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We must believe in free will, we have no choice. — Isaac Bashevis Singer


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What is behavioural finance?

Ok, as I’ve called my website The Behavioural Quant, I should probably first define the concept of behavioural finance. As with most things, people will for good reasons disagree about what behavioural finance is, and there are many alternative definitions. I will try to give my own take of what it is about.

I will not go through the history of scientific discourse in finance in much detail. Suffice it to say that we have come, in a fashion, round the full circle. In the early days (think of David Hume, Jeremy Bentham, Adam Smith and the time until the mid 19th century), there was much attention paid to the psychological underpinnings of choice, preferences, and utility. And John Maynard Keynes has been much quoted — if not actually read — on the human and social dimension of economics and the animal spirits. Later on, the era of neoclassical economics arrived along with the rational economic agent, and the human and psychological aspects of economic decision making were shunted aside for a time. Starting in 1950’s, the theory of finance grew rapidly with the development of the capital asset pricing model (CAPM), the theory of efficient markets, and the assumption of constant risk premia. Attempts to time the market were deemed futile, given that the expected return on a stock could be explained by the risk-free rate and the product of the stock’s beta and a market risk premium.

The rational worldview survived for quite some time, and was imprinted in the minds of a generation of MBA’s from the best business schools. Eventually it turned out that the theory did not correspond very closely to the reality. Value stocks produced returns unexplained by the beta, momentum stocks did way too well, and investment styles such as carry and trend-following generated abnormally good returns. The stock prices simply seemed to vary much more than could be explained by company fundamentals. And asset price bubbles kept recurring, making the idea of constant risk premia untenable. As a result of such findings, the field of finance has evolved into a much more realistic and eclectic mix. The existence of multiple risk factors, time-varying expected returns, the importance of market micro-structure, and the limits of investors’ rationality are now widely recognised as valid subjects of study. In the process, finance has been cross-fertilised with influences from psychology, neuroscience, physics, and biology.

The fact that the human mind is not the perfect calculator is not perhaps a surprising revelation. However, it was only in the mid 1950’s that the idea of bounded rationality was introduced by Herbert Simon1. To be fair, not even the most orthodox neoclassical economists would claim that all of us are always and fully rational. After all, it is only sufficient that either the economic agents mostly take rational action — regardless of what internal reasoning and mental processing may be taking place — or that the marginal agent is rational and thereby preserves a rational outcome and market equilibrium in the aggregate.

But research by psychologists such as Daniel Kahneman2 and the late Amos Tversky indicates that mental processes do matter. People use various heuristics to help them make decisions. Whilst such heuristics are often useful, effective, and economical in terms of time and effort expended, they lead to systematic biases and errors in many situations involving preferences and choice3.

One finding in psychology is that each of us behaves as if we possess two distinct minds: an intuitive one and a reflective one4. The intuitive mind is good at making rapid and often surprisingly accurate judgments and decisions. The reflective mind is good at logical reasoning and rational analysis. The reflective mind is slow, though, and making use of it takes a conscious effort and energy. Being lazy — as we are — we make most decisions using our intuitive mind, employing those various heuristics which sometimes lead us astray from our best interests.

Our sense of what best serves our interest is a manifestation of our evolutionary heritage. A big part of that heritage is loss aversion, or the fact that potential losses loom much larger than gains of equal size. Loss aversion may have been a valuable survival mechanism in the past, and it still affects our decisions in a world which is very different from those faced by our early ancestors.

The research in cognitive psychology provides a foundation for behavioural economics and behavioural finance. Within economics, work by researchers such as Maurice Allais5 and Daniel Ellsberg6 had already raised question marks about perfect rationality. The field of behavioural economics7 has advanced rapidly since 1980’s through clever and compelling experimental work, the identification of anomalies at odds with the rational theory, and the generation of alternative theories. As an example of the latter, the prospect theory8 of Kahneman and Tversky is a model that is based on psychological findings (such as loss-aversion) and helps explain violations of normative theories of decision making under uncertainty.

