk hypothesis (RWH).
Those standard theories, which reached their apex with a flurry
of rocket science like
mathematical models in the 60's and 70's,
as
sumed that:
  • People (*) take into account all relevant information
and think and act rationally,
  • They get an optimal risk risks vs. luckrewards (returns)
balance for their investment,
  • Thus the market reaches the fairest price
between buyers and sellers, a price which is assumed to vary
only when unexpected information hit the market at random,
  • Those  "fair" market prices give the best allocation 
of economic resources allocation.

Would be a wonder if it was true !


(*) Even if not all players are well informed and rational as the mythical
     
"economic man" is depicted, the EMH considers, without much
      evidence, that at least enough of those players have the knowledge
      sources, the brain and the money
to perform the right arbitrages
      that correct immediately any transient
     
distortasymm market anomaly.

In that sense, there is also some parentship between BE/BF and the
study of dynamical systems and emergences.


BE/BF recognize that the economic equilibrium, another standard -
but dubious - paradigm, is never fully reached as human and social
elements (among other causes of disruptions) make things evolve
endlessly.

Recent approaches and findings

A guided tour of the lab

BE/BF, which are areas of study only a few decades old, drew originally
some notions
from other academic fields such as the psychology of
motivations and social psychology
.

Then came more specific researches, directly linked to economic
and finance.
=> They brought a flurry of new notions, notably about biases and
      heuristics, on 
money-related decisions and the associated
      market anomalies.
The most famous one is the "prospect theory" mentioned
above.
It states that people usually give a much higher (negative) value
to a loss than a (positive) value to a gain of the same amount.
BE/BF get also inspirations from more recent research methods that
explore the human decision-making process.
Those new fields, that are bringing new findings are:
  • Experimental economics / experimental finance:
It rests mostly on decision-making simulation in small groups.
Those "games" are supposed to show how players behave in
situations that try to simulate real markets
.
Of course there might be some differences between how a small
group behaves as rats in a lab and how a market
with millions of
players works.
  • Neuroeconomics / neurofinance
derived from neurosciences.
Their main tools are to scan the brain and detect brain areas,
chemical secretions and electric waves involved in decisions,

Those researches show for example how
emotional factors,
notably
pain pain and pleasure pleasure can overcome the
rational process and impact
money-related decisions.

This is not to say that emotions should be fully
suppressed
, as actually  :

* there are positive ones (for example optimism is a bias,
   it can even be naive, but it can also help to live)
* emotions generally are the main motivators of
   actions
and thus they avoid people to be as passive as
   lettuces.


But to be conscious of those emotions can help avoid destructive
ones.


A specific application is neuromarketing: how the brain react to
a product, to an advertisement. This can lead to manipulation,
playing on emotion and suppressing rational thinking ...until
consumers discover the trick, of course!

References

This article is based on the Behavioral finance gallery,
my extensive glossary / encyclopedia
of behavioral economics and finance.


When looking for academic references

on specific BE/BF phenomena, click
http://www.behaviouralfinance.net/

A classic book focusing on investing and BF is:

SHEFRIN, Hersh, 2000. Beyond Greed and Fear :

Understanding Behavioral Finance and the Psychology
of Investing.

(sample / échantillon)

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     M.a.j. / updated : 31 July 2015
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