Financial Planning > Behavioral Finance

Finance Has Caught On to Behavioral Economics

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A lot of ink has been spilled (some of it by yours truly) about behavioral economics on the occasion of  of Richard Thaler’s new book, “Misbehaving.” The debates echo others that have been reverberating through the halls of academia since the 1980s. In general, behavioral economics has failed to penetrate the field of macroeconomics. University of Michigan macroeconomist Christopher House — typically a staunch defender of the status quo in the field – wrote last year that behavioral econ was a “fad” and has been largely a failure. 

But while macro has resisted behaviorism, finance has accepted the new ideas without even breaking stride. Behavioral finance chugs along mostly undisturbed.  

Part of the reason is a difference in definitions. To most economists, behavioral economics means using findings from psychology to modify models of individual behavior. But behavioral finance has come to have a much more expansive meaning, basically encompassing anything that doesn’t conform to the Efficient Markets Hypothesis (which says that you can only earn market-beating returns by taking on extra risk). 

That’s a lot more general. Showing that standard finance theory fails is a lot easier than showing that psychology is the reason it fails. For example, take Robert Shiller’s famous finding that stock prices fluctuate more than fundamentals would seem to warrant. That finding — which won the Yale economist a Nobel prize — is regularly referred to as a triumph of behavioral finance. 

But Shiller didn’t discover why prices bounce around too much. There could be a bunch of reasons. Many of those reasons are related to psychology, but Shiller didn’t have to come up with a specific psychological theory or experiment before his finding was labeled “behavioral.” Basically, anything that pokes holes in the standard theories offered by Eugene Fama, usually credited as the father of EMH, gets the behavioral moniker. Thaler’s finding that stock prices overreact and reverse themselves is also called “behavioral,” even though it isn’t yet known whether the reversal is the result of human psychology or some quirk of the financial system. 

That’s not to say that specific psychological theories haven’t seen success in the finance field. For example, take this 2013 paper by Kelly Shue and Stefano Giglio of the University of Chicago Booth School of Business. Entitled “No News is News: Do Markets Underreact to Nothing?,” the paper uses the psychological idea of inattention to predict anomalous price movements in companies that are the target of takeover bids. 

This idea is pretty cool, so let me explain how it works. When a company declares its intent to buy another company, there is a period of time before the deal is either finalized or dropped. If the deal is finalized, the target company’s stock price will rise; if it’s dropped, the price will fall. So knowing whether the deal will be finalized or dropped would be very useful for investors. 

But here’s the thing — the probability that the merger will be successful doesn’t just remain unchanged after the announcement. Deals tend to fall through either very quickly or after a very long period of time. This is the same with job interview callbacks – you tend to either get turned down very quickly, or simply forgotten. So the price of takeover targets should rise for a while after the deal is announced, then fall. No news, in this case, really is news. 

Shue and Giglio, however, know that humans tend to be inattentive. When nothing seems to be happening, people tend to pay attention to other events where there is more visible action. So Shue and Giglio hypothesized that investors would ignore the passage of time when pricing merger targets. The price ought to rise and fall as time passes following the merger announcement, but Shue and Giglio predicted that it would be almost unchanged. 

They were right. Prices of merger targets move much less with the passage of time than they ought to. This represents a buying opportunity for astute investors. Shue and Giglio calculate the potential returns to an investor who takes advantage of this mispricing, and find them to be fairly substantial. 

This is a victory for behavioral finance. It isn’t a world-shattering, smashing victory — it’ a small, solid, interesting victory. And in finance, that’s enough. Macroeconomists are usually seeking a grand theory of everything, but finance researchers are just interested in finding things that work. If a technique from physics helps price options, use it. If a machine learning an algorithm allows you to predict prices better, use it. If an insight from psychology helps you make a few extra bucks, by all means, use it!

Where economics is philosophical, finance is pragmatic. And behaviorism is just another tool in the toolbox.

The list of behavioral finance successes is long. No introductory finance course would be complete without them. In addition to identifying anomalies in prices, behavioral finance has found that individual investors — i.e., you and I — suffer from a large number of biases, and that their wealth suffers as a result. That is a finding that directly affects the pocketbooks of millions of Americans. 

So the next time some macroeconomist tells you that behavioral economics is passe, tell them that behavioral finance is alive and well.