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ics and finance rejected the study of human behavior and haven't ... into behavioral finance .... theories, nor has he wanted to be confined to the ivory tower.
Beyond Belief Pioneering insights into behavioral finance BY CYNTHIA HARRINGTON, CFA

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raditional economics holds that human beings make rational decisions that maximize their

current economic benefit. But the real behavior of investors often contradicts that notion. The enthusiasm of market players that caused the boom/bust cycles of the Dutch tulip bulb mania, the South Sea Bubble, the Great Crash of 1929, and the recent technology bubble are prime examples of irrational behavior. A growing number of academics and practition-

ers are studying how humans really act in an attempt to better understand markets and investors. Economics and finance rejected the study of human behavior and haven’t developed many tools necessary for the inquiry. So people interested in behavioralism turned to psychology for answers. Much of the current research in the field stems from the work of two psychologists, Daniel Kahneman

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That’s Not What’s Supposed to Happen

and Amos Tversky. Their papers “On the Psychology of Prediction” in 1973 and “Judgments Under Uncertainty: Heuristics and Biases” in 1974 spurred decades of debate about whether humans are rational. Their work also linked cognitive research to broader applications than psychology. Kahneman received the Nobel Prize in economics last year in

Illustrations: Sally Wern Comport

recognition of his important work.

Despite his formal training in standard economics, Vernon Smith’s work with subjects in the laboratory led him to step outside his training when his early experiments cast doubt on two principles of standard finance. He found that markets can be efficient even with very few participants, which contradicted the belief that efficiency depended on large numbers of players. He also found that markets reached equilibrium with vastly less information than was believed. “During these experiments, I let my subjects teach me a lot of things,” says Smith. “And I became skeptical of standard finance and continued to test real behaviors instead of the predetermined assumptions.” Smith is a leader in the field of experimental economics in which researchers create experiments in labs to watch and quantify how humans make decisions. He designed the first experiments while he was a graduate student at Harvard. His work focuses on testing the performance and functions of markets. “One surprising finding is that markets work a whole lot better than they have a right to,” says Smith. One such experiment sets up subjects as traders in three types of markets. Some trade in unilateral markets where providers set prices, like electricity markets or water markets. Others trade in bilateral markets, with buyers and sellers finding each other and making direct contracts between the two parties. Yet others operate in continuous two-sided bid-ask systems, like electronic exchanges. The bid-ask markets quickly converge to efficiency, with traders rapidly assimilating the trading behaviors of other

True to the eclectic nature of its contributors, the area of study itself goes by many names — behavioral finance, behavioral science, behavioral economics, cognitive psychology, and cognitive science. To tell the story of how the ideas developed and what findings have emerged, we spoke with four pioneers. Each of these researchers broke with his early training to seek the truth of the reality he observed. Vernon Smith shared the Nobel Prize in 2002 for

VERNON SMITH, PH.D.

his experimental economics work that helps explain

Professor of Economics and Law George Mason University Fairfax, Va., USA

how and why markets function. Richard Thaler studies investor behavior and how securities become mis-

Classifies his work as “experimental economics,” not part of behavioral finance. Advises researchers to investigate what works as well as what doesn’t; to expand past anomalies, errors, and biases; to study survival as well as maximization.

priced. Hersh Shefrin contributes to the understanding of individuals’ irrational decisions. Robert Shiller’s work addresses the effects of irrationality on market indexes in addition to proposing a framework for how investors might handle risk. Their combined stories document the genesis and development of the field of behavioral finance.

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market participants. In contrast, “markets in which participants must find each other, undergo the laborious process of learning how to price transactions, and settle trades between two participants stay inefficient,” says Smith. The next phase of the experiments holds the biggest surprise. Once subjects have gone through the first round of trading in the different market structures, they are given a choice of what type of market they want to participate in. Standard finance assumes the choice of the efficient market, where participants maximize their financial gains. But that’s not what happens in every case. “The puzzling part of this experiment is why participants do not always go to the bidask model,” says Smith. “People have lots of confidence in their ability to just go it alone. We have a long way to go to understand this choice.” Smith is fascinated by this behavior, called the “bilateral bias.” Despite the advantages of the bid-ask market, participants will look to do direct deals and split the difference of the spread. It is why every exchange has rules against off-floor trading. Yet not all market participants involve themselves in off-floor trading. Smith is particularly interested in understanding how institutions overcome the urge to bilateral trade. “I look for variations beyond what is observed,” he says. “I look to study both what is, in addition to what is not.” Smith also points to what he calls survival economics, as opposed to maximization of profits. An example is found in research of investors’ choices of stocks. Standard finance posits that investors prefer maximization of cash flow, and so will buy dividend-paying stocks over those with no current payout. In fact, research shows that investors don’t always seek current cash flow. “Here, we have to question whether the behavior is irrational,” cautions Smith. “It might actually be survival economics, because these investors might be trying to ensure the company doesn’t go bankrupt by voting to leave cash in the company.” Smith’s groundbreaking methods of studying economic decisions using laboratory subjects have broad applications. Deregulation of the electricity markets and the development of new markets, like landing slots at airports, all benefit from his research. “Markets don’t always work the way law and economic scholars predict,” he says. “What is expected is not always what happens.”