The large number of reported anomalies in finance suggests that investors’ bounded rationality matters at the market level9. Anomalies include patterns such as the value effect (the positive relation between accounting variables and subsequent stock returns), the size effect (the tendency of smaller firms’ equity to outperform large-cap stocks), the January effect (larger than average stock returns in the first few weeks of the year), the momentum effect (the tendency of stocks with prior price rises to continue doing well), stock price overreaction (on the longer term, past winners tend to under-perform and past losers tend to outperform the general market), the size of the equity premium (stock returns over time are much higher than justified by the risk), the excess volatility puzzle (the tendency of stock prices to vary much more than warranted by fundamentals) and so on.

Whilst many of the anomalies seem to be at odds with market efficiency, we should keep in mind that the evidence is not always clear-cut. This is partly due to the publish-or-perish nature of the scientific process, where interesting or unusual findings — even when due to chance or data-snooping — have a good chance of being published and advancing a scientific career. And this is partly because any test of market efficiency is always a joint test of a particular theory, so that any apparent violation can often be explained by a different or more elaborate but still a perfectly rational kind of model. And some of the findings may be statistically significant but lacking in economic significance, i.e. impossible to translate into a profitable trading strategy when realistic transaction costs are taken into account. And when profitable trading strategies can be demonstrated, their profitability tends to diminish — perhaps not surprisingly at all — after the publication.

But even with the health warnings10 duly considered, there is a large enough body of evidence to warrant, in the least, a re-examination of theories based on perfect rationality and an all-pervasive notion of market efficiency. The presence of the anomalies — to the extent that they are real — suggests that intuitive decision making combined with occasional irrationality and emotionality on the part of the individual investor is indeed reflected in the aggregate market behaviour.

I don’t view behavioural finance necessarily as a replacement of the neoclassical paradigm. There are many genuinely useful and insightful results which follow from the assumption that economic agents are perfectly rational, and some of the anomalies uncovered in behavioural finance can be explained by tweaking the rational models. But it is now widely accepted that an understanding of the limits of human rationality helps us better describe the economic and financial reality. In time, better financial theories will be produced.

In the meantime, all of us have to make a living and have to think about providing for the days to come. And having some appreciation of the findings in behavioural finance can have a very practical and meaningful impact on the decisions we make. We may make such decisions on an ad hoc basis when thinking of when to buy or sell stocks, or perhaps when making choices about our pension investments. Or we may make such decisions in a much more regular and even automated way, if we seek to grow our own or our clients’ wealth on a daily and weekly basis. And this latter aspect of financial decision making is where this blog seeks to make a contribution.


  1. Herbert A. Simon: A behavioral model of rational choice, Quarterly Journal of Economics, Vol. 69, pp. 99-118 (1955)
  2. Daniel Kahneman: Maps of Bounded Rationality: Psychology for Behavioural Economics, The American Economic Review, Vol. 93, No. 5 (2003)
  3. Daniel Kahneman, Paul Slovic, and Amos Tversky (eds.): Judgment under Uncertainty: Heuristics and Biases, Cambridge University Press (1982)
  4. Daniel Kahneman: Thinking, Fast and Slow, Macmillan (2011)
  5. Maurice Allais: Le comportement de l’homme rationnel devant le risque: critique des postulats et axiomes de l’école Américaine, Econometrica, Vol. 21, No. 4, pp. 503–546 (1953)
  6. Daniel Ellsberg: Risk, Ambiguity, and the Savage Axioms, Quarterly Journal of Economics, Vol. 75, No. 4, pp. 643–669 (1961)
  7. Colin F. Camerer and George Loewenstein: Behavioural Economics: Past, Present, and Future, in: C.F. Camerer, G. Loewenstein, and M. Rabin (eds.): Advances in Behavioral Economics, Princeton University Press (2004), pp. 3-51
  8. Daniel Kahneman and Amos Tversky: Prospect Theory: An Analysis of Decision under Risk, Econometrica, Vol. 47, No. 2, 263-292 (1979)
  9. Nicholas Barberis and Richard Thaler: A survey of behavioural finance, Handbook of the Economics of Finance, Volume 1, Part B, Chapter 18, pp. 1053–1128 (2003)
  10. G. William Schwert: Anomalies and market efficiency, Handbook of the Economics of Finance, Volume 1, Part B, Chapter 15, pp. 939–974 (2003)

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