Tuesday, December 06, 2011

Behavioral Economics and Finance - Waking up to reality!!

I had always wanted to read more about behavioural economics and finance but had been putting it off till recently. Owing to some generic stimuli as well as a real potential use in my professional life I have started reading up quite extensively on the topic. This area is indeed like the proverbial rabbit-hole – one does not know how far it can take us and what all it can open up.


An actual account of what behavioural economics is probably for later. Here is a good link to start with. A useful paper covering the background can be found here. A good lecture series - here - is also available on youtube. What is more interesting right away is the potential this domain has for reforming economics as well as finance as we know it. There are many way in which it can do so. I have summarized the following. These are not extensive.

1. There has been an appalling lack of reliance on the use of scientific method in evaluating candidate models and theories in economics. Data is used but it is historical and probably selected with a bias. In fact considering that most theories are designed to explain past observation, it is no achievement that the theory at least partially explains what was observed. It is like in-sample optimization. There is rarely an equivalent of out-of-sample optimization. Unlike theories of physics and chemistry, those of economics do not necessarily pass by predicting things that can then be verified. There are of course many reasons for that – most important being the inability to recreate precise conditions of testing theory. But there is no serious attempt to work around this limitation.

The results are obvious. Many theories are worshipped in the face of consistent contradictory evidence against them – efficient market hypothesis being the commonest example. Behavioral school of thought starts from the actual nature of human beings and then goes to construct its theories. This is not fool-proof nor does it have a certainty of producing results. But at least in the spirit of common sense as well as robust scientific process it seems like a good idea!

2. Rational economic agent is a foolish concept. It is probably the worst part of the theoretical foundations of the neoclassical economics and modern finance. The metanarrative of the REA is one where there is perfect and symmetric knowledge, no emotional interference from the actors’ minds, perfect coherence between the mathematically right answer and the appealing-to-real-human answer. The attempt is laudable to explain human choices. However, it is fundamentally wrong in so many of its assumptions that it explains almost nothing relevant and predicts even less. The most damaging characteristic of the metanarrative however is its treatment of what is not within its purview. When human beings do not follow the predictions of the REA school of thought, it is termed “irrational”, “inefficient” and some such term. This treatment itself smacks of a rather narrow thinking process which is quite dogmatic and terms everything outside of it (almost the whole real world) as some sort of anomaly. There is some intellectual hubris here. More damagingly, there is a na├»ve hope that the “anomalies” only await some refinement of theory and can then be “explained away” while preserving the grand narrative of the rational economic agent!

3. Considering the complex nature of macroeconomics and the problem it deals with there is a serious lack of multi-disciplinary approach. Sociology and psychology have a lot to teach economics in terms of the behaviour of its key decision makers. Physics has a lot to teach in terms of experimental method as well as some models of collective behaviour.

All in all, post the recent crises through last couple of decades, economics as a discipline is anyway due for an overhaul. Being able to predict bubbles, having the ability to explain the complex interactions amongst global consumers, producers, investors and investees and in general creating a coherent thinking framework which does not keep relying on the proverbial “other hand” of the economist is certainly the need of the hour.

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