the stock market in coming years.” The story of the timing of Irrational Exuberance is rooted in the editor’s history. Shiller’s editor at Princeton University Press rushed the book to press to avoid a past mistake. He had worked on a book on Saddam Hussein that was released a few days after the 1991 Gulf War ended. Shiller interrupted the writing of another book (The New Financial Order, now out), to pen the now-legendary tome. “My friend Jeremy Siegel insisted on it,” he says. “It was a painful decision to change the scheduling and all along I was afraid the market would crash before we had released the book.” Clearly, Shiller made the right decision, as Irrational Exuberance with its impeccable timing helped to popularize the concepts of behavioral finance as applied to equity pricing. Despite the broad readership of Shiller’s book and its appearance on the New York Times nonfiction bestseller list, most investors let the evidence go unheeded. A smattering of people called to thank Shiller for saving them money. One quantified the savings at US$20 million. But “all of them seemed to be individuals,” says Shiller. “Professional investors likely read the book, but fiduciaries are slow to act on the kind of book I wrote. Prudent people need a longer time to deliberate, and to corroborate any new thinking.” The newness of the field of behavioral finance is its greatest challenge. In academia, the long-standing tradition of standard finance is to neglect psychology. Technical analysis introduced methods of understanding investor psychology, but the technical approach was rejected as well.

ROBERT SHILLER, PH.D. Stanley B. Resor Professor of Economics Yale University New Haven, Conn., USA

The Crash Is Coming, The Crash Is Coming In the year 2000, just three days before the market peak, Robert Shiller’s book Irrational Exuberance hit bookstore shelves. In his book, Shiller warned investors that stock prices were too high by any number of historical measures and that the “public may be very disappointed with the performance of 28

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Believes behavioral finance is broader than behavioral psychology … that it’s the application of broader social sciences to finance, predicated on the idea that human behavior is complicated. Suggests that researchers and practitioners continue the trend of observing and analyzing real behavior.

Shiller likens behavioral finance to hypnosis in psychology. “Scholars see themselves as being precise and scientific,” he says. “When early showmen tarnished hypnosis, the entire practice was dropped from psychology for decades.” Shiller’s break with traditional finance is prompted partly by his environment and partly by his world view. His environment is heavily influenced by the profession of his wife of 27 years: psychology. But his biggest motivation is that he is a self-described curmudgeon. “I want to look at whatever view is not popular,” he says. “If everyone is doing one thing, I want to investigate something else.” He has never fit entirely into the academic world of elegant theories, nor has he wanted to be confined to the ivory tower writing papers. Shiller lives enough in the real world to be generally called a “political economist.” While the definition of the term is fuzzy, Shiller speaks to his belief that economists should have more influence on public policy. Instead, lawyers take the lead on that front because their training is steeped in case studies based on reality. “Policymakers have to immediately confront the financial behaviors of people,” he says. Behavioral finance is the answer to grounding finance and economics in reality. Since economists generally study numbers, their research can be hard to interpret. Behavioral finance proponents borrow the experimental techniques of studying what humans really do from psychology labs. “While economists can lose touch with reality and get lost in the numbers, studying people individually helps make sense of reality,” says Shiller.

RICHARD THALER, PH.D. Robert P. Gwinn Professor of Behavioral Science and Economics University of Chicago Graduate School of Business Chicago, Ill., USA

Considers behavioral finance to be a non-dogmatic field, a reaction to dogmatism. Says it works against the claim that we can explain everything about economic behavior from models of rational actors. Predicts that behavioral finance will end; finance in general will become behavioralized.

