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The Assault on Mathematical Economics


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08/27/2001Christopher Mayer

The Efficient Market Hypothesis (EMH) must be on its last legs as the reigning paradigm in finance.  If not, then it has become the prefecture of certain unbending professors who pass it on to their young pupils, finance students, and MBAs (poor souls!).  The latest assault, behavioral finance, is hot among practitioners and laymen, as evidenced by the plethora of books in recent years and the heightened prestige and presence of its disciples—Thaler, Odean, Shiller, Shefrin, et al.—as they have become more familiar figures on the financial scene.  More and more, these devotees have been quoted, interviewed, and sought after for their opinions and perspectives on the world’s financial markets.

Even though research commenced in the 1970s, behavioral finance has only now gained wider currency (perhaps under the crushing weight of the evidence against EMH that has grown over the years), with its terminology and ideas more widely disseminated and accepted.  Now, it seems, more and more people have heard about confirmatory bias, prospect theory, anchoring, mental accounting, regret theory, and other concepts brought to light by behavioral finance.

What is behavioral finance?  It is simply the study of how psychological biases influence people’s financial decisions.  

The latest contribution to the literature is a book titled Investment Madness by John Nofsinger (Financial Times Prentice Hall, June 2001, 192 pages), a finance professor at Washington State University.  This slender, enjoyable book is the best summary of behavioral finance I have encountered.  The book deals specifically with how psychological biases affect investors.  The thrust of behavioral finance in recent years has been in showing the flaws of EMH and arguing that psychology—that emotions—do matter and do impact how people behave.  Some of the inefficiencies (in the sense that they do not conform to what EMH predicts) documented in the book are quite remarkable.  

For example, Nofsinger documents obvious mistakes people have made that show demonstrably that the stock market is far from omniscient and all-knowing.  Consider that on April 11, 1997, a Financial Times story reported that the Czech Value Fund was taking heavy losses due to its investment in fraudulent companies.  When the news hit U.S. financial markets, the stock—with the ticker symbol CVF—fell 32 percent on high volume.  The only problem was that CVF was the ticker symbol for the Castle Convertible Fund, not the Czech Value Fund.  By the end of the day, the stock had mostly recovered, but it presented an obvious opportunity for those who knew the real story.  

A similar event happened on June 24, 1998.  The media reported that AT&T was to purchase Tele-Communications, Inc.  On that news, the stock with the ticker TCI jumped nearly 5 percent on thirty-seven times its normal trading volume.  Again a case of mistaken identity, as TCI was not Tele-Communications, Inc., but Transcontinental Realty Investors.  Ironically, Nofsinger reports, the same thing happened to TCI a couple of years prior, when Bell Atlantic announced its intention to purchases Tele-Communications, Inc.

Beyond events like these, many psychological biases are so persistent in so many individuals that it seems difficult anyone could deny their existence. One common error committed by people is representativeness, or making judgments based on stereotypes.  A group of investment students, financial advisers, and MBA students was asked the following question: 

Mary is quiet, studious, and very concerned with social issues. While an undergraduate at Berkeley, she majored in English literature and environmental studies.  Based on this information, which of the following cases is most probable?

The choices were that Mary was either a librarian, or a librarian and a member of the Sierra Club, or was employed in the banking industry.  More than half chose the second answer, because they were influenced by the background information on Mary.  

The correct answer is that it is most probable she works in the banking industry, since the banking industry employs many thousands of people across the country and since there are certainly many more bankers than librarians who are also members of the Sierra Club.  In investing, this error is extended by looking at past performance of stocks and mutual funds as representative of their future returns, an obviously erroneous conclusion demonstrated by performance data collected on many stocks and mutual funds.

Many more psychological biases are illustrated in the book.  Its main point is to just give a glimpse of the types of things behavioral finance researchers investigate.

Interestingly, the idea that human psychology impacts financial decisions is far older than the formal discipline of behavioral finance.  Many investment theorists and writers have taken emotions and human psychology into account from the beginning.  Benjamin Graham, Gerald Loeb, T. Rowe Price, and other famous investors all did.   

A financial classic, first published in 1930 by Fred Kelly and entitled Why You Win or Lose, explicitly deals with human emotions such as greed and vanity and their effects on behavior.  In 1926, Henry Howard Harper wrote a book called The Psychology of Speculation, the topic of which is self-evident, given its title.  In 1923, Thomas Gibson’s The Facts About Speculation stated, "Psychology plays a major role in speculation."  

I am sure there are older books that deal with these issues.  The aforementioned sampling is just from my personal library alone.  The primary difference between these older authors and the more modern "behaviorists" is that the former are not so well-dressed in academic garb, with its attendant credentials and accomplishments.  But the beginnings were there before EMH swept through finance like a tidal wave, washing many of the older theories out of mainstream academia.

While behaviorists have led the charge against the mathematical economics of EMH, Austrian economics has also played a critical role in demolishing the premise of neoclassical economics.  Austrian economics (‘praxeology’) deals with human action as its ultimate given.  Austrians deal with concrete value judgments and human actions.  These actions are always "rational" in the sense that they satisfy some want or desire in the acting human.  Grounded as they are in the reality of human action, the theories of Austrian economics are valid for every human action without regard to its underlying motives or causes.  Therefore, there is no tension between behaviorists and Austrians such as exists between behaviorists and EMH advocates or between Austrians and EMH advocates.

For a behavioral financial economist to say that investors avoid selling losing positions due to regret theory (that is, people generally try to avoid actions that confirm that they have made a mistake) is not contradicted by a praxeological analysis that simply notes the inaction of these investors and states that they did not sell because they preferred holding these particular shares against alternative actions.

Austrians can cheer on the behaviorists, because behaviorists’ successes continue to expose the inadequacies of traditional mathematical economists in its attempt to model human behavior.  In fact, this whole development reminds me a great deal of the emergence of Chaos Theory as a hot topic in finance—and in other sciences—some years ago.  

Murray Rothbard wrote a piece entitled "Chaos Theory: Destroying Mathematical Economics from Within?" in which he generally approved of chaos theory’s subversive influences.  The parallels for Austrians are very similar with regard to behavioral finance.  Rothbard writes:

With their enormous prestige, the chaos theorists have done important work in denouncing these assumptions [referring to EMH] and in reducing any attempt to abstract statistically from the actual concrete events of the real world. . . . [There are] subversive implications that chaos science offers for orthodox mathematical economics.  For if rational expectations theory violates the real world, then so too does general equilibrium, the use of calculus in assuming infinitesimally small steps, perfect knowledge, and all the rest of the elaborate neo-classical apparatus. . . . Austrians can hail the chaos theorists in their invigorating assault on orthodox mathematical economics.

The same can be said for behavioral finance.  We don’t have to swallow their political conclusions or policy recommendations (such as Shiller’s ideas on Social Security reform), but we can nonetheless applaud their efforts in a wider context as an assault on mathematical economics.


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