Workshop in Behavioral Finance

These seminars have been supported since 2001 by Bracebridge Capital, Fuller and Thaler Asset Management, and LSV Asset Management. The Russell Sage Foundation supported them from 1991–2001.

The field of behavioral finance uses a broad social science perspective to study the behavior of financial markets. Methods that originate in psychology are used as research tools, along with traditional finance research methods.

Research in behavioral finance is relatively new: it took place mostly since 1985. The workshop in behavioral finance has continued under the direction of Robert J. Shiller and Richard H. Thaler at the NBER since 1991. Over these years, we have seen the blossoming of behavioral finance into a significant body of knowledge.

The research methods in finance most in use before the advent of behavioral finance did not then seem to lend themselves to the application of psychology. Models of individual optimization were almost exclusively based on the assumption of perfectly rational individual behavior. Many of the predictions of these models were described as representing the notion that financial markets were “efficient,” that is, that prices in financial markets accurately incorporate all publicly available information. Studies of the efficiency of financial markets often reported apparent contradictions of efficient markets in the literature, but, before the development of the theory of behavioral finance, their results were hard to interpret, there being at that time no well-delineated alternative hypothesis to compare with the efficient markets hypothesis.

A substantial share of the research that has been presented at the behavioral finance workshop since its beginnings has been at work in developing alternative theoretical approaches to the study of financial markets. Such theoretical research has taken great impetus from the prospect theory of Daniel Kahneman and Amos Tversky, which was first published in 1979.

This chart shows word counts using Lexis Nexis of the terms "behavioral finance" and "efficient markets" by year in General News, Major Papers, Full Text, scaled by an estimate of the number of words of text on Lexis-Nexis for the year. The chart shows that "behavioral finance" has been growing exponentially starting from several years after we began our workshop series, while "efficient markets" has been declining. The chart is dramatic evidence that behavioral finance has been gaining in the marketplace for ideas.

Prospect theory offered the first significant alternative to the expected utility paradigm that dominated research in finance until then. Prospect theory was based on experimental evidence about human behavior under uncertainty, and was built up to fit the evidence rather than embody an abstract sense of rationality. Prospect theory relies on evidence that when making economic decisions people are easily influenced by framing, that is by the context and ambience that accompany the decision problem. Part of this context is generated by the people themselves, as when they adopt arbitrary mental accounting of their financial circumstances.

Many papers presented at the Workshop in Behavioral Finance are in the realm of clarifying the relevance of prospect theory and its associated issue of framing to financial market phenomena. For example, we have seen studies that use prospect theory to help us to understand the reasons for the apparent excess volatility of certain speculative asset prices, for the momentum that is often seen in these prices, as well as for the mean reversion that is often seen in these prices. Applying the psychological theory to such phenomena gives us a sense when to expect excess volatility, momentum or mean reversion, and when not.

There are many other psychological theories that have been applied successfully to understanding phenomena in financial markets. Extensive psychological research has documented that people tend to be overconfident in their judgments. People tend to show a wishful thinking bias, believing what they want to believe. People show problems of self control, and know that they may be unable to control themselves in the future. People often make judgments using the representativeness heuristic, that is when judging the probability that a model is true, they base their estimate on the degree to which the data resemble the model, rather than do appropriate probability calculations. People tend to exhibit belief perseverance, hanging onto past beliefs long after they should have abandoned them. People tend to make the error of anchoring, that is, when making difficult quantitative judgments they tend to start from some arbitrary initial estimate, often suggested to them by something in their immediate environment, and then allow that initial estimate to influence their judgments. People tend to show an availability bias, overweighting evidence that comes easily to mind, thereby allowing their decisions to be over-influenced by evidence that is more salient and attention-grabbing.

Many of the papers that have been presented at the Workshop for Behavioral Finance have presented empirical work making use of extensive data sets that allow testing for the relevance of such psychological principles in influencing investor behavior. Data used include returns data for speculative assets, data on measures of value relative to fundamentals, and data on the volume of trade. Increasing use has been made of data on individual trades and actions of individual investors, and these data are linked to other data on the characteristics and economic circumstances of these investors. Moreover, significant data have been employed that are generated through either experimental or questionnaire survey methods.

The combination of theoretical and empirical work has allowed us to see the relevance of the basic psychological theories to many financial phenomena. The research has helped us to understand such things as the high volume of trade in some financial markets and its relation to economic circumstances, the tendency of markets to go through periods of high volatility or apparent speculative bubbles, and why issuance of equity by firms goes through alternatively hot and cold periods. The theory helps us to understand the failure of many individuals to save adequately for their retirement, reluctance to purchase indexed bonds and annuities, and underinsuring for some of their biggest risks. Moreover, the research helps us understand why some firms insist on paying dividends despite tax disincentives and others pay no dividends, why investors tend not to diversify effectively, and why investors have a “home bias,” investing in their home country rather than diversify internationally.

Ultimately, this research helps us to understand the limits to arbitrage, that is, to understand the various reasons why the profit motive does not in fact eliminate all market inefficiencies. The research has helped us to understand apparently flagrant pricing anomalies, such as the divergent pricing of virtually the same stock on two different stock exchanges, the large discounts that closed-end mutual funds often show relative to net asset value, or the negative stub value implied by certain spin-offs.

Research in behavioral finance has important applications. The research can help guide portfolio allocation decisions, both by helping us to understand the kinds of errors that investors tend to make in managing their portfolios, and also by allowing us to understand better how to locate profit opportunities for investment managers. Beyond this, understanding the psychological foundation of human behavior in financial markets facilitates the formulation of macroeconomic policy and the devising of new financial institutions.