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While the practice of observing behavior is an improvement over ignoring reality, it’s hard to cement the results. Researchers are still working to discover what the conclusions mean to investors. Opponents to behavioral finance also sound another criticism. “The field is borrowing from psychology, and people in that area haven’t really come up with all the solutions to the problems they study,” says Shiller. The awarding of the Nobel Prize in economics in 2002 to two scholars in the behavioral field is a sign that the new study of behavior is gaining acceptance. But Shiller emphasizes the need for patience. “Market efficiency is a much touted, overextrapolated line of thinking,” he says. “Getting past the efficient market theory is going to take time. In the world of academia, everything must be proven.”

It Can’t Be Rational to Sell at Less than Zero If investor behavior were rational, then 3Com would not have sported a negative market value for a few months after the Palm Pilot spin-off. For several months after 3Com distributed shares of Palm Pilot to shareholders in March 2000, Palm Pilot traded at more than the inherent value of the shares of the original company. “This would not happen in a rational world,” says Richard Thaler. The 3Com story is an example of one of the strengths of behavioral finance: the use of behavioral questioning to explain an area of traditional finance. The 3Com case is one in the growing body of literature of what has come to be called the “limits to arbitrage.” “Behavioral theory has begun to make important contributions to the problem of anomalous asset pricing in general,” says Thaler. The 3Com story owes part of its irrationality to high investor emotions during the tech boom. Despite the difficulty that rational, efficient market proponents have in explaining the rise and fall of the NASDAQ in the late 1990s, many in standard finance contend that there’s no proof there was a bubble. Thaler does not hesitate to label the boom of the ’90s a bubble. As he talked with professional investors during that time, he’d ask how they valued a portfolio of the top Internet stocks. Despite valuing these techs at 50 cents on the US dollar, the same professionals predicted that prices would go higher in the succeeding six months. These opposing expectations are symptomatic of a bubble. “Bubbles are easy to recognize, but it’s hard to know when they’re going to end,” says Thaler. “The next one will be a long way off and will be different in character from the last. I’m not certain that we’ve learned anything so far to help with the answer to that question.” Thaler’s break from traditional finance started when he worked on his Ph.D. thesis, entitled “The Value of Saving a

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A Behavioral Finance Timeline

HISTORY OF THOUGHT

Life: A Market Estimate.” Thaler conducted a survey to determine what compensation people demanded to do risky jobs such as being a window washer or a miner. For fun, he started asking people additional questions. He tested one pair of questions concerning death. The first queried how much subjects would be willing to pay to eliminate a small risk of death, say 1 in 1000. The second questioned how much they would need to be paid to accept a higher risk of death. “Rational economic theory states that the answer to these two questions should be the same,” says Thaler. “But I found that, at a minimum, people demanded twice as much to accept a higher risk of death than they would pay to eliminate a small risk of death.” The direct study of investor behavior is a unique contribution to the field of finance. The field is also opening up new areas of data to consider. One topic of great interest to practitioners is the behavior and process of decision making of investment committees and portfolio managers. Thaler is studying decision making by portfolio managers at Fuller & Thaler Asset Management, Inc., the asset management firm where he sets strategic direction and enhances the research and investment processes. “We invite other firms to join in the inquiry,” he says. But behavioral finance will not ever coalesce around a single theory that has the power and simplicity of the efficient market hypothesis. “Behavioral finance is all about complicating things,” he says. “Once the representative agent in the economy is more human, the study of finance becomes messy.”

The Power of Denial Hersh Shefrin sees the strength of behavioral finance in helping to make sense of the divergence between theory and practice. Strict adherents to the efficient market hypothesis will be surprised by reality time and time again. Take the Crash of 1987, for instance. Efficient market theorists would say the market was either efficient before, or it was efficient after, but they can’t claim both. Then they have to say that the market is inefficient sometimes. “These are issues that investors must confront squarely, but too often they just push it back under the carpet in denial,” says Shefrin. Shefrin’s particular area of interest is in investor behavior, as opposed to the study of market prices. His book Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing described the findings of behavioral finance for investors in 1999. For those who cared to listen, the warnings of the coming bust were catalogued in his book. He showed that investors were putting excessive weight on what had happened, and that meant excessive optimism after a string of positive events. A spurt in corporate earnings in 1994 and 1995 coincided with excitement over the potential of the Internet. Investors exhibited classic behavioral finance conditions of crowd mentality, of confirmation bias, and of overvaluing what they wanted to hear while undervaluing what they didn’t. “Studies of investor behavior have a way of grabbing us

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Vernon Smith pioneers the use of laboratory experiments in evaluating the performance and function of markets.

Amos Tversky and Daniel Kahneman publish “Belief in the Law of Small Numbers.” 1971. Psychological Bulletin 76: 105-110.

Richard Thaler publishes “On Optimal Speed Limits” in Auto Safety Regulation: The Cure or the Problem?, eds. Henry Manne and Roger Miller (T. Horton, 1976).

Hersh Shefrin publishes “Differential Information and Informational Equilibrium.” 1978. Economics Letters 1.

Publication of Judgment Under Uncertainty: Heuristics and Biases. Eds. Daniel Kahneman, Paul Slovic, and Amos Tversky (New York: Cambridge University Press, 1982).

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Robert Shiller publishes “Rational Expectations and the Dynamic Structure of Macroeconomic Models: A Critical Review.” 1978. Journal of Monetary Economics 4: 1–44.

and shaking us and making us realize that we don’t understand the world as well as the traditional framework would suggest,” he says. Shefrin personally trained in the rational expectations school after earning an undergraduate degree in physics. His departure into behavioral studies occurred while conducting research on liquidation issues in real estate for his Ph.D. thesis, granted from the London School of Economics in 1974. “When I had to interact with non-academic people in the field, I had to learn to think differently about what I was studying,” he says. “The work was not fitting into the rational models.”

HERSH SHEFRIN, PH.D. Mario L. Belotti Professor of Finance Leavey School of Business, Santa Clara University Santa Clara, Calif., USA

Believes behavioral finance is an “area” of finance generally on par with asset pricing and corporate finance at professional conferences. Contends that finance needs better psychological theory and economists need to delve more deeply into their understanding of psychological theory.

Despite his extensive research and belief in the advancement of behavioral finance, Shefrin admits there are no answers yet to the strongest criticism of the field. Efficient market theorists state plainly that their theory can be wrong in many ways, and that makes it an easy target. “They ask us to tell them what markets are if they’re not efficient,” says Shefrin, “but we have no answer to their challenge.” Shefrin defines another gap in the behavioral finance camp. Those studying in the area are not well trained on the psychology side. There’s a need to develop the psychological theory behind economic behavior. One solution to this is his vision of programs at the graduate level in which finance scholars work together with practitioners of psychology, much like economics and econometrics came together. “Right now, if behavioral theorists find a new empirical phenomenon, they tend to reach up on the shelf and pull out the latest psychology theory to explain it,” says Shefrin. But he emphasizes the slow speed at which the area of behavioral finance is progressing. The tendencies to do things the way we have always done them are strong, and they are built into a survival strategy that’s been helpful to us so far. For much of evolution, we haven’t had to deal with things like sophisticated organized markets. “Human beings are wired to have to learn the hard way,” he says. These pioneers in the area of behavioral finance emphasize that we are still early in this study. “I have to be careful about overconfidence myself in predicting that we might learn enough in three or four generations to keep from repeating investment mistakes,” says Shefrin. “The truth is we’re better at predicting the moves of heavenly bodies than we are at using the understanding of irrational finance.” Cynthia Harrington, CFA, is a financial journalist with 20 years’ experience in the investment business.

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Hersh Shefrin and Meir Statman publish “The Disposition to Sell Winners Too Early and Ride Losers Too Long: Theory and Evidence.” 1985. Journal of Finance 40: 3.

Vernon Smith, James Cox, and James Walker publish “Bidding Behavior in First Price Auctions: Use of Computerized Nash Competitors.” 1987. Economic Letters 23: 239-244.

Richard Thaler publishes “Doing Economics without Homo Economicus” in Exploring the Foundations of Research in Economics: How Should Economists Do Economics?, eds. Steven Medema and Warren Samuels (Cheltenham, UK and Lyme, NH: Elgar, 1996).

Hersh Shefrin publishes Beyond Greed and Fear: Understanding Behavioral Finance and the Psychology of Investing. (Harvard Business School Press, 1999). Revised version (Oxford University Press, 2002).

Three days before market peak, Robert Shiller publishes Irrational Exuberance. (Princeton University Press, 2000). Book immediately becomes a New York Times non-fiction bestseller.

Nobel Prize in economics awarded to Daniel Kahneman for “having integrated insights from psychological research into economic science.” Vernon Smith shared prize for “having established laboratory experiments as a tool in empirical economic analysis.”

Richard Thaler and Werner De Bondt publish “Does the Stock Market Overreact?” 1985. Journal of Finance 40: 793-805.

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